[July 28, 2011] SELECTIVE INSURANCE GROUP INC - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Tweet (Edgar Glimpses Via Acquire Media NewsEdge) Forward-Looking Statements In this Quarterly Report on Form 10-Q, we discuss and make statements regarding our intentions, beliefs, current expectations, and projections regarding our company's future operations and performance. Such statements are "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements are often identified by words such as "anticipates," "believes," "expects," "will," "should," and "intends" and their negatives. We caution prospective investors that such forward-looking statements are not guarantees of future performance. Risks and uncertainties are inherent in our future performance. Factors that could cause actual results to differ materially from those indicated by such forward-looking statements include, but are not limited to, those discussed under Item 1A. "Risk Factors" below. These risk factors may not be exhaustive. We operate in a continually changing business environment and new risk factors may emerge from time to time. We can neither predict such new risk factors nor can we assess the impact, if any, of such new risk factors on our businesses or the extent to which any factor or combination of factors may cause actual results to differ materially from those expressed or implied in any forward-looking statements in this report. In light of these risks, uncertainties, and assumptions, the forward-looking events discussed in this report might not occur. We make forward-looking statements based on currently available information and assume no obligation to update these statements due to changes in underlying factors, new information, future developments, or otherwise. Introduction We offer property and casualty insurance products through our various subsidiaries. We classify our business into two operating segments: (i) Insurance Operations, which consists of commercial lines ("Commercial Lines") and personal lines ("Personal Lines"), including our flood lines of business; and (ii) Investments. The purpose of the Management's Discussion and Analysis ("MD&A") is to provide an understanding of the consolidated results of operations and financial condition and known trends and uncertainties that may have a material impact in future periods. Consequently, investors should read the MD&A in conjunction with the consolidated financial statements in our annual report on Form 10-K for the year ended December 31, 2010 ("2010 Annual Report"). In the MD&A, we will discuss and analyze the following: · Critical Accounting Policies and Estimates; · Financial Highlights of Results for Second Quarter 2011 and Six Months 2011; · Results of Operations and Related Information by Segment; · Federal Income Taxes; · Financial Condition, Liquidity, Short-term Borrowings, and Capital Resources; · Ratings; · Pending Accounting Pronouncements; · Off-Balance Sheet Arrangements; and · Contractual Obligations, Contingent Liabilities, and Commitments. Critical Accounting Policies and Estimates These unaudited interim consolidated financial statements include amounts based on our informed estimates and judgments for those transactions that are not yet complete. Such estimates and judgments affect the reported amounts in the consolidated financial statements. Those estimates and judgments most critical to the preparation of the consolidated financial statements involved the following: (i) reserves for losses and loss expenses; (ii) deferred policy acquisition costs; (iii) premium audit; (iv) pension and post-retirement benefit plan actuarial assumptions; (v) other-than-temporary investment impairments; and (vi) reinsurance. These estimates and judgments require the use of assumptions about matters that are highly uncertain and, therefore, are subject to change as facts and circumstances develop. If different estimates and judgments had been applied, materially different amounts might have been reported in the financial statements. For additional information regarding our critical accounting policies, refer to our 2010 Annual Report, pages 44 through 54. 24 -------------------------------------------------------------------------------- Financial Highlights of Results for Second Quarter 2011 and Six Months 20111 Quarter ended Change Six Months ended Change June 30, % or June 30, % or(Shares and $ in thousands, except per share amounts) 2011 2010 Points 2011 2010 Points GAAP measures: Revenues $ 399,570 387,718 3 % $ 803,026 780,830 3 % Pre-tax net investment income 39,345 36,545 8 82,818 71,251 16 Pre-tax net income 1,221 20,810 (94 ) 28,993 27,241 6 Net income 2,325 18,766 (88 ) 23,874 24,569 (3 ) Diluted net income per share 0.04 0.35 (89 ) 0.43 0.45 (4 ) Diluted weighted-average outstanding shares 55,135 54,361 1 55,092 54,289 1 GAAP combined ratio 109.2 % 100.9 8.3 pts 106.2 % 102.5 3.7 pts Statutory combined ratio 109.5 % 101.0 8.5 106.1 % 101.9 4.2 Return on average equity 0.9 % 7.3 (6.4 ) 4.4 % 4.8 (0.4 ) Non-GAAP measures: Operating income2 $ 930 22,212 (96 )% $ 18,735 28,847 (35 )% Diluted operating income per share2 0.01 0.41 (98 ) 0.34 0.53 (36 ) Operating return on average equity2 0.3 % 8.6 (8.3 ) pts 3.5 % 5.6 (2.1 ) pts 1 Refer to the Glossary of Terms attached to our 2010 Annual Report as Exhibit 99.1 for definitions of terms used in this Form 10-Q. 2 Operating income is used as an important financial measure by us, analysts, and investors, because the realization of investment gains and losses on sales in any given period is largely discretionary as to timing. In addition, these realized investment gains and losses, as well as other-than-temporary impairments ("OTTI") that are charged to earnings, and the results of discontinued operations, could distort the analysis of trends. See below for a reconciliation of operating income to net income in accordance with U.S. generally accepted accounting principles ("GAAP"). Operating return on average equity is calculated by dividing annualized operating income by average stockholders' equity. Second Quarter 2011 revenues increased 3% compared to Second Quarter 2011, including a 1% improvement in net premiums earned. On a written basis, premiums increased 6% for the same period due to economic conditions that have improved our audit and endorsement premiums, coupled with a successful balance between retention and renewal rate. However, despite these premium improvements, pre-tax net income decreased by $19.6 million in Second Quarter 2011 compared to the same period last year. The decrease was driven by: · Pre-tax underwriting losses, which increased by $29.5 million, to $32.7 million, reflecting: · Catastrophe losses which increased by $22.1 million, to $38.1 million, compared to Second Quarter 2010; and · Favorable prior year casualty development of $5 million, compared to approximately $12 million of favorable prior year casualty development in Second Quarter 2010. Partially offsetting these items are: · Pre-tax net realized gains, which increased by $5.4 million, from a realized loss of $3.3 million to a realized gain of $2.1 million. This improvement was primarily due to pre-tax non-cash OTTI charges that were $6.0 million lower than last year at $0.2 million. · Pre-tax net investment income earned, which increased $2.8 million, to $39.3 million, due to higher alternative investment income of $3.0 million, to $7.9 million. Our alternative investments, which are accounted for under the equity method, primarily consist of investments in limited partnerships, the majority of which report results to us on a one quarter lag. See Note 6. "Investments" in Item 1. "Financial Statements" of this Form 10-Q for additional information regarding our alternative investment portfolio. Tax expense from continuing operations decreased primarily due to the pre-tax results discussed above, partially offset by taxes being recorded at a lower full-year expected tax rate as required under Accounting Standards Codification 270, Interim Reporting ("ASC 270"). The effect of this accounting rule is to record every quarter at the expected annual marginal rate regardless of the relative magnitude of the individual components within any one quarter. Pre-tax net income increased by $1.8 million in Six Months 2011 compared to the same period last year. The increase was driven by: 25 -------------------------------------------------------------------------------- · Pre-tax net investment income earned, which increased $11.6 million, to $82.8 million, due to higher alternative investment income of $10.8 million, to $19.5 million. · Pre-tax net realized gains, which increased $11.2 million from a realized loss of $3.3 million to a realized gain of $7.9 million. This improvement was primarily due to pre-tax non-cash OTTI charges that were $13.6 million lower than last year at $0.8 million. · Pre-tax losses on the disposal of discontinued operations of $3.3 million as of Six Months 2010. No losses have been recorded in 2011. Partially offsetting these items are: · Pre-tax underwriting losses, which increased by $26.0 million, to $43.8 million, reflecting: · Non-catastrophe property losses of $115.2 million compared to $98.5 million in Six Months 2010; · Catastrophe losses of $44.9 million compared to $40.2 million in Six Months 2010; and · Favorable prior year casualty development of $9 million, compared to $21 million of favorable prior year casualty development in Six Months 2010. Tax expense from continuing operations increased driven by the pre-tax results discussed above coupled with the impact of taxes recorded at a full-year expected tax rate as required under ASC 270. The following table reconciles operating income and net income for the periods presented above: Quarter ended Six Months ended June 30, June 30, ($ in thousands, except per share amounts) 2011 2010 2011 2010 Operating income $ 930 22,212 18,735 28,847 Net realized gains (losses), after tax 1,395 (2,121 ) 5,139 (2,163 ) Loss on disposal of discontinued operations, net of tax - (1,325 ) - (2,115 ) Net income $ 2,325 18,766 23,874 24,569 Diluted operating income per share $ 0.01 0.41 0.34 0.53 Diluted net realized gains (losses) per share 0.03 (0.04 ) 0.09 (0.04 ) Diluted net loss from disposal of discontinued operations per share - (0.02 ) - (0.04 ) Diluted net income per share $ 0.04 0.35 0.43 0.45 Operating income decreased in Second Quarter 2011 and Six Months 2011 compared to the same periods last year reflecting increased property losses partially offset by improvements in net investment income as mentioned above. 26 --------------------------------------------------------------------------------Results of Operations and Related Information by Segment Insurance Operations Our Insurance Operations segment writes property and casualty insurance business through seven insurance subsidiaries (the "Insurance Subsidiaries"). Our Insurance Operations segment sells property and casualty insurance products and services primarily in 22 states in the Eastern and Midwestern U.S. through approximately 990 independent insurance agencies. Our Insurance Operations segment consists of two components: (i) Commercial Lines, which markets primarily to businesses and represents approximately 81% of net premium written ("NPW"); and (ii) Personal Lines, which markets primarily to individuals and represents approximately 19% of NPW. The underwriting performance of these lines is generally measured by four different statutory ratios: (i) loss and loss expense ratio; (ii) underwriting expense ratio; (iii) dividend ratio; and (iv) combined ratio. For further details regarding these ratios, see the discussion in the "Insurance Operations" section of Item 1. "Business." of our 2010 Annual Report. Summary of Insurance Operations All Lines Quarter ended Change Six Months ended Change June 30, % or June 30, % or ($ in thousands) 2011 2010 Points 2011 2010 Points GAAP Insurance Operations Results: NPW $ 374,503 353,524 6 % 736,338 721,615 2 % Net premiums earned ("NPE") 355,580 352,190 1 706,923 708,392 - Less: Losses and loss expenses incurred 274,555 239,980 14 523,761 494,123 6 Net underwriting expenses incurred 112,246 114,727 (2 ) 224,181 229,896 (2 ) Dividends to policyholders 1,461 644 127 2,747 2,139 28 Underwriting loss $ (32,682 ) (3,161 ) (934 )% (43,766 ) (17,766 ) (146 ) % GAAP Ratios: Loss and loss expense ratio 77.2 % 68.1 9.1 pts 74.1 % 69.8 4.3 pts Underwriting expense ratio 31.6 32.6 (1.0 ) 31.7 32.4 (0.7 ) Dividends to policyholders ratio 0.4 0.2 0.2 0.4 0.3 0.1 Combined ratio 109.2 100.9 8.3 106.2 102.5 3.7 Statutory Ratios: Loss and loss expense ratio 77.2 68.1 9.1 74.1 69.7 4.4 Underwriting expense ratio 31.9 32.7 (0.8 ) 31.6 31.9 (0.3 ) Dividends to policyholders ratio 0.4 0.2 0.2 0.4 0.3 0.1 Combined ratio 109.5 % 101.0 8.5 pts 106.1 % 101.9 4.2 pts · NPW increased in both Second Quarter and Six Months 2011 compared to the same periods last year. This is the first quarter since the fourth quarter of 2007 that NPW increased compared to the prior year. This increase is due to economic improvements evidenced in our audit and endorsement premium, coupled with the successful balance between retention and renewal rate. The following details the fluctuations in NPW for the comparable periods: o Audit additional premium of $1.5 million in Second Quarter 2011 and audit return premium of $2.1 million in Six Months 2011 compared to audit return premium of $13.1 million in Second Quarter 2010 and $24.3 million in Six Months 2010; o Endorsement additional premium of $1.9 million and $1.5 million in Second Quarter and Six Months 2011, respectively, compared to endorsement return premium of $2.3 million and $7.0 million in Second Quarter and Six Months 2010, respectively; and o Increase in net renewals of $6.9 million, to $320.2 million, in Second Quarter 2011 and $3.4 million, to $637.5 million, in Six Months 2011. These items were partially offset by reductions in new business premiums of $3.3 million, to $68.4 million, in Second Quarter 2011 and $19.7 million, to $128.5 million, in Six Months 2011. · NPE changes in Second Quarter and Six Months 2011 compared to the same periods last year are consistent with the fluctuation in NPW for the twelve-month period ended June 30, 2011 as compared to the twelve-month period ended June 30, 2010. 27-------------------------------------------------------------------------------- · The GAAP loss and loss expense ratio increased 9.1 points in Second Quarter 2011 compared to the prior year reflecting: o An increase in catastrophe losses of $22.1 million, or 6.2 points, to $38.1 million; o Favorable prior year casualty development of approximately $5 million, or 1.4 points, compared to approximately $12 million, or 3.3 points, in Second Quarter 2010; and o An increase in non-catastrophe property losses of $6.6 million, or 1.7 points. · The GAAP loss and loss expense ratio increased 4.3 points in Six Months 2011 compared to the prior year reflecting: o An increase in non-catastrophe property losses of $16.6 million, or 2.4 points; o An increase in catastrophe losses of $4.7 million, or 0.7 points, to $44.9 million; and o Favorable prior year casualty development of approximately $9 million, or 1.3 points, compared to approximately $21 million, or 2.9 points, in Second Quarter 2010. The decreases in the GAAP underwriting expense ratio in Second Quarter and Six Months 2011, compared to the same periods last year, were primarily due to an increase in premiums that has outpaced underwriting expenses. Insurance Operations Outlook Our Insurance Operations segment reported a statutory combined ratio of 109.5% for Second Quarter 2011 and 106.1% for Six Months 2011. This includes a Commercial Lines statutory combined ratio of 108.2% and 104.4%, respectively, and a Personal Lines statutory combined ratio of 115.3% and 113.3%, respectively. A.M. Best Company ("A.M. Best") notes that industry-wide results for the first quarter of 2011 were significantly worse than the same period in 2010 as a result of elevated levels of catastrophe-related losses, lower reserve releases, and decreased investment gains despite an increase in net premiums written. A.M Best expects the industry's return on equity to remain low for the remainder of 2011 as a result of the catastrophe losses that have continued in the second quarter, ongoing challenging market conditions in the commercial lines sector, a sluggish economic recovery, and relatively low investment yields. A.M. Best believes that the level of reserve deficiencies for the industry will increase. They also anticipate record-setting catastrophe losses in Second Quarter 2011 as a result of unprecedented tornado activity, hail, drought, and wildfires. Industry results are expected to deteriorate further as a result of these factors, coupled with continued competitive market conditions, and the low interest rate environment. Certain analysts believe that results may be unprofitable through 2013, at which time they expect that market conditions may support a broader cyclical turn. The industry has begun experiencing some improvement in pricing on select lines of business, and there are some indications that pricing may continue to improve, such as: (i) the low interest rate environment that has continued to put pressure on investment yields; (ii) an A.M. Best commercial lines industry statutory combined ratio projection for 2011 of 110.0%; (iii) higher anticipated reinsurance costs (see the "Reinsurance" section below for more detail); and (iv) declining industry profitability as a result of elevated levels of catastrophe-related losses in Six Months 2011 coupled with an Atlantic hurricane season that is expected to have above-average activity. A recent report from the Commercial Lines Insurance Pricing Survey showed that industry pricing increased by 0.4% during the first quarter of 2011, the first quarter of positive rate change since 2009. Despite this slight increase, the commercial lines industry remains very competitive and pricing has continued its downward trend in certain lines of business, such as commercial automobile and commercial property. While industry pricing has just begun to improve, we are on our ninth consecutive quarter of price increases with 2.6% in Second Quarter 2011. The price increases that we have obtained demonstrate the overall strength of the relationships that we have with our independent agents, even in difficult economic and competitive times. We believe that once the market as a whole becomes more successful at driving price, we will be able to further capitalize on our relationships with our agents to generate additional renewal price increases. The price increases we have been able to obtain, coupled with strong retention, have led to growth in our Commercial Lines NPW for the first time since the fourth quarter of 2007. 28 -------------------------------------------------------------------------------- In an effort to write profitable business in the current commercial and personal lines environment, we continue to implement a defined plan of improving risk selection and mitigating higher frequency trends to complement our strong agency relationships and unique field-based model. In addition, as we are committed to executing on our strategy to introduce more high-margin products into our portfolio, we have entered into a renewal rights agreement to write commercial contract binding authority excess and surplus lines business. The agreement, which is expected to close in the third quarter of 2011, allows us a natural expansion of our commercial lines small business and offers a new product to agents and customers. The renewal rights that we purchased relate to a commercial lines book of business that produced gross premiums written of $77 million in 2010. The personal lines market has been more receptive to price increases and our Personal Lines operations continue to experience NPW growth driven by ongoing rate increases that went into effect in 2010 and 2011, which are expected to generate an additional $26.3 million in annual premium. We were able to obtain increased Personal Lines renewal pure pricing of 6.5% in Second Quarter 2011 while retention increased two points, to 86%. Given the elevated level of property losses incurred partially offset by the rate increases achieved and favorable prior year development we have experienced in Six Months 2011, we are expecting to generate overall full year statutory and GAAP combined ratios of between 104% and 105%, which include a catastrophe loss assumption of four points for the full year. These combined ratios do not include any assumptions for additional reserve development, favorable or unfavorable. Weighted average shares at year-end 2011 are expected to be approximately 55 million. 29 --------------------------------------------------------------------------------Review of Underwriting Results by Line of Business Commercial Lines Commercial Lines Quarter ended Change Six Months ended Change June 30, % or June 30, % or ($ in thousands) 2011 2010 Points 2011 2010 PointsGAAP Insurance Operations Results: NPW $ 303,305 286,882 6 % 603,639 598,791 1 % NPE 290,295 293,001 (1 ) 577,058 590,909 (2 ) Less: Losses and loss expenses incurred 216,363 192,856 12 412,385 401,077 3 Net underwriting expenses incurred 94,802 96,196 (1 ) 189,091 195,360 (3 ) Dividends to policyholders 1,461 644 127 2,747 2,139 28 Underwriting (loss) income $ (22,331 ) 3,305 (776 )% (27,165 ) (7,667 ) 254 % GAAP Ratios: Loss and loss expense ratio 74.5 % 65.8 8.7 pts 71.5 % 67.9 3.6 pts Underwriting expense ratio 32.7 32.9 (0.2 ) 32.7 33.0 (0.3 ) Dividends to policyholders ratio 0.5 0.2 0.3 0.5 0.4 0.1 Combined ratio 107.7 98.9 8.8 104.7 101.3 3.4 Statutory Ratios: Loss and loss expense ratio 74.5 65.8 8.7 71.5 67.8 3.7 Underwriting expense ratio 33.2 33.9 (0.7 ) 32.4 32.6 (0.2 ) Dividends to policyholders ratio 0.5 0.2 0.3 0.5 0.4 0.1 Combined ratio 108.2 % 99.9 8.3 pts 104.4 % 100.8 3.6 pts · NPW increased in both Second Quarter and Six Months 2011 compared to the same periods last year. This is the first quarter since the fourth quarter of 2007 that NPW increased compared to the prior year. This increase is due to economic improvements evidenced in our audit and endorsement premium, coupled with the successful balance between retention and renewal rate. The following details the fluctuations in NPW for the comparable periods: o Audit additional premium of $1.5 million and audit return premium of $2.1 million in Second Quarter and Six Months 2011, respectively, compared to audit return premium of $13.1 million and $24.3 million in Second Quarter and Six Months 2010, respectively; and o Endorsement additional premium of $1.7 million and $1.2 million in Second Quarter and Six Months 2011, respectively, compared to endorsement return premium of $2.6 million and $7.4 million in Second Quarter and Six Months 2010, respectively. These increases were partially offset by reductions in net renewals of $1.5 million, to $260.2 million, in Second Quarter 2011, and $11.4 million, to $527.4 million, in Six Months 2011 despite renewal pure price increases of 2.6% and 2.7% in the Second Quarter and Six Months 2011, respectively. In addition, direct new business, while flat in Second Quarter 2011 compared to Second Quarter 2010, decreased $15.2 million, to $102.5 million, in Six Months 2011. · NPE decreases in Second Quarter and Six Months 2011 compared to the Second Quarter and Six Months 2010 are consistent with the fluctuation in NPW for the twelve-month period ended June 30, 2011 as compared to the twelve-month period ended June 30, 2010. 30-------------------------------------------------------------------------------- · The 8.7-point increase in the GAAP loss and loss expense ratio in Second Quarter 2011 compared to Second Quarter 2010 reflects: o An increase in catastrophe losses of $14.8 million, or 5.1 points, in Second Quarter 2011; o An increase in non-catastrophe property losses of $4.7 million, or 1.7 points, in Second Quarter 2011; and o Approximately $6 million, or 1.9 points, of favorable casualty prior year development in Second Quarter 2011 compared to approximately $13 million, or 4.3 points, in Second Quarter 2010. The 3.6-point increase in the GAAP loss and loss expense ratio in Six Months 2011 compared to Six Months 2010 reflects: o An increase in non-catastrophe property losses of $5.6 million, or 1.2 points, in Six Months 2011; and o Approximately $10 million, or 1.7 points, of favorable casualty prior year development in Six Months 2011 compared to approximately $22 million, or 3.7 points, in Six Months 2010. For further detail regarding the development in Second Quarter and Six Months 2011 and 2010 see the following lines of business discussions. The following is a discussion of our most significant commercial lines of business: General Liability Quarter ended Change Six Months ended Change June 30, % or June 30, % or ($ in thousands) 2011 2010 Points 2011 2010 Points Statutory NPW $ 90,463 83,513 8 % 179,235 173,047 4 % Statutory NPE 85,672 83,967 2 168,238 169,188 (1 ) Statutory combined ratio 103.0 % 93.5 9.5 pts 101.7 % 93.2 8.5 pts % of total statutory commercial NPW 30 % 29 30 % 29 We continue to see improvements in pricing in this line as our renewal pure price increase was 3.6% and 3.8% in Second Quarter and Six Months 2011, respectively. NPW increased in both Second Quarter and Six Months 2011 which is evidenced by the following: o Endorsement additional premium of $1.0 million and $1.3 million in Second Quarter and Six Months 2011, respectively, compared to return premium of $0.7 million and $2.3 million in Second Quarter and Six Months 2010, respectively; and o Audit return premium of $0.2 million and $3.5 million in Second Quarter and Six Months 2011, respectively, compared to $7.0 million and $13.7 million in Second Quarter and Six Months 2010, respectively. Partially offsetting the items above were: o Net renewals that decreased 2%, or $1.3 million, to $79.3 million in Second Quarter 2011, and 3%, or $4.2 million, to $160.2 million in Six Months 2011; and o New business that decreased 11%, or $3.3 million, to $28.1 million in Six Months 2011. As of June 30, 2011, approximately 55% of our premium in this line is subject to audit. At the end of the policy period, actual exposure units (usually sales or payroll) on policies with premium subject to audit are compared to beginning of period estimates and a return premium or additional premium transaction occurs. The increase in the statutory combined ratio for this line for Second Quarter and Six Months 2011 compared to the same periods last year was driven by lower favorable prior year development, which was as follows: · 2011: $1 million, or 1.2 points, in Second Quarter and $4 million, or 2.3 points, in Six Months, driven by the 2005 through 2009 accident years partially offset by adverse development in the 2010 accident year; · 2010: $10 million, or 11.9 points, in Second Quarter and $19 million, or 11.2 points, in Six Months, driven by 2008 and prior accident years. 31-------------------------------------------------------------------------------- Workers Compensation Quarter ended Change Six Months ended Change June 30, % or June 30, % or ($ in thousands) 2011 2010 Points 2011 2010 Points Statutory NPW $ 66,705 57,360 16 % 134,473 129,543 4 % Statutory NPE 63,855 62,069 3 126,381 126,710 - Statutory combined ratio 116.3 % 127.4 (11.1 ) pts 119.5 % 121.7 (2.2 ) pts % of total statutory commercial NPW 22 % 20 22 % 22 In Second Quarter and Six Months 2011, we experienced NPW increases, with renewal pure price increases of 3.3% for both periods. The increases are evidenced by the following: o Endorsement additional premiums of $0.8 million and $0.6 million in Second Quarter and Six Months 2011, respectively, compared to endorsement return premiums of $1.5 million and $3.1 million in Second Quarter and Six Months 2010, respectively; and o Audit additional premiums of $1.7 million and $1.3 million in Second Quarter and Six Months 2011, respectively, compared to return premium of $6.1 million and $10.6 million in Second Quarter and Six Months 2010, respectively. Partially offsetting the items above were: o Net renewals that decreased 2%, or $1.0 million, to $56.7 million in Second Quarter 2011 and 7%, or $8.7 million, to $117.4 million in Six Months 2011; and o New business that decreased 13%, or $3.4 million, to $23.2 million in Six Months 2011. The decrease in the statutory combined ratio for this line for Second Quarter and Six Months 2011 compared to the same periods last year was driven by lower unfavorable prior year development which was as follows: · 2011: $1 million, or 1.6 points, in Second Quarter and $7 million, or 5.5 points, in Six Months, driven by the 2010 accident year; and · 2010: $8 million, or 12.9 points, in Second Quarter and $14 million, or 11.0 points, in Six Months, primarily associated with increased severity in the 2008 and 2009 accident years. Commercial Automobile Quarter ended Change Six Months ended Change June 30, % or June 30, % or ($ in thousands) 2011 2010 Points 2011 2010 Points Statutory NPW $ 72,740 72,770 - % 144,469 148,255 (3 ) % Statutory NPE 69,199 73,176 (5 ) 138,869 147,492 (6 ) Statutory combined ratio 92.5 % 87.9 4.6 pts 92.4 % 89.4 3.0 pts % of total statutory commercial NPW 24 % 25 24 % 25 Economic factors continue to put pressure on NPW for this line as exposure levels are reduced. This is primarily evidenced in new business, which is down 14%, or $3.5 million, to $22.0 million in Six Months 2011. The increase in the statutory combined ratio for this line was primarily driven by lower favorable casualty prior year development in Second Quarter and Six Months 2011 compared to Second Quarter and Six Months 2010. Prior year casualty development was as follows: o 2011: $4 million, or 5.1 points, in Second Quarter and $8 million, or 5.8 points, in Six Months driven by accident years 2006 through 2009; and o 2010: $10 million, or 13.7 points, in Second Quarter due to lower than anticipated severity primarily in the 2007 through 2009 accident years and $17 million, or 11.2 points, in Six Months, due to lower than anticipated severity primarily in the 2005 through 2009 accident years. 32-------------------------------------------------------------------------------- Commercial Property Quarter ended Change Six Months ended Change June 30, % or June 30, % or ($ in thousands) 2011 2010 Points 2011 2010 Points Statutory NPW $ 49,049 49,502 (1 ) % 97,380 99,641 (2 ) % Statutory NPE 47,877 50,295 (5 ) 96,070 100,630 (5 ) Statutory combined ratio 130.9 % 90.3 40.6 pts 108.8 % 99.3 9.5 pts % of total statutory commercial NPW 16 % 17 16 % 17 NPW for this line of business decreased in Six Months 2011 due to lower new business, which was down 14%, or $2.8 million, to $16.7 million. Partially offsetting this decrease was an increase in net renewals of $0.6 million, to $89.2 million. The increase in the statutory combined ratio for this line was driven by the following: o An increase in catastrophe losses of $11.4 million, or 24.8 points, to $21.2 million in Second Quarter 2011 and $1.1 million, or 2.2 points, to $24.9 million in Six Months 2011; and o An increase in non-catastrophe losses of $6.7 million, or 15.3 points, to $20.7 million in Second Quarter 2011 and $4.8 million, or 6.5 points, to $38.3 million in Six Months 2011. 33-------------------------------------------------------------------------------- Personal Lines Personal Lines Quarter ended Change Six Months ended Change June 30, % or June 30, % or ($ in thousands) 2011 2010 Points 2011 2010 Points GAAP Insurance Operations Results: NPW $ 71,198 66,642 7 % 132,699 122,824 8 % NPE 65,285 59,189 10 129,865 117,483 11 Less: Losses and loss expenses incurred 58,192 47,124 23 111,376 93,046 20 Net underwriting expenses incurred 17,444 18,531 (6 ) 35,090 34,536 2 Underwriting loss $ (10,351 ) (6,466 ) (60 ) % (16,601 ) (10,099 ) (64 ) % GAAP Ratios: Loss and loss expense ratio 89.1 % 79.6 9.5 pts 85.8 % 79.2 6.6 pts Underwriting expense ratio 26.8 31.3 (4.5 ) 27.0 29.4 (2.4 ) Combined ratio 115.9 110.9 5.0 112.8 108.6 4.2 Statutory Ratios: Loss and loss expense ratio 89.2 79.6 9.6 85.7 79.2 6.5 Underwriting expense ratio 26.1 28.0 (1.9 ) 27.6 28.1 (0.5 ) Combined ratio 115.3 % 107.6 7.7 pts 113.3 % 107.3 6.0 pts · NPW increased in Second Quarter and Six Months 2011 compared to Second Quarter and Six Months 2010 primarily due to: o 21 rate increases, 17 of which are 5% or more, that went into effect across our Personal Lines footprint during Six Months 2011 and are expected to generate an additional $11.6 million in annual premium; and o Net renewal direct premium written ("DPW") increases of $8.4 million, or 16%, to $60.0 million, for Second Quarter 2011 and $14.8 million, or 16%, to $110.1 million for Six Months 2011. Renewal pure price increased 6.5% in both Second Quarter and Six Months 2011. These net renewal DPW increases reflect policy retention increases of two points in Second Quarter 2011 and one point in Six Months 2011, to 86% for both periods. · NPE increases in Second Quarter and Six Months 2011, compared to the same periods last year, are consistent with the fluctuation in NPW for the 12-month period ended June 30, 2011 as compared to the 12-month period ended June 30, 2010. · The 9.5-point increase in the GAAP loss and loss expense ratio in Second Quarter 2011 compared to Second Quarter 2010 was primarily attributable to an increase in catastrophe property losses of $7.3 million, or 10.4 points. The 6.6-point increase in the GAAP loss and loss expense ratio in Six Months 2011 compared to Six Months 2010 was primarily attributable to an increase in non-catastrophe property losses of $11.0 million, or 5.7 points. During Six Months 2011, 41 large property claims (more than $100,000) amounted to $12.4 million compared to $6.6 million from 21 large property claims for Six Months 2010. · The decrease in the GAAP underwriting expense ratio in Second Quarter and Six Months 2011 compared to Second Quarter and Six Months 2010 was attributable to an increase in premiums that has outpaced underwriting expenses. We continue to work to achieve the necessary rate increases across our footprint states to improve profitability. In addition, our Personal Lines strategy includes: (i) continued improvement in the quality of new business, focusing on low-frequency and high retaining business through the use of our predictive modeling tools; (ii) fortifying our relationships with our independent agents; (iii) continued diversification in our territory structure; and (iv) providing the excellent service that our policyholders and agents demand. The rate increases that we anticipate obtaining in 2011 are expected to generate an additional $17.6 million in annual premium. Policy retention continues to be positive, despite increases to our rates over the past several years. We believe that this increase in policy retention reflects the hardening of the personal lines market as well as: (i) the ability of our pricing tools to comprehensively analyze where rate increases are appropriate; and (ii) our strategy to obtain high retention, low frequency accounts in our core book of business. 34--------------------------------------------------------------------------------Reinsurance On February 28, 2011, Risk Management Solutions, Inc. ("RMS"), one of the leaders in catastrophe modeling, launched a new version of its US Hurricane Model. The RMS v. 11 model incorporates increased vulnerability of construction assumptions and increases to wind hazards further inland. Reinsurance brokers indicate that the RMS version change created significant increases in modeled losses across portfolios with different geographic and business mix attributes. The modeled results of our portfolio indicate increases in modeled losses of between 70%-100% of the RMS v. 9 model results. Below is a summary of the largest 3 actual hurricane losses that we experienced in the past 20 years: Accident Actual Loss Year Hurricane Name ($ in millions) 1989 Hurricane Hugo $ 26.0 1999 Hurricane Floyd 14.5 2003 Hurricane Isabel 13.4 We view catastrophe modeling as an important tool in our management of aggregation risk. The significant shift of the results created by the latest update to the RMS model, as well as the differences in the modeled losses for the same portfolio between RMS and AIR Worldwide ("AIR") hurricane models, demonstrates the limitations of available models. We therefore use these models to gauge the general direction of change in our risk profile rather than a precise risk indicator. Modeling results are an important part of the determination of the amount of reinsurance we seek to purchase to transfer some of our catastrophic risk. As a result of our blended view of RMS's v. 11.0 and AIR v. 12, on April 22, 2011 we purchased an additional $75 million layer of catastrophe coverage. This brings our Catastrophe Excess of Loss program to $435 million in excess of $40 million retention. The following table presents modeled hurricane losses on a near-term basis from: (i) RMS's v. 9.0; (ii) RMS's v. 11.0; and (iii) AIR v. 12. These projections are based on the Insurance Subsidiaries' property book of business as of July 2010: ($ in thousands) RMS v. 9.0 RMS v. 11.0 AIR v. 12 Net Losses Net Losses Net Gross as a Gross as a Gross Losses as Occurrence Exceedence Losses RMS Net Percent of Losses RMS Net Percent of Losses AIR Net a Percent Probability3 v.9.0 Losses1 Equity2 v.11.0 Losses1 Equity2 v.12 Losses1 of Equity2 4.0% (1 in 25 year event) $ 58,201 27,675 3 % $ 113,995 33,038 3 % $ 97,588 31,300 3 % 2.0% (1 in 50 year event) 121,799 33,883 3 230,242 43,926 4 168,590 38,951 4 1.0% (1 in 100 year event) 228,213 43,820 4 412,597 54,642 5 284,973 46,771 4 0.4% (1 in 250 year event) 457,873 61,438 6 784,332 265,074 24 573,510 128,041 12 1 Losses are after tax, based on total reinsurance program of $435 million excess of $40 million and includes applicable reinstatement premium. 2 Equity as of June 30, 2011. 3 Current Catastrophic Excess of Loss program exhausts at 1 in 153 year event with corresponding net loss to equity of 6% based on blended model results. The blended model results for a 1 in 250 year event corresponds to net losses equal to 18% of equity. We have successfully completed negotiations of our July 1, 2011 excess of loss treaties with highlights as follows: Property Excess of Loss The Property Excess of Loss treaty ("Property Treaty") was renewed with the same terms as the expiring treaty providing for per risk coverage of $28.0 million in excess of a $2.0 million retention. · The per occurrence cap on the total program is $64.0 million. · The first layer continues to have unlimited reinstatements. The annual aggregate limit for the second, $20.0 million in excess of $10.0 million, layer remains at $80.0 million. · Consistent with the prior year treaty, the Property Treaty excludes nuclear, biological, chemical, and radiological terrorism losses. 35-------------------------------------------------------------------------------- Casualty Excess of Loss The Casualty Excess of Loss treaty ("Casualty Treaty") was renewed with substantially the same terms as the expiring treaty providing the following per occurrence coverage: · The first layer now provides coverage for 100% of up to $3.0 million in excess of a $2.0 million retention, compared to 85% coverage in the expiring treaty. · The next five layers provide coverage for 100% of up to $85.0 million in excess of $5.0 million. · Consistent with the prior year, the Casualty Treaty excludes nuclear, biological, chemical, and radiological terrorism losses. Annual aggregate terrorism limits increased to $201.0 million from $198.8 million due to the increased participation on the first layer. 36--------------------------------------------------------------------------------Investments Our investment philosophy includes certain return and risk objectives for the fixed maturity, equity, and other investment portfolios. The primary return objective of the fixed maturity portfolio is to maximize after-tax investment yield and income while balancing risk. A secondary objective is to meet or exceed a weighted-average benchmark of public fixed income indices. The equity portfolio return objective is to meet or exceed a weighted-average benchmark of public equity indices with a secondary goal of generating dividend income. Although yield and income generation remain the key drivers to our investment strategy, our overall philosophy is to invest with a long-term horizon along with a "buy-and-hold" principle. During the first quarter of 2011, we began repositioning our equity portfolio into a high dividend yield equities strategy that is benchmarked to the Standards and Poor's ("S&P") 500 Index. The return objective for other investments, which includes alternative investments, is to meet or exceed the S&P 500 Index. Total Invested Assets June 30, December 31, ($ in thousands) 2011 2010 Change % Total invested assets $ 4,007,338 3,925,722 2 % Unrealized gain - before tax 102,312 82,872 23 Unrealized gain - after tax 66,503 53,867 23 Our investment portfolio totaled $4.0 billion at June 30, 2011, an increase of 2% compared to December 31, 2010. This increase was driven primarily by: (i) cash flows generated from our Insurance Operations; and (ii) increased valuations on securities in our available-for-sale ("AFS") portfolio. The unrealized gain position on the AFS portfolio increased by $19.4 million on a pre-tax basis, to $102.3 million, as of June 30, 2011. The breakdown of our investment portfolio, which generally remained unchanged from December 31, 2010, is as follows: June 30, December 31, 2011 2010 U.S. government obligations 10 % 11 % Foreign government obligations 1 1 State and municipal obligations 33 36 Corporate securities 29 27 Mortgage-backed securities ("MBS") 15 14 Asset-backed securities ("ABS") 2 2 Total fixed maturity securities 90 91 Equity securities 3 2 Short-term investments 4 4 Other investments 3 3 Total 100 % 100 % We structure our portfolio conservatively with a focus on: (i) asset diversification; (ii) investment quality; (iii) liquidity, particularly to meet the cash obligations of our Insurance Operations segment; (iv) consideration of taxes; and (v) preservation of capital. We believe that we have a high quality and liquid investment portfolio. The average duration of the fixed maturity securities portfolio as of June 30, 2011, including short-term investments, was 3.3 years compared to the Insurance Subsidiaries' liability duration of approximately 3.8 years. The current duration of the fixed maturity securities portfolio is within our historical range, and is monitored and managed to maximize yield and limit interest rate risk. We manage liquidity with a laddered maturity structure and an appropriate level of short-term investments to avoid liquidation of AFS fixed maturities in the ordinary course of business. We typically have a long investment time horizon and every purchase or sale is made with the intent of improving future investment returns while balancing capital preservation. 37 -------------------------------------------------------------------------------- Our fixed maturity securities portfolio carries a weighted average credit rating of "AA" despite ratings migration over the past year due to general economic conditions and our recent heavier allocation to investment-grade corporate bonds. The following table presents the credit ratings of our fixed maturity securities portfolio: Fixed Maturity June 30, December 31, Security Rating 2011 2010 Aaa/AAA 42 % 42 % Aa/AA 28 28 A/A 22 21 Baa/BBB 7 8 Ba/BB or below 1 1 Total 100 % 100 % 38-------------------------------------------------------------------------------- The following table summarizes the fair value, unrealized gain (loss) balances, and the weighted average credit qualities of our AFS fixed maturity securities at June 30, 2011 and December 31, 2010: June 30, 2011 December 31, 2010 Average Average Fair Unrealized Credit Fair Unrealized Credit ($ in millions) Value Gain (Loss) Quality Value Gain (Loss) Quality AFS Fixed Maturity Portfolio: U.S. government obligations1 $ 296.9 8.2 AAA 320.5 8.1 AAA Foreign government obligations 30.1 0.3 AA 19.0 - AA State and municipal obligations 542.6 29.7 AA+ 533.9 21.9 AA+ Corporate securities 1,078.5 31.4 A 993.7 19.9 A MBS 498.9 12.5 AA+ 426.9 6.7 AA+ ABS 78.2 0.6 AAA 48.7 0.2 AAA Total AFS fixed maturity portfolio $ 2,525.2 82.7 AA 2,342.7 56.8 AA State and Municipal Obligations: General obligations $ 294.9 16.6 AA+ 289.6 11.1 AA+ Special revenue obligations 247.7 13.1 AA 244.3 10.8 AA Total state and municipal obligations $ 542.6 29.7 AA+ 533.9 21.9 AA+ Corporate Securities: Financial $ 344.4 8.7 A+ 289.9 4.5 A+ Industrials 81.2 4.4 A 77.0 3.6 A- Utilities 68.5 1.1 A- 56.5 0.2 BBB+ Consumer discretion 85.0 2.0 A- 98.9 1.1 A- Consumer staples 118.0 3.5 A 101.6 2.1 A- Healthcare 141.9 5.2 AA- 138.0 4.1 AA- Materials 52.9 1.3 A- 57.0 0.8 A- Energy 56.6 2.1 A 49.5 1.2 A Information technology 70.7 1.1 A+ 51.5 0.4 A+ Telecommunications services 44.1 0.8 BBB+ 50.5 0.2 A- Other 15.2 1.2 AA+ 23.3 1.7 AA+ Total corporate securities $ 1,078.5 31.4 A 993.7 19.9 A MBS: Government guaranteed agency commercial MBS ("CMBS") $ 72.3 3.6 AAA 71.9 3.3 AAA Non-agency CMBS 36.8 (0.2 ) A- 32.6 (2.1 ) A- Government guaranteed agency residential MBS ("RMBS") 94.7 3.9 AAA 91.1 3.0 AAA Other agency RMBS 250.6 5.5 AAA 183.6 3.8 AAA Non-agency RMBS 36.1 (0.3 ) BBB- 38.3 (1.0 ) BBB Alternative-A ("Alt-A") RMBS 8.4 - AA+ 9.4 (0.3 ) AAA Total MBS $ 498.9 12.5 AA+ 426.9 6.7 AA+ ABS: ABS $ 77.4 0.7 AAA 47.8 0.2 AAA Sub-prime ABS2, 3 0.8 (0.1 ) D 0.9 - D Total ABS $ 78.2 0.6 AAA 48.7 0.2 AAA 1 U.S. government includes corporate securities fully guaranteed by the Federal Deposit Insurance Corporation ("FDIC"). 2 We define sub-prime exposure as exposure to direct and indirect investments in non-agency residential mortgages with average FICO® scores below 650. 3 Subprime ABS consists of one security that is currently expected by rating agencies to default on its obligations. 39 -------------------------------------------------------------------------------- The following tables provide information regarding our held-to-maturity ("HTM") fixed maturity securities and their credit qualities at June 30, 2011 and December 31, 2010: June 30, 2011 Total Unrecognized Unrealized Unrealized/ Average Fair Carry Holding Gain Gain (Loss) in Unrecognized Credit ($ in millions) Value Value (Loss) AOCI Gain (Loss) Quality HTM Portfolio: U.S. government obligations1 $ 97.1 90.8 6.3 4.3 10.6 AAA Foreign government obligations 5.5 5.6 (0.1 ) 0.3 0.2 AA+ State and municipal obligations 821.5 796.3 25.2 17.3 42.5 AA Corporate securities 77.7 69.7 8.0 (3.0 ) 5.0 A MBS 109.9 100.2 9.7 (5.3 ) 4.4 AA+ ABS 9.3 8.0 1.3 (2.3 ) (1.0 ) A- Total HTM portfolio $ 1,121.0 1,070.6 50.4 11.3 61.7 AA State and Municipal Obligations: General obligations $ 234.5 227.2 7.3 8.1 15.4 AA Special revenue obligations 587.0 569.1 17.9 9.2 27.1 AA Total state and municipal obligations $ 821.5 796.3 25.2 17.3 42.5 AA Corporate Securities: Financial $ 21.7 18.5 3.2 (2.0 ) 1.2 A- Industrials 20.7 18.0 2.7 (0.8 ) 1.9 A Utilities 17.0 16.0 1.0 (0.1 ) 0.9 A Consumer discretion 7.3 7.0 0.3 0.1 0.4 AA- Consumer staples 5.3 5.0 0.3 - 0.3 A Materials 2.1 1.9 0.2 (0.1 ) 0.1 BBB Energy 3.6 3.3 0.3 (0.1 ) 0.2 BBB- Total corporate securities $ 77.7 69.7 8.0 (3.0 ) 5.0 A MBS: Government guaranteed agency CMBS $ 5.2 5.0 0.2 - 0.2 AAA Non-agency CMBS 38.7 31.6 7.1 (6.2 ) 0.9 AA Government guaranteed agency RMBS 7.5 6.9 0.6 (0.1 ) 0.5 AAA Other agency RMBS 58.4 56.6 1.8 1.0 2.8 AAA Non-agency RMBS 0.1 0.1 - - - BBB Total MBS $ 109.9 100.2 9.7 (5.3 ) 4.4 AA+ ABS: ABS $ 6.4 5.5 0.9 (0.7 ) 0.2 BBB+ Alt-A ABS 2.9 2.5 0.4 (1.6 ) (1.2 ) AA- Total ABS $ 9.3 8.0 1.3 (2.3 ) (1.0 ) A- 40-------------------------------------------------------------------------------- December 31, 2010 Total Unrealized/ Average Fair Carry Unrecognized Unrealized Gain Unrecognized Credit ($ in millions) Value Value Holding Gain (Loss) in AOCI Gain (Loss) Quality HTM Portfolio: U.S. government obligations1 $ 103.1 98.1 5.0 4.7 9.7 AAA Foreign government obligations 5.6 5.6 - 0.3 0.3 AA+ State and municipal obligations 912.3 896.6 15.7 22.2 37.9 AA Corporate securities 82.1 72.7 9.4 (4.0 ) 5.4 A- MBS 141.3 130.8 10.5 (6.3 ) 4.2 AAA ABS 11.9 10.5 1.4 (2.4 ) (1.0 ) A Total HTM portfolio $ 1,256.3 1,214.3 42.0 14.5 56.5 AA State and Municipal Obligations: General obligations $ 240.3 236.8 3.5 9.7 13.2 AA Special revenue obligations 672.0 659.8 12.2 12.5 24.7 AA Total state and municipal obligations $ 912.3 896.6 15.7 22.2 37.9 AA Corporate Securities: Financial $ 23.5 20.0 3.5 (2.5 ) 1.0 A- Industrials 22.8 19.4 3.4 (1.2 ) 2.2 A Utilities 16.9 16.1 0.8 (0.1 ) 0.7 BBB Consumer discretion 7.7 7.1 0.6 0.2 0.8 AA- Consumer staples 5.4 4.9 0.5 (0.1 ) 0.4 A Materials 2.1 1.9 0.2 (0.1 ) 0.1 BBB- Energy 3.7 3.3 0.4 (0.2 ) 0.2 BB+ Total corporate securities $ 82.1 72.7 9.4 (4.0 ) 5.4 A- MBS Government guaranteed agency CMBS $ 9.2 8.9 0.3 - 0.3 AAA Other agency CMBS 3.6 3.6 - - - AAA Non-agency CMBS 42.1 35.0 7.1 (7.4 ) (0.3 ) AA+ Government guaranteed agency RMBS 4.5 4.0 0.5 (0.1 ) 0.4 AAA Other agency RMBS 81.8 79.2 2.6 1.2 3.8 AAA Non-agency RMBS 0.1 0.1 - - - BBB Total MBS $ 141.3 130.8 10.5 (6.3 ) 4.2 AAA ABS: ABS $ 9.1 8.0 1.1 (0.9 ) 0.2 A- Alt-A ABS 2.8 2.5 0.3 (1.5 ) (1.2 ) AA- Total ABS $ 11.9 10.5 1.4 (2.4 ) (1.0 ) A 1 U.S. government includes corporate securities fully guaranteed by the FDIC. A portion of our AFS and HTM municipal bonds contain insurance enhancements. The following table provides information regarding these insurance-enhanced securities as of June 30, 2011: Insurers of Municipal Bond Securities Ratings Ratings with without ($ in thousands) Fair Value Insurance Insurance National Public Finance Guarantee Corporation, a subsidiary of MBIA, Inc. $ 354,577 AA- A+ Assured Guaranty 232,604 AA+ A Ambac Financial Group, Inc. 95,127 AA- AA- Other 20,685 AA A+ Total $ 702,993 AA A+ 41-------------------------------------------------------------------------------- To manage and mitigate exposure, we perform analyses on MBS both at the time of purchase and as part of the ongoing portfolio evaluation. This analysis includes review of average FICO® scores, loan-to-value ratios, geographic spread of the assets securing the bond, delinquencies in payments for the underlying mortgages, gains/losses on sales, evaluations of projected cash flows, as well as other information that aids in determination of the health of the underlying assets. We also consider the overall credit environment, economic conditions, total projected return on the investment, and overall asset allocation of the portfolio in our decisions to purchase or sell structured securities. The following table details the top 10 state exposures of the municipal bond portion of our fixed maturity securities portfolio at June 30, 2011: State Exposures of Municipal Bonds Average General Obligation Special Fair Credit ($ in thousands) Local State Revenue Value Quality Texas $ 85,750 1,056 59,425 146,231 AA Washington 45,866 - 45,122 90,988 A+ Arizona 6,837 - 68,695 75,532 AA Florida - - 69,155 69,155 A+ North Carolina 23,474 22,266 23,385 69,125 AA+ New York - - 67,348 67,348 AA+ Ohio 13,687 7,345 33,343 54,375 AA Minnesota 5,156 41,240 6,797 53,193 AAA Illinois 19,856 - 28,388 48,244 AA- Colorado 28,535 1,847 16,885 47,267 AA- Other 123,111 76,479 379,770 579,360 AA- 352,272 150,233 798,313 1,300,818 AA Advanced refunded/escrowed to maturity bonds 21,482 5,389 36,457 63,328 A+ Total $ 373,754 155,622 834,770 1,364,146 AA There has recently been widespread concern regarding the stress on state and local governments emanating from declining revenues, large unfunded liabilities, and entrenched cost structures. This has led to speculation about potential fallout on the municipal bond market. Overall, we are comfortable with the quality, composition, and diversification of our $1.4 billion municipal bond portfolio, but we closely monitor our exposure, particularly in light of the changing landscape for municipalities. Our municipal bond portfolio is very high quality with an average AA rating and is well laddered with 35% maturing within three years and another 33% maturing between three and five years. The weightings of the municipal bond portfolio are: 61% of high-quality revenue bonds that have dedicated revenue streams, 27% of local general obligation bonds, and 12% of state general obligation bonds. In addition, approximately 5% of the municipal bond portfolio has been refunded in advance. Our largest state exposure is to Texas, at 11% excluding the impact of advanced refunded bonds. Of the $86 million in local Texas general obligation bonds, $42 million represents investments in Texas Permanent School Fund bonds, which are considered to be lower risk. The sector composition and credit quality of our special revenue bonds did not significantly change from December 31, 2010. For details regarding our special revenue bond sectors and additional information regarding credit risk associated with our portfolio, see Item 7A. "Quantitative and Qualitative Disclosures About Market Risk." of our 2010 Annual Report. 42 -------------------------------------------------------------------------------- As of June 30, 2011, alternative investments represented 3% of our total invested assets. The following table outlines a summary of our other investment portfolio by strategy and the remaining commitment amount associated with each strategy: Other Investments June 30, 2011 Carrying Value Remaining ($ in thousands) June 30, 2011 December 31, 2010 Commitment Alternative Investments: Energy/power generation $ 29,862 35,560 10,296 Secondary private equity 27,601 26,709 12,334 Distressed debt 19,868 20,432 3,389 Private equity 18,786 21,601 7,966 Real estate 15,642 14,192 10,670 Mezzanine financing 10,126 10,230 15,865 Venture capital 7,666 6,386 1,100 Total alternative investments 129,551 135,110 61,620 Other securities 2,586 2,755 - Total other investments $ 132,137 137,865 61,620 In addition to the capital that we have already invested to date, we are contractually obligated to invest up to an additional $61.6 million in these alternative investments through commitments that currently expire at various dates through 2022. For a description of our seven alternative investment strategies outlined above, as well as redemption, restrictions, and fund liquidations, refer to Note 5. "Investments" in Item 8. "Financial Statements and Supplementary Data." of our 2010 Annual Report. Net Investment Income The components of net investment income earned were as follows: Quarter ended June 30, Six Months ended June 30, ($ in thousands) 2011 2010 2011 2010 Fixed maturity securities $ 32,752 32,977 65,875 66,173 Equity securities 785 480 1,102 932 Short-term investments 33 133 95 233 Other investments 7,922 4,884 19,588 8,816 Investment expenses (2,147 ) (1,929 ) (3,842 ) (4,903 ) Net investment income earned - before tax 39,345 36,545 82,818 71,251 Net investment income tax expense (9,925 ) (8,617 ) (21,273 ) (16,498 ) Net investment income earned - after tax $ 29,420 27,928 61,545 54,753 Effective tax rate on net investment income 25.2 % 23.6 25.7 % 23.2 Annual after-tax yield on fixed maturity securities 2.7 2.9 Annual after-tax yield on investment portfolio 3.1 2.9 Net investment income, before tax, increased by: (i) $2.8 million for Second Quarter 2011 compared to Second Quarter 2010; and (ii) $11.6 million for Six Months 2011 compared to Six Months 2010. These increases were primarily driven by income from our alternative investments within our investment portfolio. Our alternative investments, which are accounted for under the equity method, primarily consist of investments in limited partnerships, the majority of which report results to us on a one quarter lag. The following table illustrates income by strategy for these partnerships: Quarter ended June 30, Six Months ended June 30, ($ in thousands) 2011 2010 2011 2010 Energy/power generation $ 1,284 965 5,839 3,031 Private equity 1,181 99 3,758 807 Secondary private equity 3,067 2,665 4,716 3,684 Distressed debt 421 (41 ) 1,394 723 Real estate 681 (494 ) 1,450 (2,359 ) Venture capital 565 (18 ) 1,323 248 Mezzanine financing 701 1,692 1,061 2,629 Other 22 16 47 53 Total other investment income $ 7,922 4,884 19,588 8,816 43--------------------------------------------------------------------------------Realized Gains and Losses Realized Gains and Losses (excluding OTTI) Realized gains and losses, by type of security excluding OTTI charges, are determined on the basis of the cost of specific investments sold and are credited or charged to income. The components of net realized gains were as follows: Quarter ended Six Months ended June 30, June 30, ($ in thousands) 2011 2010 2011 2010 HTM fixed maturity securities Gains $ 8 368 9 412 Losses (108 ) (210 ) (322 ) (450 ) AFS fixed maturity securities Gains 1,947 325 2,354 4,782 Losses - (7,558 ) (7 ) (7,589 ) AFS equity securities Gains 468 9,995 6,671 14,174 Losses - - - (233 ) Total other net realized investment gains 2,315 2,920 8,705 11,096 Total OTTI charges recognized in earnings (169 ) (6,184 ) (799 ) (14,424 ) Total net realized gains (losses) $ 2,146 (3,264 ) 7,906 (3,328 ) For a discussion of realized gains and losses, see Note 6. "Investments" in Item 1. "Financial Statements" of this Form 10-Q. There were no securities sold at a loss during Second Quarter 2011 and Six Months 2011. The following tables present the period of time that securities sold at a loss in Second Quarter 2010 and Six Months 2010 were continuously in an unrealized loss position prior to sale: Period of Time in an Quarter ended Unrealized Loss Position June 30, 2010 Fair Value on Realized ($ in thousands) Sale Date Loss Fixed maturities: 0 - 6 months $ 6,403 432 7 - 12 months - - Greater than 12 months 10,257 7,098 Total fixed maturities 16,660 7,530 Total equity securities - - Total other investments - - Total $ 16,660 7,530 Period of Time in an Six Months ended Unrealized Loss Position June 30, 2010 Fair Value on Realized ($ in thousands) Sale Date Loss Fixed maturities: 0 - 6 months $ 11,462 463 7 - 12 months - - Greater than 12 months 10,257 7,098 Total fixed maturities 21,719 7,561 Equities: 0 - 6 months 4,128 233 7 - 12 months - - Total equity securities 4,128 233 Total other investments - - Total $ 25,847 7,794 44-------------------------------------------------------------------------------- Our general philosophy for sales of securities is to reduce our exposure to securities and sectors based on economic evaluations and when the fundamentals for that security or sector have deteriorated. We typically have a long investment time horizon and every purchase or sale is made with the intent of improving future investment returns while balancing capital preservation. From time to time, this may involve initiating sales programs to rebalance the overall portfolio allocation. Other-than-Temporary Impairments The following table provides information regarding our OTTI charges recognized in earnings: Quarter ended Six Months ended June 30, June 30, ($ in thousands) 2011 2010 2011 2010 HTM securities ABS $ - - - 31 CMBS - 1,464 - 4,125 RMBS - 317 - 317 Total HTM securities - 1,781 - 4,473 AFS securities Obligations of state and political subdivisions - - 17 - Corporate securities - - 244 - CMBS 142 1,372 472 1,372 RMBS 27 2,359 66 7,907 Total fixed maturity AFS securities 169 3,731 799 9,279 Equity Securities - 672 - 672 Total AFS securities 169 4,403 799 9,951 Total OTTI charges recognized in earnings $ 169 6,184 799 14,424 We regularly review our entire investment portfolio for declines in fair value. If we believe that a decline in the value of a particular investment is other than temporary, we record it as an OTTI, through realized losses in earnings for the credit-related portion and through unrealized losses in OCI for the non-credit related portion. If there is a decline in fair value of an equity security that we do not intend to hold, or if we determine the decline is other than temporary, we write down the cost of the investment to fair value and record the charge through earnings as a component of realized losses. For discussion of our OTTI methodology, see Note 2. "Summary of Significant Accounting Policies" in Item 8. "Financial Statements and Supplementary Data." of our 2010 Annual Report. In addition, for qualitative information regarding these charges, see Note 6. "Investments," included in Item 1. "Financial Statements" of this Form 10-Q. 45 -------------------------------------------------------------------------------- Unrealized/Unrecognized Losses The following table summarizes the aggregate fair value and gross pre-tax unrealized/unrecognized losses recorded, by asset class and by length of time, for all securities that have continuously been in an unrealized/unrecognized loss position at June 30, 2011 and December 31, 2010: June 30, 2011 Less than 12 months 12 months or longer Unrealized Unrealized ($ in thousands) Fair Value Losses1 Fair Value Losses1 AFS securities U.S. government and government agencies2 $ 4,051 (52 ) - - Foreign government 15,355 (145 ) - - Obligations of states and political subdivisions - - 305 (6 ) Corporate securities 254,600 (4,125 ) - - ABS 25,317 (56 ) 765 (72 ) CMBS 8,064 (33 ) 10,362 (1,148 ) RMBS 68,028 (888 ) 7,201 (624 ) Total fixed maturity securities 375,415 (5,299 ) 18,633 (1,850 ) Equity securities 51,650 (1,663 ) - - Subtotal $ 427,065 (6,962 ) 18,633 (1,850 ) Less than 12 months 12 months or longer Unrecognized Unrecognized Fair Unrealized Gains Fair Unrealized Gains ($ in thousands) Value Losses1 (Losses)3 Value Losses1 (Losses)3 HTM securities Obligations of states and political subdivisions $ 13,127 (549 ) 476 23,379 (1,630 ) 1,312 ABS - - - 3,364 (1,635 ) 340 CMBS - - - 6,438 (3,554 ) 1,137 RMBS - - - 112 (38 ) 18 Subtotal $ 13,127 (549 ) 476 33,293 (6,857 ) 2,807 Total AFS and HTM $ 440,192 (7,511 ) 476 51,926 (8,707 ) 2,807 December 31, 2010 Less than 12 months 12 months or longer Fair Unrealized Fair Unrealized ($ in thousands) Value Losses1 Value Losses1 AFS securities U.S. government and government agencies2 $ 3,956 (147 ) - - Foreign government 10,776 (349 ) - - Obligations of states and political subdivisions 40,410 (650 ) - - Corporate securities 362,502 (8,784 ) - - ABS 30,297 (273 ) 880 (66 ) CMBS 5,453 (271 ) 11,115 (2,652 ) RMBS 70,934 (1,098 ) 20,910 (1,145 ) Total fixed maturity securities 524,328 (11,572 ) 32,905 (3,863 ) Equity securities - - - - Subtotal $ 524,328 (11,572 ) 32,905 (3,863 ) 46-------------------------------------------------------------------------------- Less than 12 months 12 months or longer Unrealized Unrecognized Fair (Losses) Gains Fair Unrealized Unrecognized ($ in thousands) Value Gains1 (Losses)3 Value Losses1 Gains3 HTM securities Obligations of states and political subdivisions $ 21,036 (381 ) 45 27,855 (1,969 ) 670 Corporate securities 1,985 (434 ) 420 - - - ABS 507 (546 ) (440 ) 2,931 (1,095 ) 747 CMBS 3,621 15 (17 ) 5,745 (3,933 ) 833 RMBS - - - 95 (38 ) 1 Subtotal $ 27,149 (1,346 ) 8 36,626 (7,035 ) 2,251 Total AFS and HTM $ 551,477 (12,918 ) 8 69,531 (10,898 ) 2,251 1 Gross unrealized losses include non-OTTI unrealized amounts and OTTI losses recognized in AOCI. In addition, this column includes remaining unrealized gain or loss amounts on securities that were transferred to an HTM designation in the first quarter of 2009 for those securities that are in a net unrealized/unrecognized loss position. 2 U.S. government includes corporate securities fully guaranteed by the FDIC. 3 Unrecognized holding gains/(losses) represent fair value fluctuations from the later of: (i) the date a security is designated as HTM; or (ii) the date that an OTTI charge is recognized on an HTM security. The number of securities in an unrealized/unrecognized loss position increased from 199 at December 31, 2010 to 225 at June 30, 2011, with an associated fair value of $621.0 million and $492.1 million, respectively. Despite the increase in the number of securities and the associated fair value, the corresponding unrealized/unrecognized position in total declined by $8.6 million, reflecting smaller loss positions. This is further illustrated in the following table wherein the number of issues in the 80% - 99% market/book category increased since December 31, 2010 while the overall loss position decreased during the same period: ($ in thousands) June 30, 2011 December 31, 2010 Unrealized Unrealized Number % of Unrecognized Number of % of Unrecognized of Issues Market/Book Loss Issues Market/Book Loss 221 80% - 99% $ 9,331 193 80% - 99% $ 16,310 1 60% - 79% 23 2 60% - 79% 1,125 2 40% - 59% 2,529 2 40% - 59% 2,160 1 20% - 39% 1,052 1 20% - 39% 986 - 0% - 19% - 1 0% - 19% 976 $ 12,935 $ 21,557 We have reviewed the securities in the tables above in accordance with our OTTI policy, which is discussed in Note 2. "Summary of Significant Accounting Policies" in Item 8. "Financial Statements and Supplementary Data." of our 2010 Annual Report. For qualitative information regarding our conclusion as to why these impairments are deemed temporary, see Note 6. "Investments," in Item 1. "Financial Statements" of this Form 10-Q. Contractual Maturities The following table presents amortized cost and fair value regarding our AFS fixed maturities that were in an unrealized loss position at June 30, 2011 by contractual maturity: Contractual Maturities Amortized Fair ($ in thousands) Cost Value One year or less $ 17,181 17,017 Due after one year through five years 228,793 226,007 Due after five years through ten years 146,623 143,051 Due after ten years 8,600 7,973 Total $ 401,197 394,048 47-------------------------------------------------------------------------------- The following table presents information regarding our HTM fixed maturities that were in an unrealized/unrecognized loss position at June 30, 2011 by contractual maturity: Contractual Maturities Amortized Fair ($ in thousands) Cost Value One year or less $ 363 361 Due after one year through five years 37,422 34,553 Due after five years through ten years 10,719 10,542 Due after ten years 2,039 964 Total $ 50,543 46,420 Investments Outlook Through Six Months 2011 the economic recovery has been proceeding at a slow pace. The labor market continues to be sluggish, with the Bureau of Labor Statistics reporting that the June 2011 unemployment rate was 9.2%, up from the March reading and down only 0.3% from June 2010. The Federal Reserve continues to maintain an accommodative monetary policy with no indication of an upcoming change. We are focused on the following areas of concern: (i) instability in oil producing countries and the impact on oil prices; (ii) efforts to contain the Eurozone debt crisis; (iii) commodity input price inflation; (iv) overall inflation expectations; and (v) the overhang in the domestic housing market. Inflation and the monetary response to it will have a significant impact on our fixed income portfolio. At its June meeting, the Federal Reserve acknowledged recent inflationary indicators although consensus remains for stable longer term inflation. The accommodative monetary policy is likely to continue through 2011 and it will be challenging to maintain yield and credit quality given the spread between maturing assets and current reinvestment rates. Our fixed income strategy remains focused on maintaining sufficient liquidity while maximizing yield within acceptable risk tolerances. We will continue to invest in high quality instruments including additions to investment grade corporate bonds with diversified maturities to manage incremental interest rate risk. When market conditions warrant, we may opportunistically invest in higher yielding fixed income securities to take advantage of attractive risk adjusted return opportunities. We have modified our equity portfolio and are pursuing a more sector-neutral position for this asset class. As mentioned previously, we have allocated assets to a high dividend yield strategy, which is expected to improve our equity portfolio's diversification and provide additional yield while maintaining our allocation to the domestic equities market. Our current outlook for alternative investments is positive. Private markets remain strong and the improved merger and acquisition environment is an important driver of exit opportunities for our general partners, and has also positively impacted the underlying funds' portfolio values. 48 -------------------------------------------------------------------------------- Federal Income Taxes Federal income taxes from continuing operations decreased by $3.9 million for Second Quarter 2011 and increased by $1.3 million for Six Months 2011, to a benefit of $1.1 million for Second Quarter 2011 and an expense of $5.1 million for Six Months 2011, compared to an expense of $2.8 million and $3.8 million, respectively. The decrease in Second Quarter 2011 is primarily due to an increase in underwriting losses compared to the prior year. The increase for Six Months 2011 is attributable to an increase in net investment income and net realized gains. The effective tax rate was approximately (90)% for Second Quarter 2011 and 18% for Six Months 2011, compared to an effective tax rate of 12% for both Second Quarter and Six Months 2010. Our effective tax rate for continuing operations differs from the federal corporate rate of 35% primarily as a result of tax-advantaged investment income. Financial Condition, Liquidity, Short-term Borrowings, and Capital Resources Capital resources and liquidity reflect our ability to generate cash flows from business operations, borrow funds at competitive rates, and raise new capital to meet operating and growth needs. Liquidity We manage liquidity with a focus on generating sufficient cash flows to meet both the short-term and long-term cash requirements of our business operations. Our cash and short-term investment position was $143 million at June 30, 2011, primarily comprised of $41 million at Selective Insurance Group, Inc. (the "Parent") and $102 million at the Insurance Subsidiaries. We continually evaluate our liquidity levels and short-term investments are maintained in AAA rated money market funds approved by the National Association of Insurance Commissioners. Sources of cash for the Parent have historically consisted of dividends from the Insurance Subsidiaries, borrowings under its line of credit, loan agreements with our Indiana-domiciled Insurance Subsidiaries ("Indiana Subsidiaries"), and the issuance of stock and debt securities. We continue to monitor these sources, giving consideration to our long-term liquidity and capital preservation strategies. The Parent had no private or public issuances of stock or debt during 2011 and there were no borrowings under its $30 million line of credit ("Line of Credit"). We currently anticipate the Insurance Subsidiaries paying approximately $63 million of dividends to the Parent in 2011, of which $29 million was paid through Second Quarter 2011, compared to our allowable ordinary maximum dividend amount of approximately $110 million. Any dividends to the Parent continue to be subject to the approval and/or review of the insurance regulators in the respective domiciliary states under insurance holding company acts, and are generally payable only from earned surplus as reported in the statutory annual statements of those subsidiaries as of the preceding December 31. Although past dividends have historically been met with regulatory approval, there is no assurance that future dividends that may be declared will be approved. For additional information regarding dividend restrictions, refer to Note 6. "Stockholders' Equity and Other Comprehensive Income (Loss)" in Item 8. "Financial Statements and Supplementary Data." of our 2010 Annual Report. The Indiana Subsidiaries are members in the Federal Home Loan Bank of Indianapolis ("FHLBI"), which provides these companies with access to additional liquidity. The Indiana Subsidiaries' aggregate investment of $0.8 million provides them with the ability to borrow up to 20 times the total amount of the FHLBI common stock purchased, at comparatively low borrowing rates. The Parent's Line of Credit agreement permits collateralized borrowings by the Indiana Subsidiaries from the FHLBI so long as the aggregate amount borrowed does not exceed 10% of the respective Indiana Subsidiary's admitted assets from the preceding calendar year. For additional information regarding the Parent's Line of Credit, refer to the section below entitled "Short-term Borrowings." All borrowings from FHLBI are required to be secured by certain investments. The Indiana Department of Insurance has approved lending agreements from the Indiana Subsidiaries to the Parent. At June 30, 2011, the outstanding borrowings of the Indiana Subsidiaries from the FHLBI were $13 million in fixed rate borrowings after pledging the required collateral. These funds have been loaned to the Parent under the approved lending agreements. For additional information regarding the required collateral, refer to Note 6. "Investments" of this Form 10-Q. 49-------------------------------------------------------------------------------- The Insurance Subsidiaries also generate liquidity through insurance float, which is created by collecting premiums and earning investment income before losses are paid. The period of the float can extend over many years. Our investment portfolio consists of maturity dates that are well-laddered to continually provide a source of cash flows for claims payments in the ordinary course of business. The duration of the fixed maturity securities portfolio, including short-term investments, was 3.3 years as of June 30, 2011, while the liabilities of the Insurance Subsidiaries have a duration of approximately 3.8 years. In addition, the Insurance Subsidiaries purchase reinsurance coverage for protection against any significantly large claims or catastrophes that may occur during the year. The liquidity generated from the sources discussed above is used, among other things, to pay dividends to our stockholders. Dividends on shares of the Parent's common stock are declared and paid at the discretion of the Board of Directors based on our operating results, financial condition, capital requirements, contractual restrictions, and other relevant factors. Our ability to meet our interest and principal repayment obligations on our debt, as well as our ability to continue to pay dividends to our stockholders is dependent on liquidity at the Parent coupled with the ability of the Insurance Subsidiaries to pay dividends, if necessary, and/or the availability of other sources of liquidity to the Parent. Our next principal repayment of $13 million is due in 2014, with the next principal repayment occurring beyond that in 2034. Restrictions on the ability of the Insurance Subsidiaries to declare and pay dividends, without alternative liquidity options, could materially affect the Parent's ability to service its debt and pay dividends on common stock. Short-term Borrowings Our Line of Credit with Wells Fargo Bank, National Association, as administrative agent, and Branch Banking and Trust Company (BB&T), was renewed effective June 13, 2011 with a borrowing capacity of $30 million, which can be increased to $50 million with the approval of both lending parties. This Line of Credit, which is not used in our daily cash management, provides the Parent an additional source of short-term liquidity, if needed. The interest rate on our Line of Credit varies and is based on the Parent's debt ratings. The Line of Credit expires on June 13, 2014. There were no balances outstanding under this credit facility as of June 30, 2011 or at any time during 2011. The Line of Credit agreement contains representations, warranties, and covenants that are customary for credit facilities of this type, including, without limitation, financial covenants under which we are obligated to maintain a minimum consolidated net worth, minimum combined statutory surplus, and maximum ratio of consolidated debt to total capitalization, as well as covenants limiting our ability to: (i) merge or liquidate; (ii) incur debt or liens; (iii) dispose of assets; (iv) make investments and acquisitions; and (v) engage in transactions with affiliates. The table below outlines information regarding certain of the covenants in the Line of Credit: Required as of Actual as of June 30, 2011 June 30, 2011 Consolidated net worth $783 million $1.1 billion Statutory surplus Not less than $750 million $1.1 billion Debt-to-capitalization ratio1 Not to exceed 35% 17.73% A.M. Best financial strength rating Minimum of A- A+ 1 Calculated in accordance with Line of Credit agreement. Capital Resources Capital resources provide protection for policyholders, furnish the financial strength to support the business of underwriting insurance risks, and facilitate continued business growth. At June 30, 2011, we had statutory surplus and GAAP stockholders' equity of $1.1 billion. We had total debt of $262 million at June 30, 2011, which equates to a debt-to-capital ratio of approximately 19.2%. Our cash requirements include, but are not limited to, principal and interest payments on various notes payable and dividends to stockholders, payment of claims, payment of commitments under limited partnership agreements and capital expenditures, as well as other operating expenses, which include agents' commissions, labor costs, premium taxes, general and administrative expenses, and income taxes. For further details regarding our cash requirements, refer to the section below entitled "Contractual Obligations, Contingent Liabilities, and Commitments." 50-------------------------------------------------------------------------------- We continually monitor our cash requirements and the amount of capital resources that we maintain at the holding company and operating subsidiary levels. As part of our long-term capital strategy, we strive to maintain capital metrics, relative to the macroeconomic environment, that support an "A+" (Superior) financial strength A.M. Best rating for the Insurance Subsidiaries. Based on our analysis and market conditions, we may take a variety of actions, including, but not limited to, contributing capital to the Insurance Subsidiaries, issuing additional debt and/or equity securities, repurchasing shares of the Parent's common stock, and increasing stockholders' dividends. Our capital management strategy is intended to protect the interests of the policyholders of the Insurance Subsidiaries and our stockholders, while enhancing our financial strength and underwriting capacity. Book value per share increased to $20.33 as of June 30, 2011 from $19.95 as of December 31, 2010, primarily driven by: (i) net income, which led to an increase in book value per share of $0.44; and (ii) an increase in unrealized gains on our investment portfolio, which led to an increase in book value of $0.23. Partially offsetting this increase was: (i) the impact of dividends paid to our stockholders, which resulted in a decrease in book value per share of $0.26; and (ii) the issuance of stock under our stock compensation plans, which led to a decrease in book value of $0.06. Ratings We are rated by major rating agencies that issue opinions on our financial strength, operating performance, strategic position, and ability to meet policyholder obligations. We believe that our ability to write insurance business is most influenced by our rating from A.M. Best, which was reaffirmed in Second Quarter 2011 as "A+ (Superior)," their second highest of 15 ratings, with a "negative" outlook. They cited our strong capitalization, solid level of operating profitability, and established presence within our targeted regional markets. We have been rated "A" or higher by A.M. Best for the past 81 years, with our current rating of "A+ (Superior)" being in place for the last 50 consecutive years. The financial strength reflected by our A.M. Best rating is a competitive advantage in the marketplace and influences where independent insurance agents place their business. A downgrade from A.M. Best to a rating below "A-" could: (i) affect our ability to write new business with customers and/or agents, some of whom are required (under various third-party agreements) to maintain insurance with a carrier that maintains a specified A.M. Best minimum rating; or (ii) be an event of default under our Line of Credit. Our ratings by other major rating agencies are as follows: · S&P Insurance Rating Services - Our "A" financial strength rating was reaffirmed in the third quarter of 2010. S&P cited our strong competitive position in Mid-Atlantic markets, effective use of well-developed predictive modeling, strong financial flexibility, conservative financial leverage, and strong agency relationships. At the same time, S&P revised our outlook to "stable" from "negative," citing strong cycle management, careful risk selection, improved capital adequacy, and continuing price increases across most commercial and personal lines along with strong retention. · Moody's Investor Service - Our financial strength rating of "A2" and outlook of stable, was reaffirmed in the first quarter of 2011. Moody's cited our strong regional franchise with established independent agency support, along with good risk adjusted capitalization and moderate financial leverage. Their outlook reflects the expectation that we will continue to employ our technologically-based risk management process to identify and manage underperforming segments, while maintaining pricing discipline and reserve adequacy. · Fitch Ratings - Our "A+" rating and outlook of stable was reaffirmed in Second Quarter 2011, citing our disciplined underwriting culture, conservative balance sheet with very good capitalization and reserve strength, strong independent agency relationships, and improved diversification through our continued efforts to reduce our concentration in New Jersey. Our S&P and Moody's financial strength ratings affect our ability to access capital markets. There can be no assurance that our ratings will continue for any given period of time or that they will not be changed. It is possible that positive or negative ratings actions by one or more of the rating agencies may occur in the future. We review our financial debt agreements for any potential triggers that could dictate a material change in terms. 51 -------------------------------------------------------------------------------- Pending Accounting Pronouncements In October 2010, the FASB issued ASU 2010-26, Financial Services-Insurance (Topic 944): Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts ("ASU 2010-26"). This guidance requires that only costs that are incremental or directly related to the successful acquisition of new or renewal insurance contracts are to be capitalized as a deferred acquisition cost. This would include, among other items, sales commissions paid to agents, premium taxes, and the portion of employee salaries and benefits directly related to time spent on acquired contracts. This guidance is effective, either with a prospective or retrospective application, for interim and annual periods beginning after December 15, 2011, with early adoption permitted. Although we continue to evaluate the impact of this guidance, we anticipate that ASU 2010-26 would have an after-tax impact on our stockholders' equity of approximately $55 million, or about $1 of book value per share. The adoption of this guidance is not expected to have a material impact on our results of operations on both a historical and prospective basis. Off-Balance Sheet Arrangements At June 30, 2011 and December 31, 2010, we did not have any relationships with unconsolidated entities or financial partnerships, such entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or for other contractually narrow or limited purposes. As such, we are not exposed to any financing, liquidity, market, or credit risk that could arise if we had engaged in such relationships. Contractual Obligations, Contingent Liabilities, and Commitments Our future cash payments associated with loss and loss expense reserves, contractual obligations pursuant to operating leases for office space and equipment, and notes payable have not materially changed since December 31, 2010. We expect to have the capacity to repay and/or refinance these obligations as they come due. At June 30, 2011, we had contractual obligations that expire at various dates through 2022 that may require us to invest up to an additional $61.6 million in alternative investments. There is no certainty that any such additional investment will be required. We have issued no material guarantees on behalf of others and have no trading activities involving non-exchange traded contracts accounted for at fair value. We have no material transactions with related parties other than those disclosed in Note 17. "Related Party Transactions" included in Item 8. "Financial Statements and Supplementary Data." of our 2010 Annual Report. [ Back To TMCnet.com's Homepage ]