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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D. C. 20549
FORM 10-K
[x] Annual Report Pursuant to Section 13 or 15 (d) of the Securities
Exchange Act of 1934
For the fiscal year ended December 31, 2004
[ ] 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 0-5544
OHIO CASUALTY CORPORATION
(Exact name of registrant as specified in its charter)
OHIO 31-0783294
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
9450 SEWARD ROAD, FAIRFIELD, OHIO 45014
(Address of principal executive offices) (Zip Code)
(513) 603-2400
(Registrant's telephone number)
SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:
NONE
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
Common Shares, Par Value $.125 Each
(Title of Class)
Common Share Purchase Rights
(Title of Class)
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.
Yes [X] 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 an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act).
Yes [X] No [ ]
The aggregate market value as of June 30, 2004 of the voting stock held by
non-affiliates of the registrant was $1,162,813,516 determined by multiplying
the price at which the common equity was last sold as of the last business day
of the Registrant's most recently completed second fiscal quarter. Such
determination shall not, however, be deemed to be an admission that any person
is an "affiliate" as defined in Rule 405 under the Securities Act of 1933.
On March 1, 2005 there were 62,445,018 common shares outstanding.
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DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Registrant's definitive Proxy Statement for its Annual Meeting
of Shareholders to be held on May 18, 2005, are incorporated by reference into
Parts II and III of this Annual Report on Form 10-K.
2
TABLE OF CONTENTS
Page
----
PART I
Item 1. Business 4
Item 2. Properties 14
Item 3. Legal Proceedings 14
Item 4. Submission of Matters to a Vote of Security Holders 15
PART II
Item 5. Market for Registrant's Common Equity, Related Stockholder Matters
and Issuer Purchases of Equity Securities 16
Item 6. Selected Financial Data 17
Item 7. Management's Discussion and Analysis of Financial Condition and Results 18
of Operation
Item 7A. Quantitative and Qualitative Disclosures about Market Risk 45
Item 8. Financial Statements and Supplementary Data 46
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure 46
Item 9A. Controls and Procedures 46
Item 9B. Other Information 47
PART III
Item 10. Directors and Executive Officers of the Registrant 47
Item 11. Executive Compensation 48
Item 12. Security Ownership of Certain Beneficial Owners and Management 48
Item 13. Certain Relationships and Related Transactions 48
Item 14. Principal Accounting Fees and Services 48
PART IV
Item 15. Exhibits, Financial Statement Schedules 49
Signatures 74
Index to Exhibits
Exhibit 4a Certificate of Adjustment
Exhibit 10.1 Form of Change in Control Agreement
Exhibit 10.2 Amended and Restated Ohio Casualty Corporation Directors
Deferred Compensation Plan
Exhibit 10.3 Form of Stock Option Agreement
Exhibit 21 Subsidiaries of the Registrant
Exhibit 23 Consent of Independent Registered Public Accounting Firm to
incorporation of their opinion by reference in Registration
Statements on Forms S-3 and Form S-8
Exhibit 31.1 Certification of Chief Executive Officer of Ohio Casualty
Corporation in accordance with SEC Rule 13(a)-14(a)/15(d)-14(a)
Exhibit 31.2 Certification of Chief Financial Officer of Ohio Casualty
Corporation in accordance with SEC Rule 13(a)-14(a)/15(d)-14(a)
Exhibit 32.1 Certification of Chief Executive Officer of Ohio Casualty
Corporation in accordance with Section 1350 of the
Sarbanes-Oxley Act of 2002
Exhibit 32.2 Certification of Chief Financial Officer of Ohio Casualty
Corporation in accordance with Section 1350 of the
Sarbanes-Oxley Act of 2002
3
PART I
ITEM 1. BUSINESS
(a) GENERAL DEVELOPMENT OF BUSINESS
Ohio Casualty Corporation (the Corporation) was incorporated in Ohio in 1969.
With its predecessors, the Corporation has been engaged in the property and
casualty insurance business since 1919. The Corporation has six direct and
indirect subsidiaries which are collectively known as the Ohio Casualty Group
(the Group). The Group actively writes commercial, specialty and personal lines
business in over 40 states. The Group consists of:
- - The Ohio Casualty Insurance Company (the Company);
- - West American Insurance Company (West American);
- - Ohio Security Insurance Company (Ohio Security);
- - American Fire and Casualty Company (American Fire);
- - Avomark Insurance Company (Avomark); and
- - Ohio Casualty of New Jersey, Inc. (OCNJ).
On December 1, 1998, the Company acquired substantially all of the assets and
assumed certain liabilities of the commercial lines division of the Great
American Insurance Company (GAI) and certain of its affiliates. The major lines
of business included in the acquisition were workers' compensation, commercial
multi-peril, umbrella, general liability and commercial auto.
During the fourth quarter of 2001, OCNJ entered into an agreement to transfer
its obligation to renew private passenger auto business in New Jersey. This
transaction effectively exited the Group from the New Jersey private passenger
auto market beginning in March of 2002. Under the terms of the transaction, OCNJ
agreed to pay $40.6 million to a third party, Proformance Insurance Company
(Proformance), to transfer its renewal obligations. The before-tax amount of
$40.6 million was charged to income in the fourth quarter of 2001 with payments
made over the course of twelve months beginning in early 2002. The contract
further stipulated that a premiums-to-surplus ratio of 2.5 to 1.0 must be
maintained by Proformance on the transferred business during the periods of
March 2002 through December 2004. If this criteria is not met, OCNJ will have to
pay up to a maximum cumulative amount of $15.6 million to Proformance to
maintain this premiums-to-surplus ratio. For further discussion on this
transaction, see Item 7, Management's Discussion and Analysis of Financial
Conditions and Results of Operation on page 19 of this Annual Report on Form
10-K.
The Corporation continually evaluates the competitive environment within the
insurance industry. Most high performing insurance companies, including a number
of peer companies, have achieved combined ratios in the low 90% to 100% range.
Also, the surplus positions of many of these companies have strengthened, while
at the same time investment income growth has been constrained by the low yields
on new investments. In addition, the industry took less aggressive price
increases in 2004 in most insurance product lines and had an increased focus on
the quality of reinsurers. Recognizing that improved industry results may mean
further price competition, the Corporation has taken steps in 2004 to achieve
improved profitability through expense reduction initiatives while maintaining
disciplined underwriting and pricing.
In September 2003, the Corporation announced its Corporate Strategic Plan for
the 2004-2006 time frame. The plan brings together five broad objectives to help
achieve the Corporation's Vision to be a leading super regional Property and
Casualty carrier providing a broad range of products/services through
independent agents and brokers. The broad objectives include the ability to
generate above market growth, produce competitive loss ratios, create a
competitive expense structure, achieve a competitive return on equity and
improve credit ratings and financial flexibility. Competitive advantages include
strong agency relationships, especially with key agents, and technology
platforms that will provide superior operating flexibility. Technology is being
leveraged to make it easier for agents to do business with the Group and to
increase pricing and underwriting sophistication.
4
ITEM 1. CONTINUED
(b) FINANCIAL INFORMATION ABOUT SEGMENTS
The revenues and operating profit of each reportable segment for the three years
ended December 31, 2004, 2003 and 2002 are set forth in Item 15, Note 13,
Segment Information, in the Notes to the Consolidated Financial Statements on
pages 67 and 68 of this Annual Report on Form 10-K. The combined ratios and
component ratios for each reportable segment for the three years ended December
31, 2004, 2003 and 2002 are presented in Item 7, Management's Discussion and
Analysis of Financial Condition and Results of Operation on pages 29 and 30 of
this Annual Report on Form 10-K.
(c) NARRATIVE DESCRIPTION OF BUSINESS
SEGMENT DESCRIPTION
COMMERCIAL LINES SEGMENT
The Group's Commercial Lines segment accounted for 57.0%, 55.0% and 52.6% of net
premiums written in 2004, 2003 and 2002, respectively, consisting of the
following product lines:
(in millions) 2004 2003 2002
- ------------- ------- ------- -------
Workers' compensation $ 132.9 $ 132.4 $ 143.9
Commercial auto 233.5 228.3 213.4
General liability 89.5 83.4 84.5
CMP, fire and inland marine 372.3 348.5 320.4
------- ------- -------
Total Commercial Lines $ 828.2 $ 792.6 $ 762.2
======= ======= =======
These product lines include:
- - Workers' compensation insurance - insures employers for their obligations
to provide workers' compensation benefits as required by applicable
statutes, including medical payments, rehabilitation costs, lost wages,
and disability and death benefits. These policies also provide coverage to
employees for their liability exposures under the common law;
- - Commercial automobile insurance - insures policyholders against third
party liability related to the ownership and operation of motor vehicles
used in the course of business and property damage to insured vehicles.
These policies may provide uninsured motorist coverage, which provides
coverage to insureds and their employees for bodily injury and property
damage caused by an uninsured party;
- - General liability insurance - insures policyholders against third party
liability for bodily injury and property damage, including liability for
products sold and covers the cost of the defense of claims alleging such
damages; and
- - Commercial multi-peril insurance (CMP) - insures a business against risks
from property, liability, crime and boiler and machinery explosion losses.
SPECIALTY LINES SEGMENT
The Group's Specialty Lines segment accounted for 9.3%, 11.4% and 12.4% of net
premiums written in 2004, 2003 and 2002, respectively, consisting of the
following product lines:
(in millions) 2004 2003 2002
- ------------- ------- ------- -------
Commercial umbrella $ 87.1 $ 120.9 $ 132.6
Fidelity and surety 48.4 43.9 45.6
Farmowners - 0.1 1.7
------- ------- -------
Total Specialty Lines $ 135.5 $ 164.9 $ 179.9
======= ======= =======
5
ITEM 1. CONTINUED
These product lines include:
- - Commercial umbrella insurance - indemnifies policyholders for liability
and defense costs which exceed coverage provided by the underlying primary
policies, typically commercial automobile and general liability policies,
and provides coverage for some items not covered by underlying policies;
and
- - Fidelity and surety - insures against dishonest acts of bonded employees
and the non-performance of parties under contracts, respectively.
PERSONAL LINES SEGMENT
The Group's Personal Lines segment accounted for the remaining 33.7%, 33.6% and
35.0% of net premiums written in 2004, 2003 and 2002, respectively, consisting
of the following product lines:
(in millions) 2004 2003 2002
- ------------- ------- ------- -------
Personal auto incl. personal umbrella $ 294.1 $ 296.8 $ 324.5
Personal property 196.1 187.3 182.0
------- ------- -------
Total Personal Lines $ 490.2 $ 484.1 $ 506.5
======= ======= =======
These product lines include personal automobile and homeowners' insurance sold
to individuals.
MARKETING AND DISTRIBUTION
The Group is represented by approximately 3,400 independent insurance agencies
with approximately 5,300 agents. These agents also represent other unaffiliated
companies which may compete with the Group. The six claim, underwriting and
service offices operated by the Group assist these independent agents in
producing and servicing the Group's business.
Certain agencies that meet established profitability and production targets are
eligible for "key agent" status. At December 31, 2004, these agencies
represented 16.2% of the Group's total agency force and wrote 39.8% of its book
of business. The policies placed by key agents have consistently produced a
lower loss ratio for the Group than policies placed by other agents.
The Group targets small business customers for its Commercial Lines segment. The
Group's typical Commercial Lines customer is a small business with a limited
number of employees that needs to conveniently purchase a package of coverages.
For the year 2004, this Commercial Lines customer group, categorized by
commercial liability premium volume, included approximately 76%
contractors/artisans, 10% mercantile, 8% building/premises, and 6%
manufacturers. The Group believes this small business customer group offers an
opportunity to achieve superior underwriting results through development and
maintenance of strong agent and customer relationships and application of the
Group's underwriting and pricing expertise.
The Group markets its Specialty Lines segment predominately to policyholders who
have purchased commercial automobile and general liability policies and have a
need for additional coverage under umbrella policies to cover costs which might
exceed the underlying policies limits or are not covered under such policies.
The Group markets personal automobile insurance primarily to standard and
preferred risk drivers. Standard and preferred risk drivers are those who have
met certain criteria, including a driving record which reflects a low historical
incidence of at-fault accidents and moving violations of traffic laws. The Group
does not target "non-standard" risk drivers who fall outside these criteria.
6
ITEM 1. CONTINUED
COMPETITION
The property and casualty insurance industry is highly competitive. The Group
competes on the basis of service, price and coverage. According to A.M. Best,
based on net insurance premiums written in 2003, the latest year for which
industry-wide comparison statistics are available:
- - more than $415 billion of net premiums were written by property and
casualty insurance companies in the United States and no one company or
company group had a market share greater than approximately 11.2%; and
- - the Group ranked as the forty-eighth largest property and casualty
insurance group in the United States.
REGULATION
STATE REGULATION
The Corporation's insurance subsidiaries are subject to regulation and
supervision in the states in which they are domiciled and in which they are
licensed to transact business. The Company, American Fire, Ohio Security and
OCNJ are all domiciled in Ohio. West American and Avomark are domiciled in
Indiana. Collectively, the Corporation's subsidiaries are licensed to transact
business in all 50 states and the District of Columbia. Although the federal
government does not directly regulate the insurance industry, federal
initiatives can impact the industry.
The authority of state insurance departments extends to various matters,
including:
- - the establishment of standards of solvency, which must be met and
maintained by insurers;
- - the licensing of insurers and agents;
- - the imposition of restrictions on investments;
- - approval and regulation of premium rates and policy forms for property and
casualty insurance;
- - the payment of dividends and distributions;
- - the provisions which insurers must make for current losses and future
liabilities; and
- - the deposit of securities for the benefit of policyholders.
State insurance departments also conduct periodic examinations of the financial
and business affairs of insurance companies and require the filing of annual and
other reports relating to the financial condition of insurance companies.
Regulatory agencies require that premium rates not be excessive, inadequate or
unfairly discriminatory. In general, the Corporation's insurance subsidiaries
must file all rates for personal and commercial insurance with the insurance
department of each state in which they operate.
State laws also regulate insurance holding company systems. Each insurance
holding company in a holding company system is required to register with the
insurance supervisory agency of its state of domicile and furnish information
concerning the operations of companies within the holding company system that
may materially affect the operations, management or financial condition of the
insurers. Pursuant to these laws, the respective departments may examine the
parent and the insurance subsidiaries at any time and require prior approval or
notice of various transactions including dividends or distributions to the
parent from the subsidiary domiciled in that state.
These state laws also require prior notice or regulatory agency approval of
changes in control of an insurer or its holding company and of other material
transfers of assets within the holding company structure. Under applicable
provisions of Indiana and Ohio insurance statutes, the states in which the
members of the Group are domiciled, a person would not be permitted to acquire
direct or indirect control of the Corporation or any of its
7
ITEM 1. CONTINUED
insurance subsidiaries, unless that person had obtained prior approval of the
Indiana Insurance Commissioner and the Ohio Superintendent of Insurance. For the
purposes of Indiana and Ohio insurance laws, any person acquiring more than 10%
of the voting securities of a company is presumed to have acquired "control" of
that company.
NATIONAL ASSOCIATION OF INSURANCE COMMISSIONERS (NAIC)
The Corporation's insurance subsidiaries are subject to the general statutory
accounting practices and reporting formats established by the NAIC. The NAIC
also promulgates model insurance laws and regulations relating to the financial
condition and operations of insurance companies, including the Insurance
Regulating Information System.
NAIC model laws and rules are not usually applicable unless enacted into law or
promulgated into regulation by the individual states. The adoption of NAIC model
laws and regulations is a key aspect of the NAIC Financial Regulations Standards
and Accreditation Program, which also sets forth minimum staffing and resource
levels for all state insurance departments. Ohio and Indiana are accredited.
The NAIC has developed a "Risk-Based Capital" model for property and casualty
insurers. The model is used to establish standards, which relate insurance
company statutory surplus to risks of operations and assist regulators in
determining solvency requirements. The standards are designed to assess capital
adequacy and to raise the level of protection that statutory surplus provides
for policyholders. The Risk-Based Capital model measures the following four
major areas of risk to which property and casualty insurers are exposed:
- - asset and liability risk;
- - credit risk;
- - underwriting risk; and
- - off-balance sheet risk.
The Risk-Based Capital model law requires the calculation of a ratio of total
adjusted capital to Authorized Control Level risk-based capital. Insurers with a
ratio below 200% are subject to different levels of regulatory intervention and
action. Based upon their 2004 statutory financial statements, all insurance
companies in the Group exceeded the necessary statutory capital requirements.
REGULATIONS ON DIVIDENDS
The Corporation is dependent on dividend payments from its insurance
subsidiaries in order to meet operating expenses, debt obligations and to pay
dividends. Insurance regulatory authorities impose various restrictions and
prior approval requirements on the payment of dividends by insurance companies
and holding companies. This regulation allows dividends to equal the greater of
(1) 10% of policyholders' surplus or (2) 100% of the insurer's net income, each
determined as of the preceding year end, without prior approval of the insurance
department.
Dividend payments to the Corporation from the Company are limited to
approximately $138.3 million during 2005 without prior approval of the Ohio
insurance department based on 100% of the Company's net income for the year
ending December 31, 2004. Additional restrictions limiting the amount of
dividends paid by the Company to the Corporation may result from the minimum net
worth and surplus requirements in the Corporation's revolving credit agreement
as disclosed in Item 15, Note 16, Debt, on pages 69 and 70 of this Annual Report
on Form 10-K.
8
ITEM 1. CONTINUED
POOLING AGREEMENT
All of the Company's insurance subsidiaries, except OCNJ, have entered into an
intercompany reinsurance pooling agreement with the Company. The purpose of this
agreement is to:
- - pool or share proportionately the results of property and casualty
insurance underwriting operations through reinsurance;
- - reduce administration expenses; and
- - broaden each participating insurance subsidiary's distribution of risk.
Under the terms of the intercompany reinsurance pooling agreement, all of the
participants' outstanding underwriting liabilities as of January 1, 1984, and
all subsequent insurance transactions were pooled. The participating insurance
subsidiaries share in losses in 2004, 2003 and 2002 were based on the following
percentages:
Insurance Subsidiary Percentage of Losses
- -------------------- --------------------
The Company 46.75%
West American 46.75
American Fire 5.00
Ohio Security 1.00
Avomark 0.50
Effective January 1, 2005, the intercompany reinsurance pooling agreement was
revised. The Company, the lead company of the pool, will assume and retain 100%
of the pool's underwriting experience, therefore there will be no retrocessions
to the Company's insurance subsidiaries.
INVESTMENTS
The distribution of the Corporation's and the Group's invested assets is
determined by a number of factors, including:
- - rates of return;
- - investment risks;
- - insurance law requirements;
- - diversification;
- - liquidity needs;
- - tax planning;
- - general market conditions; and
- - business mix and liability payout patterns.
Periodically, the investment portfolios are reallocated subject to the
parameters set by management, under the direction of the Finance Committee of
the Board of Directors. Management evaluates the investment portfolio on a
regular basis to determine the optimal investment strategy based upon the
factors mentioned above. Throughout 2002 equity securities were sold, many of
which had substantially appreciated in value compared to earlier periods. This
sale program was in response to a decision to reduce equity holdings in favor of
investment grade fixed maturities.
Assets relating to property and casualty operations are invested to maximize
after-tax returns with appropriate diversification of risk. As a result of
improved underwriting profitability, the Corporation and Group began to increase
funds invested in tax exempt fixed maturities in 2004. This change will result
in lower before-tax
9
ITEM 1. CONTINUED
investment income, but will also be accompanied by a lower effective tax rate on
investment income, due to the tax-exempt status of the securities.
The portfolio strategy, with respect to common stocks, is to focus on large
companies with dominant market positions, excellent profitability and strong
balance sheets. Equity securities are marked to fair value on the consolidated
balance sheets. As a result, shareholders' equity and statutory surplus
fluctuate with changes in the value of the equity portfolio. The effect of
future stock market volatility is managed by maintaining an appropriate ratio of
equity securities to shareholders' equity and statutory surplus.
See further detailed information and discussion on the results and liquidity of
the Corporation and Group's investment portfolio in the "Investment Results"
section on pages 20-23 and the "Investment Portfolio" section on pages 43 and 44
of Item 7, Management's Discussion and Analysis of Financial Condition and
Results of Operation, of this Annual Report on Form 10-K.
LIABILITIES FOR UNPAID LOSSES AND LOSS ADJUSTMENT EXPENSES
Liabilities for losses and loss adjustment expenses (LAE) are established for
the estimated ultimate costs of settling claims for insured events, both
reported claims and incurred but not reported claims, based on information known
as of the evaluation date. The estimated liabilities include direct costs of the
loss under terms of insurance policies, as well as legal fees and general
expenses of administering the claims adjustment process. Because of the inherent
future uncertainties in estimating ultimate costs of settling claims, actual
losses and LAE may deviate substantially from the amounts recorded in the
Corporation's consolidated financial statements. Furthermore, the timing,
frequency and extent of adjustments to the estimated liabilities cannot be
accurately predicted since conditions, events and trends which led to historical
loss and LAE development and which serve as the basis for estimating ultimate
claims cost may not occur in the future in exactly the same manner, if at all.
As more information becomes available and claims are settled, the estimated
liabilities are adjusted upward or downward with the effect of increasing or
decreasing net income at the time of the adjustments. The effect of these
adjustments may have a material adverse impact on the results of operations of
the Group.
The following tables present an analysis of losses and LAE and related
liabilities for the periods indicated. The first table represents the impact of
current and prior accident years on calendar year losses and LAE. The second
table displays the development of losses and LAE liabilities as of successive
year-end evaluations for each of the past ten years.
Reconciliation of Liabilities for Losses and Loss Adjustment Expenses
(in millions)
2004 2003 2002
--------- --------- ---------
Net liabilities, balance as of January 1 $ 2,131.3 $ 2,079.3 $ 1,982.0
Incurred related to:
Current year 958.1 993.3 1,045.4
Prior years (21.8) 34.1 84.4
--------- --------- ---------
Total incurred 936.3 1,027.4 1,129.8
Paid related to:
Current year 354.1 388.6 423.6
Prior years 527.4 586.8 608.9
--------- --------- ---------
Total paid 881.5 975.4 1,032.5
Net liabilities, balance as of December 31 2,186.1 2,131.3 2,079.3
Reinsurance recoverable 570.3 496.5 354.4
--------- --------- ---------
Gross liabilities, balance as of December 31 $ 2,756.4 $ 2,627.9 $ 2,433.7
========= ========= =========
10
ITEM 1. CONTINUED
Analysis of Development of Loss and Loss Adjustment Expense Liabilities
(In millions)
Year Ended December 31 1994 1995 1996 1997 1998 1999
- -------------------------------- ---------- ---------- ---------- ---------- ---------- ----------
Net liability as originally
estimated: $ 1,606.5 $ 1,557.1 $ 1,486.6 $ 1,421.8 $ 1,865.6 $ 1,823.3
Life Operations Liability 1.0 3.9 3.7 0.1 0.1 -
P&C Operations Liability $ 1,605.5 $ 1,553.2 $ 1,482.9 $ 1,421.7 $ 1,865.5 $ 1,823.3
Net cumulative payments as of:
One year later 510.2 486.2 483.6 449.8 640.2 614.0
Two years later 803.3 772.7 747.4 751.2 999.1 960.5
Three years later 997.0 944.3 950.1 919.3 1,223.3 1,226.2
Four years later 1,106.4 1,080.4 1,058.3 1,016.9 1,385.2 1,399.5
Five years later 1,203.7 1,151.0 1,121.3 1,088.7 1,485.7 1,504.1
Six years later 1,257.3 1,198.3 1,171.2 1,137.6 1,548.2
Seven years later 1,293.5 1,239.3 1,207.0 1,171.3
Eight years later 1,329.0 1,271.2 1,233.5
Nine years later 1,357.4 1,293.2
Ten years later 1,376.9
Gross cumulative payments as of:
One year later 522.8 500.1 498.3 469.9 654.2 636.5
Two years later 827.2 798.1 781.9 775.4 1,022.2 1,007.1
Three years later 1,030.7 988.7 983.4 950.4 1,261.1 1,281.4
Four years later 1,158.8 1,123.2 1,098.7 1,057.5 1,426.5 1,492.0
Five years later 1,254.5 1,200.6 1,171.2 1,131.5 1,532.4 1,616.7
Six years later 1,314.6 1,257.4 1,223.2 1,187.0 1,601.0
Seven years later 1,359.9 1,300.6 1,265.3 1,226.7
Eight years later 1,397.7 1,338.8 1,297.2
Nine years later 1,432.4 1,366.2
Ten years later 1,457.0
Year Ended December 31 2000 2001 2002 2003 2004
- -------------------------------- ---------- ---------- ---------- ---------- ----------
Net liability as originally
estimated: $ 1,907.3 $ 1,982.0 $ 2,079.3 $ 2,131.3 $ 2,186.1
Life Operations Liability - - - - -
P&C Operations Liability $ 1,907.3 $ 1,982.0 $ 2,079.3 $ 2,131.3 $ 2,186.1
Net cumulative payments as of:
One year later 609.1 608.9 586.7 527.4
Two years later 1,002.7 1,015.2 951.5
Three years later 1,290.4 1,281.9
Four years later 1,465.9
Five years later
Six years later
Seven years later
Eight years later
Nine years later
Ten years later
Gross cumulative payments as of:
One year later 647.1 636.8 674.9 609.9
Two years later 1,060.6 1,122.7 1,111.6
Three years later 1,404.5 1,455.5
Four years later 1,620.5
Five years later
Six years later
Seven years later
Eight years later
Nine years later
Ten years later
11
ITEM 1. CONTINUED
Analysis of Development of Loss and Loss Adjustment Expense Liabilities
(continued)
(In millions)
Year Ended December 31 1994 1995 1996 1997 1998 1999
- --------------------------------- ---------- ---------- ---------- ---------- ---------- ----------
Net liability re-estimated as of:
One year later 1,500.5 1,474.8 1,428.0 1,355.6 1,888.4 1,880.2
Two years later 1,501.5 1,441.1 1,403.1 1,386.4 1,885.2 1,907.6
Three years later 1,486.5 1,445.7 1,439.0 1,400.7 1,901.8 1,997.6
Four years later 1,507.3 1,478.8 1,456.9 1,392.0 1,975.8 2,032.9
Five years later 1,546.8 1,497.6 1,448.0 1,441.7 1,993.4 2,058.9
Six years later 1,566.3 1,492.0 1,489.8 1,459.7 2,018.0
Seven years later 1,560.9 1,532.2 1,504.2 1,469.1
Eight years later 1,597.8 1,548.0 1,510.7
Nine years later 1,614.6 1,554.0
Ten years later 1,620.1
Decrease (increase) in
original estimates: $ (14.6) $ (0.9) $ (27.8) $ (47.3) $ (152.4) $ (235.6)
Net liability as originally
estimated: $ 1,605.5 $ 1,553.1 $ 1,482.9 $ 1,421.7 $ 1,865.5 $ 1,823.3
Reinsurance recoverable on
unpaid losses and LAE 65.3 71.1 64.7 60.0 80.2 85.1
Gross liability as originally
estimated: $ 1,671.8 $ 1,631.2 $ 1,556.7 $ 1,483.8 $ 1,956.9 $ 1,908.5
Life Operations Liability 1.0 7.0 9.1 2.2 11.2 -
P&C Operations Liability 1,670.9 1,624.2 1,547.6 1,481.7 1,945.8 1,908.5
One year later 1,574.2 1,546.0 1,496.1 1,447.0 1,972.9 1,981.1
Two years later 1,579.9 1,515.0 1,507.4 1,477.9 1,975.7 2,041.7
Three years later 1,565.6 1,561.7 1,537.4 1,495.8 2,006.1 2,189.9
Four years later 1,630.3 1,585.5 1,559.5 1,495.6 2,114.3 2,261.6
Five years later 1,657.0 1,608.3 1,558.2 1,571.1 2,155.4 2,291.8
Six years later 1,680.6 1,609.8 1,623.2 1,618.8 2,175.4
Seven years later 1,682.8 1,671.4 1,667.9 1,624.6
Eight years later 1,739.3 1,718.2 1,672.6
Nine years later 1,787.4 1,722.6
Ten years later 1,791.5
Decrease (increase) in
original estimates: (120.6) (98.4) (125.0) (142.9) (229.6) (383.3)
Year Ended December 31 2000 2001 2002 2003 2004
- --------------------------------- ---------- ---------- ---------- ---------- ----------
Net liability re-estimated as of:
One year later 1,965.8 2,066.4 2,115.2 2,109.5
Two years later 2,066.1 2,139.5 2,128.5
Three years later 2,131.1 2,165.1
Four years later 2,157.5
Five years later
Six years later
Seven years later
Eight years later
Nine years later
Ten years later
Decrease (increase) in
original estimates: $ (250.2) $ (183.1) $ (49.2) $ 21.8
Net liability as originally
estimated: $ 1,907.3 $ 1,982.0 $ 2,079.3 $ 2,131.3 $ 2,186.1
Reinsurance recoverable on
unpaid losses and LAE 96.2 168.7 354.4 496.5 570.3
Gross liability as originally
estimated: $ 2,003.5 $ 2,150.7 $ 2,433.7 $ 2,627.8 $ 2,756.4
Life Operations Liability - - - - -
P&C Operations Liability 2,003.5 2,150.7 2,433.7 2,627.8 2,756.4
One year later 2,129.9 2,346.9 2,558.2 2,615.5
Two years later 2,310.6 2,502.4 2,576.1
Three years later 2,432.4 2,536.2
Four years later 2,465.3
Five years later
Six years later
Seven years later
Eight years later
Nine years later
Ten years later
Decrease (increase) in
original estimates: (461.8) (385.4) (142.4) 12.4
12
ITEM 1. CONTINUED
The accounting policies used to estimate liabilities for losses and LAE are
considered critical accounting policies and are further discussed in the
"Critical Accounting Policies" and "Loss and LAE" sections of Item 7,
Management's Discussion and Analysis of Financial Condition and Results of
Operation, on pages 31 and 39-41 in this Annual Report on Form 10-K. In addition
loss and LAE liabilities are further discussed in Note 1J, Summary of
Significant Accounting Policies and Note 9, Losses and Loss Reserves, in the
Notes to the Consolidated Financial Statements on pages 55 and 66 of this Annual
Report on Form 10-K.
REINSURANCE
Reinsurance is a contract by which one insurer, called a reinsurer, agrees to
cover, under certain defined circumstances, a portion of the losses incurred by
a primary insurer in the event a claim is made under a policy issued by the
primary insurer. The Group purchases reinsurance to protect against large or
catastrophic losses. Reinsurance contracts do not relieve the Group of their
obligations to policyholders. The collectibility of reinsurance depends on the
solvency of the reinsurers at the time any claims are presented. The Group
monitors each reinsurer's financial health and claims settlement performance
because reinsurance protection is an important component of the Corporation's
financial plan. Each year, the Group reviews financial statements and calculates
various ratios used to identify reinsurers who no longer meet appropriate
standards of financial strength. Reinsurers who fail these tests are reviewed
and those that are determined by the Group to have insufficient financial
strength are removed from the program at renewal. Additionally, a large number
of reinsurers are utilized to mitigate concentration of risk. The Group also
records an estimated allowance for uncollectible reinsurance amounts, as deemed
necessary. During the last three fiscal years, no reinsurer accounted for more
than 15% of total ceded premiums. As a result of these controls, amounts of
uncollectible reinsurance have not been significant. There are several programs
that provide reinsurance coverage and the programs in effect for 2005 are
discussed in the "Reinsurance Programs" section of Item 7, Management's
Discussion and Analysis of Financial Condition and Results of Operation, on page
42 of this Annual Report on Form 10-K.
SEASONALITY
The Group's insurance business experiences modest seasonality with regard to
premiums written, which are usually highest in January and July and lowest
during the fourth quarter. Although written premium experiences modest
seasonality, premiums are earned ratably over the period of coverage. Losses and
LAE incurred tend to remain consistent throughout the year, unless a catastrophe
occurs. Catastrophes can occur at any time during the year from weather-related
events that include, but are not limited to, hail, tornadoes, hurricanes and
windstorms.
EMPLOYEES
At December 31, 2004, the Company had 2,190 employees of which approximately
1,300 were located in the Fairfield and Hamilton, Ohio offices.
13
ITEM 1. CONTINUED
(d) FINANCIAL INFORMATION ABOUT GEOGRAPHIC AREAS
The Group's business is geographically concentrated in the Mid-West and
Mid-Atlantic regions. The following table shows consolidated direct premiums
written for the Group's ten largest states:
Ten Largest States
Direct Premiums Written
($ in millions)
Percent Percent Percent
2004 of Total 2003 of Total 2002 of Total
-------- -------- ------- -------- ------- --------
New Jersey $ 168.5 10.7 New Jersey $ 166.9 10.6 New Jersey $ 186.6 12.1
Pennsylvania 139.6 8.8 Ohio 140.1 8.9 Ohio 142.7 9.3
Ohio 135.7 8.6 Pennsylvania 129.1 8.2 Pennsylvania 119.0 7.8
Kentucky 131.5 8.3 Kentucky 122.0 7.8 Kentucky 115.4 7.5
Illinois 75.6 4.8 Illinois 81.1 5.2 Illinois 79.5 5.2
North Carolina 75.5 4.8 North Carolina 77.7 4.9 North Carolina 75.2 4.9
Maryland 73.2 4.6 Maryland 70.2 4.5 Indiana 63.2 4.1
Texas 70.2 4.4 Texas 65.7 4.2 Maryland 61.8 4.0
Indiana 56.6 3.6 New York 63.3 4.0 New York 57.9 3.8
New York 54.9 3.5 Indiana 60.9 3.9 Texas 55.9 3.6
-------- ----- ------- ------ ------- -----
$ 981.3 62.1 $ 977.0 62.2 $ 957.2 62.3
======== ===== ======= ====== ======= =====
(e) AVAILABLE INFORMATION
The Corporation's internet website is www.ocas.com. The Corporation provides a
hyperlink to the website of the Securities and Exchange Commission, www.sec.gov,
where the Corporation's Annual Report on Form 10-K, Quarterly Reports on Form
10-Q, Current Reports on Form 8-K, and all amendments to these reports (SEC
Reports) are available as soon as reasonably practicable after the Corporation
has electronically filed or furnished them to the SEC. The information contained
on the Corporation's website is not incorporated by reference into this Annual
Report on Form 10-K and should not be considered part of this report except as
stated in Part III, Item 10.
ITEM 2. PROPERTIES
The Corporation owns and leases office space in various parts of the country.
The principal office buildings consist of facilities owned in Fairfield and
Hamilton, Ohio. These office buildings service all of the Corporation's
segments. The Fairfield, Ohio office building is subject to a mortgage with an
outstanding balance of $3.2 million as of December 31, 2004. For additional
information related to the mortgage, refer to Footnote 16 in Item 15 on pages 69
and 70 of this Annual Report on Form 10-K.
ITEM 3. LEGAL PROCEEDINGS
A proceeding entitled Carol Murray v. Ohio Casualty Corporation, The Ohio
Casualty Insurance Co., Avomark Insurance Co., Ohio Security Insurance Co., West
American Insurance Co. (West American), American Fire and Casualty Insurance
Co., and OCNJ was filed in the United States District Court for the District of
Columbia on February 5, 2004. A motion to change venue was granted on May 25,
2004 with the proceeding assigned to the U.S. District Court for the Southern
District of Ohio, Eastern Division, Columbus, Ohio. The plaintiff, a former
automobile physical damage claim adjuster, originally sought to certify a
nationwide collective action consisting of all current and former salaried
employees since February 5, 2001 who are/were employed to process claims by
policyholders and other persons for automobile property damage. The plaintiff
has filed motions to expand the definition to include claim specialists,
representative trainees, and representatives performing claims adjusting
services. The complaint seeks overtime compensation for the plaintiff and the
class of persons plaintiff seeks to represent. The defendants deny the
allegations made in the complaint and are vigorously defending themselves.
14
ITEM 3. CONTINUED
A proceeding entitled Carol Lazarus v. The Ohio Casualty Group was brought
against West American in the Court of Common Pleas Cuyahoga County, Ohio on
October 25, 1999. The Court ordered the case to proceed solely against West
American on July 10, 2003. The complaint alleges West American improperly
charged for uninsured motorists coverage following an October 1994 decision of
the Supreme Court of Ohio in Martin v. Midwestern Insurance Company. The Martin
decision was overruled legislatively in September 1997. West American filed a
motion for summary judgment on December 16, 2003. Plaintiff filed a motion for
class certification on February 23, 2004. West American has responded to the
motion for class certification stating the motion is untimely (filed more than
four years after the initial complaint) and that Carol Lazarus failed to provide
sufficient evidence to satisfy the requirements for class certification.
A proceeding entitled Douglas and Carla Scott v. The Ohio Casualty Insurance
Company, West American, American Fire and Casualty Company, and Ohio Security
Company was filed in the District Court of Tulsa County, State of Oklahoma and
served on January 3, 2005. The proceeding challenges the use of a certain vendor
in valuing total loss automobiles. Plaintiff alleges that use of the database
results in valuations to the detriment of the insureds. Plaintiff is seeking
class status and alleges breach of contract, fraud and bad faith. The lawsuit is
in its early stages and will be vigorously defended.
The proceedings described above and various other legal and regulatory
proceedings are currently pending that involve the Corporation and specific
aspects of the conduct of its business. The outcome of these proceedings is
currently unpredictable. However, at this time, based on their present status,
it is the opinion of management that the ultimate liability, if any, in one or
more of these proceedings in excess of amounts currently reserved is not
expected to have a material adverse effect on the financial condition, liquidity
or results of operation of the Corporation.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SHAREHOLDERS
There were no matters submitted during the fourth quarter of the Corporation's
2004 fiscal year to a vote of Shareholders through the solicitation of proxies
or otherwise.
15
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND
ISSUER PURCHASES OF EQUITY SECURITIES
(a) The Corporation's common shares, par value $0.125 per share, are traded on
the Nasdaq Stock Market under the symbol OCAS. The following table shows
the high and low sales prices for the Corporation's common shares for each
quarterly period within the Corporation's last three most recent fiscal
years:
High/Low Market Price Per Share
(in dollars)
Quarter 1st 2nd 3rd 4th
----- ----- ----- -----
2004 High 20.25 20.93 20.95 23.53
Low 17.00 17.80 18.47 19.30
2003 High 13.25 14.66 15.14 17.79
Low 11.38 11.58 12.95 14.13
2002 High 19.50 22.24 20.90 18.40
Low 15.00 18.21 15.56 11.01
(b) On March 1, 2005, the Corporation's common shares were held by 4,724
shareholders of record.
(c) The Corporation's Board of Directors discontinued the Corporation's
regular quarterly dividend in February, 2001. For further discussion
regarding restrictions on the payment of dividends by the Corporation,
refer to Item 7, Management Discussion and Analysis of Financial Condition
and Results of Operation on page 33 of this Annual Report on Form 10-K.
(d) Incorporated by reference herein from those portions of the Corporation's
Proxy Statement for the Annual Meeting of Shareholders of the Corporation
for 2005 under the heading "Equity Compensation Plans."
16
ITEM 6. SELECTED FINANCIAL DATA
FIVE-YEAR SUMMARY OF OPERATIONS
(ALL AMOUNTS ARE IN ACCORDANCE WITH GAAP UNLESS OTHERWISE NOTED; NUMBER OF
WEIGHTED AVERAGE SHARES AND DOLLARS IN MILLIONS, EXCEPT SHARE AND PER SHARE
DATA)
2004 2003 2002 2001 2000
--------- --------- --------- --------- ---------
CONSOLIDATED OPERATIONS
Premiums and finance charges earned $ 1,446.8 $ 1,424.4 $ 1,450.5 $ 1,506.7 $ 1,534.0
Investment income, less expenses 201.2 208.7 207.1 212.4 205.1
Investment gains (losses) realized, net 23.0 35.9 45.2 182.9 (2.4)
--------- --------- --------- --------- ---------
Total revenues 1,671.0 1,669.0 1,702.8 1,902.0 1,736.7
Total expenses 1,484.5 1,561.4 1,709.5 1,775.6 1,866.4
Income (loss) before cumulative effect
of an accounting change 130.0 75.8 (0.9) 98.6 (79.2)
--------- --------- --------- --------- ---------
Cumulative effect of accounting change (1.6) - - - -
--------- --------- --------- --------- ---------
NET INCOME (LOSS) $ 128.4 $ 75.8 $ (0.9) $ 98.6 $ (79.2)
========= ========= ========= ========= =========
INCOME (LOSS) AFTER TAXES PER AVERAGE SHARE
OUTSTANDING - DILUTED*
Income (loss) before cumulative effect
of an accounting change $ 1.91 $ 1.18 $ (0.01) $ 1.64 $ (1.32)
Cumulative effect of accounting change (0.02) - - - -
--------- --------- --------- --------- ---------
NET INCOME (LOSS) $ 1.89 $ 1.18 $ (0.01) $ 1.64 $ (1.32)
========= ========= ========= ========= =========
Average shares outstanding - diluted* 71.5 70.2 60.5 60.2 60.1
Total assets $ 5,715.0 $ 5,168.9 $ 4,779.0 $ 4,524.6 $ 4,489.4
Total debt 383.3 198.0 198.3 210.2 220.8
Shareholders' equity 1,294.9 1,145.8 1,058.7 1,080.0 1,116.6
Book value per share 20.82 18.80 17.43 17.97 18.59
Dividends per share - - - - 0.59
PROPERTY AND CASUALTY OPERATIONS
Net premiums written(1) $ 1,453.9 $ 1,441.6 $ 1,448.6 $ 1,472.2 $ 1,505.4
Net premiums earned 1,446.8 1,424.4 1,450.5 1,506.7 1,533.4
Statutory loss ratio(2) 53.8% 59.7% 62.2% 66.5% 72.8%
Statutory loss adjustment expense ratio(3) 10.7% 12.3% 15.7% 13.4% 11.6%
Statutory underwriting expense ratio(4) 33.9% 34.1% 34.9% 35.4% 34.8%
Statutory combined ratio(5) 98.4% 106.1% 112.8% 115.3% 119.2%
Property and casualty reserves
Unearned premiums $ 715.5 $ 703.0 $ 668.7 $ 666.8 $ 696.4
Losses 2,269.6 2,163.7 1,978.8 1,746.8 1,627.6
Loss adjustment expenses 486.8 464.1 454.9 403.9 376.0
Statutory policyholders' surplus(6) $ 972.0 $ 867.6 $ 725.7 $ 767.5 $ 812.1
(1) Net premiums written are premiums for all policies sold during a specific
accounting period less premiums returned.
(2) Statutory loss ratio measures net losses incurred as a percentage of net
premiums earned based upon statutory accounting principals.
(3) Statutory loss adjustment expense ratio measures loss adjustment expenses as
a percentage of net premiums earned based upon statutory accounting
principals.
(4) Statutory underwriting expense ratio measures underwriting expenses as a
percentage of net premiums written based upon statutory accounting
principals.
(5) Statutory combined ratio measures the percentage of premium dollars used to
pay insurance losses, loss adjustment expenses and underwriting expenses
based upon statutory accounting principals.
(6) Statutory policyholders' surplus is equal to an insurance company's admitted
assets minus liabilities based upon statutory accounting principals.
* Adjusted for effect of EITF Issue No. 04-8 in 2004, 2003 and 2002, see
Footnote 10, Earnings Per Share.
17
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATION
Ohio Casualty Corporation (the Corporation) is the holding company of The Ohio
Casualty Insurance Company (the Company), which is one of six property-casualty
companies that make up the Ohio Casualty Group (the Group). All dollar amounts
in this Management Discussion and Analysis (MD&A) are in millions unless
otherwise noted.
The following discussion of financial condition and results of operation
highlights significant factors influencing the consolidated results and
financial position of the Corporation. This discussion should be read in
conjunction with the consolidated financial statements and related notes, all of
which are integral parts of the following analysis of the results of operations
and financial position.
EXECUTIVE-LEVEL OVERVIEW
The Corporation earns revenue by providing businesses and consumers with
competitive insurance products with high quality service and by income on funds
invested. In 2004, the Corporation achieved meaningful improvement in financial
performance. Net income increased in 2004 compared to 2003 as a result of a
better priced book of business through realization of price increases in certain
lines and an improved risk profile as a result of more disciplined underwriting.
The statutory expense ratio continued to improve as a result of expense
management initiatives. The statutory combined ratio was the best since 1980.
The 2004 All Lines statutory combined ratio improved to 98.4% compared to 106.1%
in 2003 as a result of significantly improved loss experience, including lower
loss adjustment expenses (LAE) because of our cost reduction programs, which are
continuing into 2005. The improved loss experience is the result of disciplined
underwriting and enhanced pricing methodologies the Corporation continues to
develop and implement. In addition, the Corporation experienced favorable prior
years reserve development for the first year since 1998. While full year 2004
premiums increased only slightly when compared to the prior year, the Group's
risk profile has improved as the focus was on disciplined underwriting,
improving pricing methodologies and driving operational efficiencies and expense
reductions throughout the organization. The results of this focus and effort are
discussed throughout the following sections.
In September 2003, the Corporation announced its Corporate Strategic Plan for
the 2004-2006 time frame. The plan brings together five broad objectives to help
achieve the Corporation's Vision to be a leading super regional Property and
Casualty carrier providing a broad range of products/services through
independent agents and brokers. The broad objectives include abilities to
generate above market growth, produce competitive loss ratios, create a
competitive expense structure, achieve a competitive return on equity and
improve credit ratings and financial flexibility. Competitive advantages include
strong agency relationships, especially with key agents, and technology
platforms that provide operating flexibility. Technology is being leveraged to
make it easier for agents to do business with the Group and to increase pricing
and underwriting sophistication. The Corporation continues to execute against
this plan and the Corporation's results in 2004 are an indication that the plan
and its execution are working.
The key financial indicators management utilizes consist of statutory combined
ratios and component ratios on both a calendar year and accident year basis,
gross and net written premium growth, impact of catastrophes, renewal price
increases and investment income growth.
RESULTS OF OPERATIONS
NET INCOME
The Corporation reported net income of $128.4, or $1.89 per share, for 2004,
compared with $75.8, or $1.18 per share, for the year 2003, and a net loss of
$0.9, or $0.01 per share, in 2002. The Corporation reported operating income of
$115.1, or $1.71 per share, for 2004, compared with $52.5, or $0.84 per share,
for the year 2003 and an operating loss of $30.3, or $0.50 per share, for 2002.
18
ITEM 7. CONTINUED
Management of the Corporation believes the significant volatility of realized
investment gains and losses limits the usefulness of net income (loss) as a
measure of current operating performance. Accordingly, management uses the
non-GAAP financial measure of operating income (loss) to further evaluate
current operating performance. Operating income (loss), both in dollar amount
and per share amount, is reconciled to net income (loss) in the table below:
December 31
2004 2003 2002
------- ----- -------
Operating income (loss) $115.1 $52.5 $ (30.3)
After-tax net realized gains 14.9 23.3 29.4
Cumulative effect of accounting change (1.6) - -
------ ----- -------
Net income (loss) $128.4 $75.8 $ (0.9)
====== ===== =======
Operating income/(loss) per
share - diluted $ 1.71 $0.84 $ (0.50)
After-tax net realized gains
per share - diluted 0.20 0.34 0.49
Cumulative effect of accounting change
per share - diluted (0.02) - -
------ ----- -------
Net income (loss) per share - diluted $ 1.89 $1.18 $ (0.01)
====== ===== =======
The Corporation adopted the Emerging Issues Task Force ("EITF") Consensus 04-8
"The Effect of Contingently Convertible Debt on Diluted Earnings per Share" in
December 2004 and as required by the EITF restated the average diluted shares
outstanding and diluted net income per share for each of the three years
presented in this MD&A using the "if-converted" method. The impact of the
adoption of the EITF was a reduction to diluted net income per share of $0.16
and $0.06 for the years ended December 31, 2004 and 2003, respectively. The
impact of this EITF on operating income per share was a reduction of $0.13 and
$0.02 for the years ended December 31, 2004 and 2003, respectively. The year
ended December 31, 2002 was not restated for either net income or operating
income per share as the Corporation incurred a net loss during that year, which
resulted in the calculation being anti-dilutive.
The improved financial results for 2004 were driven by significantly improved
loss experience, including lower LAE, a result of cost reduction programs that
have been implemented. The improved loss and LAE ratios are the result of
disciplined underwriting and improved pricing methodologies, reduced claim
frequency, a decline in large losses (losses greater than $250,000 per loss) and
favorable prior years reserve development. Catastrophe losses decreased $0.3 in
2004 to $43.5. During 2004, underwriting and loss adjustment expenses were
impacted by increased severance and other related costs, primarily associated
with the Cost Structure Efficiency (CSE) initiative and expenses related to the
Proformance transaction. As previously discussed, in 2001 OCNJ entered into a
transaction which effectively exited the Group from the New Jersey private
passenger auto market. Based upon data through December 31, 2003 as provided by
Proformance in the first quarter of 2004, the Group estimated and accrued $9.0
(of which $6.8 was paid in July 2004) related to this obligation. During the
second half of 2004, the Group accrued an additional $6.6. At December 31, 2004,
the Group has $8.8 accrued in the consolidated financial statements for any
possible additional liability that may be incurred based upon the final
liability calculation using Proformance's 2004 results. This amount, which is
management's best estimate of the liability, reflects the maximum additional
amount that could be required to be paid to Proformance. The Group expects to
resolve the final settlement to be paid to Proformance relative to the surplus
guarantee in the first half of 2005. For additional information on this
transaction, see Item 15, Notes to Consolidated Financial Statements, Footnote 8
on pages 64 and 65 of this Annual Report on Form 10-K.
Decreases in personnel and sales related expenses led to the improved results
for 2003 compared with 2002. Staff reductions of 11.2% in 2003 compared to 2002
were the result of the claim department reorganization and the Lexington and
Indianapolis underwriting offices being consolidated into other locations. The
loss ratio improved in 2003 due to tighter underwriting standards and an
improved risk profile. In addition, development on prior accident years' losses
and LAE decreased $50.3 before tax from 2002 to $34.1 before tax in 2003. These
improved results were offset by increased catastrophe losses during 2003.
Catastrophe losses before tax more than doubled to $43.8 in 2003 from $20.8 in
2002 resulting from storms that swept through the Midwest
19
ITEM 7. CONTINUED
and the effects of Hurricane Isabel. During 2002, the increase in provision for
prior accident years' losses and LAE totaled $84.4 before tax and was
concentrated in the general liability, commercial auto and personal auto product
lines. The majority of the charge, $62.2 before tax, occurred in the third
quarter and was primarily related to construction defect claims for residential
developers and contractors. The Group continues to address this specific type of
business for non-renewal. For further discussion, refer to the "Loss and Loss
Adjustment Expenses" section under "Liquidity and Capital Resources" on pages
39-41 of this MD&A.
INVESTMENT RESULTS
Consolidated before-tax net investment income was $201.2 in 2004, compared with
$208.7 in 2003 and $207.1 in 2002. The decrease in 2004 consolidated before-tax
net investment income of $7.5 is attributable to reinvestment yields being below
average portfolio yields, the strategic decision to invest, or reinvest, more of
the portfolio into tax exempt fixed maturities, increased investment expenses
attributable to outside management fees and the allocation of interest income
pertaining to investments held in the reinsurance treaty fund as part of the
Group's reinsurance program. This decrease is partially offset by larger average
portfolio holdings during 2004 than in 2003 and a favorable amortization
adjustment on certain fixed income securities, with a portion of this adjustment
representing a reclassification from realized gains. The change in investment
strategy to invest more into tax exempt securities is the result of improved
profitability. This change in investment strategy will result in the
Corporation's and the Group's before-tax investment income declining when
compared to prior periods when the strategy was to invest in taxable securities.
As a result of this strategy, the Corporation's and the Group's effective tax
rate on investment income will be lower when compared to these prior periods.
The increase in 2003 consolidated before-tax net investment income of $1.6 is
attributable to an increase in investment assets held, partially offset by
increased investment expenses attributable to the implementation of a new
investment accounting system, lower average yields on its fixed income
portfolio, and increased investment management fees from expanded use of outside
investment managers. As part of a conversion to a new investment accounting
system in 2003, before tax investment income was reduced by $5.9 as a result of
a change in accounting estimate relating to amortization of interest only
mortgage-backed and asset-backed securities. Offsetting most of this charge was
a $5.3 credit for interest received on a federal income tax settlement.
Consolidated before-tax realized net investment gains amounted to $23.0, $35.9
and $45.2 for the years ended 2004, 2003 and 2002, respectively. During 2004,
2003 and 2002, there were no significant realized losses on sales of securities.
In the first quarter of 2003, management decided to transfer a portion of its
fixed maturity securities from the available-for-sale classification into the
held-to-maturity classification. This transfer was made as the Corporation and
the Group have both the ability to hold the securities to maturity and the
positive intent to do so. At December 31, 2004, the amortized cost of the
held-to-maturity portfolio was $301.4.
Invested assets comprise a majority of the consolidated assets. Consequently,
accounting policies related to investments are critical. See further discussion
of important investment accounting policies in the "Critical Accounting
Policies" section of this MD&A and in Item 15, Notes to Consolidated Financial
Statements, Footnote 1C on page 54 of this Annual Report on Form 10-K. The
Corporation and the Group continually evaluate all of their investments based on
current economic conditions, credit loss experience and other developments. The
difference between the cost and estimated fair value of investments is
continually evaluated to determine whether a decline in value is temporary or
other than temporary in nature. This determination involves a degree of
uncertainty. If a decline in the fair value of a security is determined to be
temporary, the decline is recorded as an unrealized loss, net of tax, in
shareholders' equity. If there is a decline in a security's fair value that is
considered to be other than temporary, the security is written down to the
estimated fair value with a corresponding realized loss recognized in the
consolidated statements of income.
The assessment of whether a decline in fair value is considered temporary or
other-than-temporary includes management's judgement as to the financial
position and future prospects of the entity issuing the security. It is not
possible to accurately predict when it may be determined that a specific
security will become impaired.
20
ITEM 7. CONTINUED
Future impairment charges could be material to the results of operations. The
amount of the before-tax other-than-temporary impairment charge recorded was
$8.7, $10.5 and $10.9 for the years ended 2004, 2003 and 2002, respectively.
This impairment charge represents less than 0.5% of the market value of the
investment portfolio at December 31, 2004, 2003 and 2002, respectively. Included
in both the 2004 and 2003 impairment charges were $5.1 and $5.9, respectively,
related to fixed maturity securities issued by companies in the airline
industry, Delta Air Lines, Inc. and AMR Corporation specifically.
The following tables summarize for all available-for-sale and held-to-maturity
securities, the total gross unrealized losses, excluding gross unrealized gains,
by investment category and length of time the securities have continuously been
in an unrealized loss position as of December 31, 2004 and December 31, 2003:
2004
Available-for-sale securities with unrealized losses:
Less than 12 months 12 months or longer Total
---------------------- ---------------------- ----------------------
Fair Value Unrealized Fair Value Unrealized Fair Value Unrealized
Losses Losses Losses
---------- ---------- ---------- ---------- ---------- ----------
Securities:
States, municipalities and
political subdivisions $187.8 $(0.7) $ - $ - $187.8 $(0.7)
Corporate securities 97.7 (1.1) 9.8 (0.3) 107.5 (1.4)
Mortgage-backed
securities:
Other 88.4 (1.2) 16.5 (0.3) 104.9 (1.5)
------ ----- ------- ----- ------ -----
Total fixed maturities 373.9 (3.0) 26.3 (0.6) 400.2 (3.6)
Equity securities 9.6 (0.7) - - 9.6 (0.7)
Short term investments 177.4 (0.8) - - 177.4 (0.8)
------ ----- ------- ----- ------ -----
Total temporarily impaired
securities $560.9 $(4.5) $ 26.3 $(0.6) $587.2 $(5.1)
====== ===== ======= ===== ====== =====
Held-to-maturity securities with unrealized losses:
Less than 12 months 12 months or longer Total
---------------------- ---------------------- ----------------------
Fair Value Unrealized Fair Value Unrealized Fair Value Unrealized
Losses Losses Losses
---------- ---------- ---------- ---------- ---------- ----------
Securities:
Corporate securities $ 85.8 $ (1.0) $ - $ - $ 85.8 $ (1.0)
Mortgage-backed
securities:
Other 66.8 (0.7) 9.9 (0.1) 76.7 (0.8)
---------- --------- ---------- --------- ---------- ---------
Total temporarily impaired
securities $ 152.6 $ (1.7) $ 9.9 $ (0.1) $ 162.5 $ (1.8)
========== ========= ========== ========= ========== =========
21
ITEM 7. CONTINUED
2003
Available-for-sale securities with unrealized losses:
Less than 12 months 12 months or longer Total
---------------------- ---------------------- ----------------------
Unrealized Unrealized Unrealized
Fair Value Losses Fair Value Losses Fair Value Losses
---------- ---------- ---------- ---------- ---------- ----------
Securities:
U.S. Government $ 14.8 $ (0.1) $ - $ - $ 14.8 $ (0.1)
States, municipalities and
political subdivisions 9.0 (0.2) - - 9.0 (0.2)
Corporate securities 248.4 (6.5) 37.0 (1.9) 285.4 (8.4)
Mortgage-backed
securities:
Other 242.2 (6.8) 19.2 (1.2) 261.4 (8.0)
---------- --------- ---------- --------- ---------- ---------
Total temporarily impaired
securities $ 514.4 $ (13.6) $ 56.2 $ (3.1) $ 570.6 $ (16.7)
========== ========= ========== ========= ========== =========
Held-to-maturity securities with unrealized losses:
Less than 12 months 12 months or longer Total
---------------------- ---------------------- ----------------------
Unrealized Unrealized Unrealized
Fair Value Losses Fair Value Losses Fair Value Losses
---------- ---------- ---------- ---------- ---------- ----------
Securities:
Corporate securities $ 106.0 $ (1.8) $ 5.0 $ (0.2) $ 111.0 $ (2.0)
Mortgage-backed
securities:
Other 115.7 (1.9) 27.7 (0.6) 143.4 (2.5)
---------- --------- ---------- --------- ---------- ---------
Total temporarily impaired
securities $ 221.7 $ (3.7) $ 32.7 $ (0.8) $ 254.4 $ (4.5)
========== ========= ========== ========= ========== =========
Management believes that it will recover the cost basis in the securities held
with unrealized losses as it has both the intent and ability to hold the
securities until they mature or recover in value. Securities are sold to achieve
management's investment goals, which include the diversification of credit risk,
the maintenance of adequate portfolio liquidity, a competitive investment yield
and the management of interest rate risk. In order to achieve these goals, sales
of investments are based upon current market conditions, liquidity needs and
estimates of the future market value of the individual securities.
As part of its evaluation of the aggregate $6.9 unrealized loss on securities in
the investment portfolio at December 31, 2004, management performed a more
intensive review of securities with a higher unrealized loss percentage when
compared with their cost or amortized cost. Based on this review of each
security, management believes that unrealized losses on these securities were
temporary declines in value at December 31, 2004. In the table above, there are
approximately 180 securities represented. Of this total, 7 securities have
unrealized loss positions greater than 5% of their market values at December 31,
2004, with none exceeding 25%. This group represents $0.8, or 11.6% of the total
unrealized loss position. Of this group, 3 securities representing approximately
$0.6 in unrealized losses have been in an unrealized loss position for less than
twelve months. Of the remaining 4 securities in an unrealized loss position for
longer than twelve months totaling $0.2, management believes they will recover
the cost basis of these securities, and has both the intent and ability to hold
the securities until they mature or recover in value. All securities are
monitored by portfolio managers who consider many factors such as an issuer's
degree of financial flexibility, management competence and industry fundamentals
in evaluating whether the decline in fair value is temporary. In addition,
management considers whether it is probable that all contract terms of the
security will be satisfied and whether
22
ITEM 7. CONTINUED
the unrealized loss position is due to changes in the interest rate environment.
Should management subsequently conclude the decline in fair value is other than
temporary, the book value of the security is written down to fair value with the
realized loss recognized in the consolidated statements of income.
The amortized cost and estimated fair value of fixed maturity securities
classified as available-for-sale and held-to-maturity with an unrealized loss
position at December 31, 2004, by contractual maturity, are shown below.
Expected maturities will differ from contractual maturities because borrowers
may have the right to call or prepay obligations with or without call or
prepayment penalties.
2004
Available-for-sale:
Amortized Estimated Unrealized
Cost Fair Value Loss
--------- ---------- ----------
Due in one year or less $ - $ - $ -
Due after one year through five years 27.3 27.2 (0.1)
Due after five years through ten years 156.4 155.4 (1.0)
Due after ten years 113.7 112.7 (1.0)
Mortgage-backed securities 106.4 104.9 (1.5)
--------- ---------- ---------
Total $ 403.8 $ 400.2 $ (3.6)
========= ========== =========
Held-to-maturity:
Amortized Estimated Unrealized
Cost Fair Value Loss
--------- ---------- ----------
Due in one year or less $ 2.1 $ 2.1 $ (0.0)
Due after one year through five years 24.0 23.8 (0.2)
Due after five years through ten years 52.3 51.7 (0.6)
Due after ten years 8.4 8.2 (0.2)
Mortgage-backed securities 77.5 76.7 (0.8)
--------- ---------- ---------
Total $ 164.3 $ 162.5 $ (1.8)
========= ========== =========
For additional discussion relative to the Corporation's investment portfolio,
see the "Investment Portfolio" section under "Liquidity and Capital Resources"
on pages 43 and 44 of this MD&A.
AGENT RELATIONSHIPS ASSET
The Corporation maintains an identifiable intangible asset referred to as "Agent
Relationships." See the "Critical Accounting Policies" section of this MD&A on
page 32 for additional information. In 2004, the before-tax amortization and
impairment costs related to this asset were $20.6 compared with $18.7 in 2003
and $79.7 in 2002. At December 31, 2004, the largest individual agent asset
carrying value was $5.6, which represents the maximum future impairment charge
for an individual agent, compared to $5.9 at December 31, 2003. Based upon
historical performance of this agent, it is unlikely the agent will become
impaired or cancelled in the near term. For the approximately 250 individual
agents remaining that represent the total agent relationships intangible asset,
the average asset carrying value as of December 31, 2004, was $0.5 which
compares to approximately 300 agents with an average asset carrying value of
$0.5 at December 31, 2003. The larger than usual impairment charge in 2002 was
due primarily to the recognition that certain agents experienced sustained
premium revenue trends that were significantly different from prior estimates,
resulting in changes in estimated future cash flows for those agents.
INTERNALLY DEVELOPED SOFTWARE
The Group has introduced into production, for certain lines of business, an
internally developed software application for issuing and maintaining insurance
policies named P.A.R.I.S.(sm), a policy administration, rating and issuance
system. During 2004 and 2003, the Group capitalized application development
costs associated with the Personal Lines segment, which is expected to begin
rollout in 2006. In addition, in December 2004, the Group began rollout for the
Specialty Lines segment. The Specialty Lines segment rollout is expected to
continue throughout 2005. During 2002, the Group substantially completed the
rollout for the Commercial Lines operating segment. A rollout begins when the
application has been placed into service for one or more states for an
individual major product line and ends when the application is placed into
service for the final state. The rollout period can exceed one year for an
individual major product line. The Group capitalizes costs incurred during the
application development stage, primarily relating to payroll and payroll-related
costs for employees,
23
ITEM 7. CONTINUED
along with costs incurred for external consultants who are directly associated
with the internal-use software project. The cost associated with this
application is amortized on a straight-line basis over the estimated useful life
of ten years from the date placed into service with before-tax amortization
expense of $3.1, $2.6 and $1.3 for 2004, 2003 and 2002, respectively.
Capitalized internally developed software costs (including P.A.R.I.S.(sm) and
other internally developed software) and accumulated amortization are summarized
in the table below:
2004 2003
----- -----
Cost $55.2 $52.0
Accumulated amortization 11.4 7.2
----- -----
Carrying value $43.8 $44.8
===== =====
For additional information relative to the internally developed software, see
the "Critical Accounting Policies" section of this MD&A on page 32.
ALL LINES DISCUSSION
STATUTORY RESULTS
Management uses statutory financial data to analyze the Group's property and
casualty results and insurance industry regulators require the Group to report
statutory financial measures. Management analyzes statutory results of
operations through the use of insurance industry financial measures including
statutory loss and LAE ratios, statutory underwriting expense ratio, statutory
combined ratio, net premiums written and net premiums earned. The statutory
combined ratio is a commonly used gauge of underwriting performance measuring
the percentage of premium dollars used to pay insurance losses and related
expenses. The combined ratio is the sum of the loss, LAE and underwriting
expense ratios. All references to combined ratio or its components in the MD&A
are calculated on a statutory accounting basis and are calculated on a calendar
year basis unless specified as calculated on an accident year basis. A
discussion of the differences between statutory accounting and generally
accepted accounting principles in the United States is included in Item 15,
Notes to Consolidated Financial Statements, Footnote 15 on page 69 of this
Annual Report on Form 10-K.
Insurance industry financial measures are included in the next several sections
of this MD&A that discuss results of operations. Statutory surplus, a financial
measure that is required by insurance regulators and used to monitor financial
strength, is discussed in the "Statutory Surplus" section of the "Liquidity and
Capital Resources" section on page 37 of this MD&A.
PREMIUM REVENUE RESULTS
Premium revenue reflects premiums earned by the Group. The Group's premiums are
earned principally on a monthly pro rata basis over the term of the policy.
Management analyzes premium revenues primarily by premiums written in the
current period. Net premiums written differ from gross premiums written by
premiums ceded to reinsurers.
The table below summarizes property and casualty premiums on a gross and net
basis compared with the same period of the prior year for 2004, 2003 and 2002,
respectively:
% Chg % Chg
December 31, 2004 2003
2004 2003 2002 vs. 2003 vs. 2002
--------- ------------ -------- -------- --------
GROSS PREMIUMS WRITTEN
Commercial Lines $ 856.2 $ 824.4 $ 796.6 3.8% 3.5%
Specialty Lines 251.5 271.9 235.2 (7.5)% 15.6%
Personal Lines 496.7 494.1 520.6 0.5% (5.1)%
--------- ------------ --------
All Lines $ 1,604.4 $ 1,590.4 $1,552.4 0.9% 2.4%
========= ============ ========
24
ITEM 7. CONTINUED
% Chg % Chg
December 31, 2004 2003
2004 2003 2002 vs. 2003 vs. 2002
--------- ------------ -------- -------- --------
NET PREMIUMS WRITTEN
Commercial Lines $ 828.2 $ 792.6 $ 762.2 4.5% 4.0%
Specialty Lines 135.5 164.9 179.9 (17.8)% (8.3)%
Personal Lines 490.2 484.1 506.5 1.3% (4.4)%
--------- ------------ --------
All Lines $ 1,453.9 $ 1,441.6 $1,448.6 0.8% (0.5)%
========= ============ ========
Statutory net premiums written increased $12.3 in 2004 to $1,453.9. The increase
in statutory net premiums written over 2003 reflects the Group's improved
retention ratios and price increases. Net premiums written for 2004 include
negative impacts for higher reinsurance costs and lower new business production.
Net premiums written totaled $1,441.6 in 2003 and $1,448.6 in 2002. The slight
decline of net premiums written in 2003 when compared to 2002 is primarily
attributable to the Group's withdrawal from select markets and implementation of
stricter underwriting guidelines, including the non-renewal of certain
construction defect related risks. In addition, the decline in net premiums
written from 2002 to 2003 reflects the impact of higher reinsurance costs.
The Group's business is geographically concentrated in the Mid-West and
Mid-Atlantic regions. The following table shows consolidated net premiums
written for the Group's five largest states for each of the last three years:
All Lines Net Premiums Written Distributed by Top States
2004 2003 2002
----- ----- -----
New Jersey 11.5% 11.1% 12.5%
Pennsylvania 9.1% 8.5% 7.9%
Ohio 8.9% 9.2% 9.4%
Kentucky 8.8% 8.2% 7.7%
Illinois 4.9% 5.3% 5.3%
New Jersey remains the Group's largest state, with 11.5% of the total net
premiums written during 2004, even after the Group ceased writing in the New
Jersey private passenger auto and personal umbrella markets in early 2002. The
Group continues to underwrite other product lines in the New Jersey market.
Commercial Lines gross and net premiums written increased in 2004 and 2003, a
result of policy renewal rate increases as new business gross written premium
has remained relatively flat. Renewal pricing increased during 2004, 2003 and
2002, but the rate of increase slowed as the Commercial Lines segment approached
price adequacy and competitive pricing pressures in the marketplace have
increased. The 2004 average renewal price increase 1 was 5.0% for Commercial
Lines direct premiums written, compared with 11.4% and 16.3% average renewal
price increases in 2003 and 2002, respectively.
Specialty Lines gross and net premiums written decreased in 2004, a result of
lower new business production and higher reinsurance costs in the commercial
umbrella product line partially offset by growth in the fidelity and surety
product line. Net premiums written for the commercial umbrella product line
decreased $33.8 or 28.0% in 2004 to $87.1, compared with $120.9 in 2003 and
$132.7 in 2002. Fidelity and surety net premiums written increased 10.2% to
$48.4 million, compared to $43.9 million and $45.6 million in 2003 and 2002,
respectively. Stricter underwriting guidelines for certain classes of business
and market prices falling below what the Group believes are acceptable levels,
contributed to the decline in new business production for the commercial
umbrella product line. The net premiums written decline from 2002 to 2003 was
impacted by higher reinsurance costs, including the addition of a ceding
commission and increased reinsurance rates per dollar of premium. The addition
of ceding commissions on the 2003 and 2004 reinsurance contracts causes a
corresponding increase to ceded premiums. Average renewal price increases for
the commercial umbrella product line were 8.0%, compared to 18.1% in 2003 and
37.6% in 2002.
(1) When used in this report, renewal price increase means the average increase
in premium for policies renewed by the Group. The average increase in premiums
for each renewed policy is calculated by comparing the total expiring premium
for the policy with the total renewal premium for the same policy. Renewal price
increases include, among other things, the effects of rate increases and changes
in the underlying insured exposures of the policy. Only policies issued by the
Group in the previous policy term with the same policy identification codes are
included. Therefore, renewal price increases do not include changes in premiums
for newly issued policies and business assumed through reinsurance agreements,
including Great American business not yet issued in the Group's systems in 2002.
Renewal price increases also do not reflect the cost of any reinsurance
purchased on the policies issued.
25
ITEM 7. CONTINUED
Personal Lines gross premiums written remained relatively flat during 2004 and
net premiums written increased $6.1. Both gross and net premiums written were
reduced in 2004 due to a refund of escrowed premiums for North Carolina personal
auto of $2.2. The personal auto including personal umbrella product line net
premiums written decreased $2.7 to $294.1 in 2004 compared to $296.8 and $324.6
in 2003 and 2002, respectively. The decrease in Personal Lines gross and net
premiums written from 2002 to 2003 is driven by the withdrawal from New Jersey
private passenger auto, which began in 2002, and the Group's continued effort to
narrow the geographic focus for Personal Lines products.
The following table provides key financial measures for All Lines for each of
the last three years:
December 31
2004 2003 2002
---- ----- -----
All Lines
Loss ratio 53.8% 59.7% 62.2%
Loss adjustment expense ratio 10.7% 12.3% 15.7%
Underwriting expense ratio 33.9% 34.1% 34.9%
---- ----- -----
Combined ratio 98.4% 106.1% 112.8%
==== ===== =====
The All Lines combined ratio improved 7.7 points driven by a 7.5 point
improvement in the loss and LAE ratios. The loss and LAE ratio was impacted by
favorable prior year reserve development of $21.7 in 2004 compared to adverse
reserve development of $34.1 in 2003, which reduced the 2004 loss and LAE ratio
by 1.4 points and increased the 2003 loss and LAE ratio by 2.4 points. The
remaining improvement of 3.7 points in the 2004 loss and LAE ratio over 2003 was
due to improved price adequacy, more disciplined underwriting standards and
improved claims efficiency. The underwriting expense ratio improved 0.2 points
as a result of operational efficiencies implemented throughout 2003 and 2004,
somewhat offset by $15.6, or 1.1 points of expense related to the Proformance
surplus guarantee.
The All Lines combined ratio improved 6.7 points in 2003 compared to 2002 with
an improved underwriting expense ratio as well as lower loss and LAE ratios each
contributing to the improvement. The All Lines combined ratio was impacted by
$34.1 of adverse prior year reserve development, a $50.3 reduction from 2002.
The 2003 combined ratio benefited from a reduction in personnel and sales
related expenses, somewhat offset by increased expenses for technology including
amortization of internally developed software.
The loss and LAE ratio components of the accident year combined ratio measure
losses and LAE arising from insured events that occurred in the respective
accident year. The current accident year excludes losses and LAE for insured
events that occurred in prior accident years.
The table below summarizes the impact of changes in provision for all prior
accident year losses and LAE for each of the last three years:
2004 2003 2002
-------- -------- --------
Statutory net liabilities, beginning of period $2,128.9 $2,078.7 $1,982.0
Increase in provision for prior accident
year claims $ (21.7) $ 34.1 $ 84.4
Increase in provision for prior accident
year claims as % of premiums earned (1.4)% 2.4% 5.8%
In 2004, the impact of the favorable development for prior accident years'
losses and LAE was concentrated in the Commercial and Specialty Lines operating
segments. In 2004, the Specialty Lines segment experienced significant favorable
development for prior years' losses and LAE, primarily due to a reduction in
estimated future costs for claims adjuster related expenses. The total provision
reduction for prior years' losses and LAE of $21.7 before-tax represents 1.0% of
loss and LAE reserves as of year-end 2003.
During 2003, the Group reported adverse development of $34.1 for prior years'
losses and LAE, representing 1.6% of loss and LAE reserves as of year-end 2002.
This adverse development was concentrated in the Commercial and Personal Lines
operating segments.
26
ITEM 7. CONTINUED
The comparable amount of adverse development for prior years' losses and LAE
recognized during 2002 was $84.4 before tax. This represents 4.3% of loss and
LAE reserves as of year-end 2001. The adverse development was concentrated in
the Commercial Lines operating segment.
The 2002 combined ratio includes a reallocation of LAE reserve estimates related
to claims adjuster salaries, benefits and similar costs from the Commercial and
Specialty Lines segments, to the Personal Lines segment. This increased the 2002
Personal Lines segment combined ratio by 1.5 points and decreased the Commercial
and Specialty Lines segments combined ratios by 0.6 and 2.4 points,
respectively.
Catastrophe losses in 2004, 2003 and 2002 were $43.5, $43.8 and $20.8,
respectively. The Group was impacted by 22 separate catastrophes in 2004,
compared with 21 catastrophes in 2003 and 25 in 2002. The Group uses the serial
number assigned by Property Claims Services, a unit of the Insurance Services
Office, to define and track losses for specific catastrophes. Property Claims
Services defines catastrophes as industry events that cause $25.0 or more in
direct insured losses to property. The effects of future catastrophes on the
Corporation's results cannot be accurately predicted. As such, severe weather
patterns, acts of war or terrorist activities could have a material adverse
impact on the Corporation's results, reinsurance pricing and availability of
reinsurance.
Catastrophe losses, net of reinsurance, for each of the last three years were:
Catastrophe Losses
(before tax) 2004 2003 2002
- ------------------ ------- ------- -------
Dollar Impact $ 43.5 $ 43.8 $ 20.8
Statutory Combined
Ratio Impact 3.0% 3.1% 1.4%
The seven-year historical catastrophe impact on the loss ratio compared to 2004
actual for all lines of business was:
Loss Ratio Point Impact Q1 Q2 Q3 Q4 Annual
- ---------------------------- ---- ---- ---- ---- ------
1997-2003 Historical Average 1.6% 4.7% 3.1% 0.8% 2.6%
2004 Actual 0.8 3.2 6.4 1.5 3.0
The underwriting expense ratio, which measures underwriting expenses as a
percentage of net premiums written, decreased by 0.2 points in 2004. The 2004
underwriting expense ratio was favorably impacted by a reduction in employee
related costs, a non-recurring reduction in assessments, fees and premium taxes
and by other operating efficiencies. These improvements were partially offset by
1.1 points of expense related to the Proformance surplus guarantee, previously
discussed. The employee count continued to decline in 2004 with an approximate
18.0% reduction from 2003 as a result of the CSE initiative. The employee count
was 2,190, 2,669 and 3,004 as of December 31, 2004, 2003 and 2002, respectively.
The 2003 underwriting expense ratio was favorably impacted by a reduction in
employee related costs and lower sales related expenses as a percentage of
premiums, and was partially offset by higher expenses related to investments in
technology. Sales related expenses for 2003 included the resumption of a ceding
commission for certain layers of commercial umbrella reinsurance and agent bonus
commission levels which were higher than 2002.
The year 2002 underwriting expense ratio experienced upward pressure due to two
factors with a total impact of approximately 1.6 points. These two factors were
the non-renewal of the New Jersey private passenger auto business, which had
lower commission rates and lower variable processing costs than most other
business and the elimination of ceding commissions on umbrella premiums ceded to
reinsurers, which had reduced expenses in previous years. The 2002 commission
expense ratio, a component of the underwriting expense ratio, was at a
relatively high level due to higher than expected umbrella net premiums written,
which had a relatively high commission rate on a net of reinsurance basis and to
higher than expected accruals for agent bonus commissions.
27
ITEM 7. CONTINUED
The 2004, 2003 and 2002 statutory underwriting expenses also included $6.3, $5.2
and $2.6 of software amortization expense before tax, respectively, related to
the rollout of P.A.R.I.S.(sm). On a statutory accounting basis, the new
application is being amortized over a five-year period (compared to ten-year
period under GAAP) in accordance with statutory accounting principles. The
additional amortization expense is expected to be offset in part by reduced
labor costs related to underwriting and policy processing.
In 2001, the Group introduced into operation, after more than three years of
development, the Policy Administration Rating and Issuance System
(P.A.R.I.S.(sm)) for Commercial Lines. At the end of 2004, P.A.R.I.S.(sm) was
deployed for the Specialty Lines commercial umbrella excess capacity product
line. Further implementation for other Specialty and Personal Lines products is
expected during 2005 and 2006.
The P.A.R.I.S.(sm) system provides the policy administration environment used
internally by the Group's associates. An extension of P.A.R.I.S.(sm) called
P.A.R.I.S. Express(sm) leverages the P.A.R.I.S.(sm) system to provide
functionality to our agents. P.A.R.I.S. Express(sm) is a proprietary internet
interface that uses the P.A.R.I.S.(sm) system to provide real-time functionality
through a web browser to our agents. In addition, the Group is simultaneously
introducing P.A.R.I.S. Connect(sm) which allows agents to transact with the
Group directly from their agency management system.
For Commercial Lines, P.A.R.I.S. Express(sm) and P.A.R.I.S. Connect(sm)
currently provide agents with on-line quoting capability. In February of 2005
P.A.R.I.S. Express(sm) was extended to support issuance and endorsement
processing for selected pilot agents; nationwide roll-out is expected during
2005. Personal Lines currently offers on-line and real time quoting and issuance
for new business and endorsements through existing (non- P.A.R.I.S.(sm))
systems.
Agents want a cost effective, timely and simple system for issuing and
maintaining insurance policies. P.A.R.I.S. Express(sm) and P.A.R.I.S.
Connect(sm) are the cornerstone in the Group's strategy of focusing on superior
agent service. The success of this strategic plan depends in part on the ability
to provide agents with the technological advantages of these tools. If they do
not work as expected, or fail to satisfy agents' needs, the Group may lose
business to insurers with preferred technologies.
SEGMENT DISCUSSION
The Corporation is organized around three business units: Commercial, Specialty
and Personal Lines. These business units represent the Corporation's operating
segments as well as its reportable segments. Within each operating segment are
distinct insurance product lines that generate revenues by selling a variety of
commercial, surety and personal insurance products. The Commercial Lines
operating segment sells commercial multiple peril, commercial auto, general
liability and workers' compensation insurance as its primary products. The
Specialty Lines operating segment sells commercial umbrella, excess insurance
and fidelity and surety insurance as its primary products. The Personal Lines
operating segment sells personal automobile and homeowners insurance as its
primary products. The Corporation also has an all other segment, which derives
its revenue from investment income. The following table provides key financial
measures for each of the property and casualty reportable segments and product
lines:
28
ITEM 7. CONTINUED
STATUTORY EARNED PREMIUM AND COMBINED RATIOS
Combined Ratios
------------------------------------------------------------
2004 Accident Accident Accident
(by operating segment, including Earned Year Year Year
selected major product lines) Premium 2004 2004(a) 2003 2003(a) 2002 2002(a)
- -------------------------------- --------- ----- -------- ----- -------- ----- --------
Commercial Lines $ 807.9 99.3% 101.1% 112.3% 103.7% 115.1% 100.0%
Workers' compensation 132.6 115.4% 112.3% 123.0% 111.8% 129.2% 112.9%
Commercial auto 229.6 90.3% 98.2% 105.5% 101.1% 110.2% 94.9%
General liability 86.6 105.0% 105.6% 122.6% 109.5% 171.3% 109.9%
CMP, fire & inland marine 359.1 97.5% 97.7% 109.7% 100.8% 95.8% 94.6%
Specialty Lines 150.3 97.2% 103.3% 77.2% 88.5% 94.0% 87.1%
Commercial umbrella 105.1 103.8% 108.7% 80.5% 92.6% 97.7% 92.2%
Fidelity & surety 45.2 78.9% 88.1% 68.1% 76.0% 81.7% 71.9%
Personal Lines 488.4 97.6% 97.2% 105.6% 101.4% 114.1% 111.5%
Personal auto incl. personal
umbrella 295.7 104.7% 103.3% 107.0% 102.8% 116.5% 113.5%
Personal property 192.7 86.8% 87.6% 103.3% 98.9% 108.6% 107.2%
--------- ----- ----- ----- ----- ----- -----
Total All Lines $ 1,446.6 98.4% 99.8% 106.1% 101.2% 112.8% 103.5%
========= ===== ===== ===== ===== ===== =====
(a) The loss and LAE ratio component of the accident year combined ratio
measures losses and LAE arising from insured events that occurred in the
respective accident year. The current accident year excludes losses and LAE for
insured events that occurred in prior accident years. Accident year 2004 as of
December 31, 2004 measures insured events for the twelve months of 2004.
Accident year 2003 as of December 31, 2004 measures insured events for the
twelve months of 2003 with remaining related liabilities estimated as of
December 31, 2004. Accident year 2002 as of December 31, 2004 measures insured
events for the twelve months of 2002 with remaining related liabilities
estimated as of December 31, 2004. Accident periods may not be comparable due to
seasonality, claim reporting and development patterns, claim settlement rates
and other factors.
COMMERCIAL LINES SEGMENT
2004 2003 2002
---- ------ ------
Commercial Lines Segment
Loss ratio 52.9% 61.4% 60.8%
Loss adjustment expense ratio 12.1% 14.5% 18.0%
Underwriting expense ratio 34.3% 36.4% 36.3%
---- ------ ------
Combined ratio 99.3% 112.3% 115.1%
==== ====== ======
The Commercial Lines combined ratio for the year 2004 decreased 13.0 points due
to a significantly lower loss ratio as a result of improved pricing and
underwriting quality in addition to favorable development on prior year
reserves. Favorable claim frequency trends, driven in part by underwriting
actions, and improved pricing helped to offset the Commercial Lines claim
severity trend. The 2004 combined ratio included 1.9 points of favorable
development on loss and LAE reserves from prior years, compared to adverse
development of 5.3 points in 2003 on loss and LAE reserves from prior years. The
decline in the combined ratio also included a 2.1 point improvement in the
underwriting expense ratio primarily as a result of staff reductions and
employee benefit changes.
The combined ratio improved from 2002 to 2003 by 2.8 points, in spite of $41.0
or 5.3 points of adverse development on loss and LAE reserves. The 2002 combined
ratio was impacted by $73.9 or 10.2 points of adverse prior year development of
loss and LAE reserves. Of this amount, approximately $51.6 related to
construction defect issues, which added 7.1 points to the combined ratio for
2002.
Commercial Lines results for 2004 included higher than expected catastrophe
losses which added 2.4 points to the Commercial Lines combined ratio in 2004,
compared to 2.6 points and 0.5 points in 2003 and 2002, respectively.
The workers' compensation product line combined ratio was 115.4% in 2004 a
decline of 7.6 points compared to 123.0% in 2003 and 129.2% in 2002. Although
the Group has taken actions to improve workers' compensation results with higher
pricing and a conservative underwriting posture, this product line continues to
perform at an
29
ITEM 7. CONTINUED
unprofitable level. The current results continue to be negatively impacted by
assessments for the National Workers' Compensation Pool (NWCP) residual market.
The impact of the NWCP residual market added 4.8 points to the workers'
compensation combined ratio in 2004 compared to 4.5 points in 2003. The NWCP
residual market lowered the 2002 combined ratio by 1.5 points. The Group's
assessments have a larger percentage impact than those reported by the industry
due to historical concentration of business in states with inactive pools. In
addition, the concentration of the Group's business in a few states with limited
pricing flexibility provides less opportunity to address issues specific to the
workers' compensation product line. These issues are offset by the Group's
approach to writing workers' compensation as part of an overall Commercial Lines
account, where underwriters look to ensure that the pricing for the entire
account is adequate.
The general liability product line combined ratio was 105.0% in 2004 a decline
of 17.6 points compared to 122.6% in 2003 and 171.3% in 2002. This line is
exposed to construction defect issues which are being addressed through strict
underwriting standards for certain classes of business that are more prone to
construction defect claims. In addition, the Group has introduced policy
language changes to limit exposure to broadening court interpretations of
additional insured and contractual general liability provisions within the
policy.
SPECIALTY LINES SEGMENT
2004 2003 2002
---- ---- ----
Specialty Lines Segment
Loss ratio 42.7% 28.7% 39.0%
Loss adjustment expense ratio 4.8% 5.0% 11.0%
Underwriting expense ratio 49.7% 43.5% 44.1%
---- ---- ----
Combined ratio 97.2% 77.2% 94.1%
==== ==== ====
Specialty Lines combined ratio for 2004 increased 20.0 points. Given the volume
and nature of the coverage, the Specialty Lines combined ratio is subject to
more volatility than