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SELECTIVE INSURANCE GROUP INC - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.(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 in Part II "Other Information." These risk factors may not be exhaustive. We operate in a continually changing business environment and new risk factors emerge from time to time. We can neither predict such new risk factors nor can we assess the impact, if any, of such new risk factors on our businesses or the extent to which any factor or combination of factors may cause actual results to differ materially from those expressed or implied in any forward-looking statements in this report. In light of these risks, uncertainties, and assumptions, the forward-looking events discussed in this report might not occur. 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 classify our business into three operating segments: • Our Standard Insurance Operations segment, which is comprised of both commercial lines ("Commercial Lines") and personal lines ("Personal Lines") business, sells property and casualty insurance products and services in the standard market, including flood insurance through the National Flood Insurance Program's ("NFIPs") write-your-own ("WYO") program; • Our Excess and Surplus ("E&S") Insurance Operations segment sells Commercial Lines property and casualty insurance products and services to insureds who have not obtained coverage in the standard market; and • Our Investments segment, which invests the premiums collected by our Standard and E&S Insurance Operations and amounts generated through our capital management strategies, which may include the issuance of debt and equity securities. Our Standard Insurance Operations products and services are sold through nine subsidiaries that write Commercial Lines and Personal Lines business, some of which write flood business through the NFIP's WYO program. Our E&S Insurance Operations products and services are sold through one subsidiary. This subsidiary, Mesa Underwriters Specialty Insurance Company ("MUSIC"), provides us with a nationally-authorized non-admitted platform to write commercial and personal E&S lines business. Our ten insurance subsidiaries are collectively referred to as the "Insurance Subsidiaries." The purpose of 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 2013 Annual Report filed with the U.S. Securities and Exchange Commission ("SEC"). In the MD&A, we will discuss and analyze the following: • Critical Accounting Policies and Estimates; • Financial Highlights of Results for Third Quarter and Nine Months 2014 and Third Quarter and Nine Months 2013; • Results of Operations and Related Information by Segment; • Federal Income Taxes; • Financial Condition, Liquidity, Short-term Borrowings, and Capital Resources; • Ratings; • Off-Balance Sheet Arrangements; and • Contractual Obligations, Contingent Liabilities, and Commitments. 27-------------------------------------------------------------------------------- Table of Contents 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 involve the following: (i) reserves for loss and loss expenses; (ii) pension and post-retirement benefit plan actuarial assumptions; (iii) other-than-temporary investment impairments ("OTTI"); and (iv) 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 example, the Society of Actuaries issued final versions of its mortality tables and mortality improvement scale in October 2014, which reflect increasing life expectancies in the United States. We will adopt the new mortality information in the fourth quarter of this year, which will potentially result in a pre-tax charge to other comprehensive income of approximately $20 million as of December 31, 2014, assuming all other assumptions related to the post-retirement plan remain unchanged. For additional information regarding our critical accounting policies, refer to our 2013 Annual Report, pages 44 through 52. Financial Highlights of Results for Third Quarter and Nine Months 2014 and Third Quarter and Nine Months 20131 Quarter ended September 30, Nine Months ended September 30, ($ and shares in thousands, except per share Change Change amounts) 2014 2013 % or Points 2014 2013 % or Points Generally Accepted Accounting Principles ("GAAP") measures: Revenues $ 515,358 486,813 6 % $ 1,531,278 1,415,707 8 % Pre-tax net investment income 34,292 32,457 6 106,600 99,330 7 Pre-tax net income 75,326 44,485 69 139,931 108,019 30 Net income 53,162 32,653 63 100,477 81,083 24 Diluted net income per share 0.93 0.57 63 1.75 1.43 22 Diluted weighted-average outstanding shares 57,406 56,900 1 57,286 56,719 1 GAAP combined ratio 92.6 % 97.7 (5.1 ) pts 97.1 97.9 (0.8 ) pts Statutory combined ratio 91.5 % 96.3 (4.8 ) 96.6 96.9 (0.3 ) Return on average equity 17.0 % 11.7 5.3 11.1 9.8 1.3 Non-GAAP measures: Operating income2 $ 43,262 23,922 81 % $ 82,935 67,819 22 % Diluted operating income per share2 0.76 0.42 81 1.44 1.20 20 Operating return on average equity2 13.8 % 8.6 5.2 pts 9.1 8.2 0.9 pts 1 Refer to the Glossary of Terms attached to our 2013 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 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 GAAP. Operating return on average equity is calculated by dividing annualized operating income by average stockholders' equity. The following table reconciles operating income and net income for the periods presented above: Nine Months ended Quarter ended September 30, September 30, ($ in thousands, except per share amounts) 2014 2013 2014 2013 Operating income $ 43,262 23,922 82,935 67,819 Net realized gains, net of tax 9,900 8,731 17,542 14,261 Loss on disposal of discontinued operations, net of tax - - - (997 ) Net income $ 53,162 32,653 100,477 81,083 Diluted operating income per share $ 0.76 0.42 1.44 1.20 Diluted net realized gains per share 0.17 0.15 0.31 0.25 Diluted net loss from disposal of discontinued operations per share - - - (0.02 ) Diluted net income per share $ 0.93 0.57 1.75 1.43 28-------------------------------------------------------------------------------- Table of Contents Over the long term, we target a return on average equity that is three points higher than our cost of capital, or 12%, excluding the impact of realized gains and losses, which is referred to as operating return on average equity. Our operating return on average equity and contribution by component for Third Quarter 2014 and Nine Months 2014 and the comparable prior year periods are as follows: Operating Return on Average Equity Quarter ended September 30, Nine Months ended September 30, 2014 2013 2014 2013 Standard Insurance Operations 7.4 % 2.4 % 2.9 % 2.3 % E&S Insurance Operations (0.3 )% - % - % (0.2 )% Investments 8.2 % 8.8 % 8.8 % 9.0 % Other (1.5 )% (2.6 )% (2.6 )% (2.9 )% Total 13.8 % 8.6 % 9.1 % 8.2 % Our operating return on average equity in Third Quarter 2014 and Nine Months 2014 reflects GAAP combined ratios of 92.6% and 97.1%, respectively, compared to 97.7% and 97.9% in the same periods a year ago. Lower catastrophe losses coupled with increased favorable prior year casualty reserve development and the impact of renewal pure price increases drove the improvement in operating return on average equity in the quarter. On a year-to-date basis, higher property losses, including catastrophe losses, partially offset the benefits of rate and favorable prior year casualty reserve development, resulting in a modest improvement over last year. Further descriptions of the variances for the quarter and year-to-date periods are as follows: • Catastrophe losses for Third Quarter 2014 and Nine Months 2014 were $5.4 million, or 1.2 points, and $66.9 million, or 4.8 points, respectively, compared to $11.9 million, or 2.7 points, and $33.1 million, or 2.6 points, in the respective prior year periods. The majority of these catastrophe losses in the year-to-date period were attributed to extreme weather events in the first quarter of 2014, which brought freezing temperatures and snowstorms to our 22-state standard lines footprint, coupled with hail, tornadoes, and wind events in the second quarter of 2014. • Non-catastrophe property losses of $60.4 million, or 13.0 points, for Third Quarter 2014 were comparable to last year. However, on a year-to-date basis, non-catastrophe property losses of $224.8 million, or 16.3 points, were 2.8 points higher than Nine Months 2013. These non-catastrophe property losses were primarily the result of fires, roof collapses, and water damage, which were often related to the weather events experienced throughout our footprint states in the first half of 2014. • Renewal pure price increases of 7.6% and 5.8% were achieved in full-year 2013 and Nine Months 2014, respectively, which are currently earning in at 6.4% in Third Quarter 2014 and 6.8% in Nine Months 2014. This earned rate is above the loss inflation trend of approximately 3%. After taking into account the incremental expenses associated with the additional premium, the net benefit to the combined ratio is approximately 2.5 points for both periods. • Favorable prior year casualty development in Third Quarter 2014 and Nine Months 2014 was $7.5 million, or 1.6 points, and $39.5 million, or 2.8 points, respectively, compared to favorable prior year casualty development of $3.5 million, or 0.8 points, and $7.5 million, or 0.6 points, in Third Quarter 2013 and Nine Months 2013, respectively. We experienced improved workers compensation trends in the quarter and year-to-date periods, with no development either favorable or unfavorable. We believe the stability in workers compensation reserves over the past three quarters is largely due to our claims initiatives. Our strategic case management unit employs a triage process that focuses on claims with the potential for high severity. After the claims are directed into the unit, specialists and expert medical resources manage the cases through settlement. The level of prior year casualty reserve releases in Third Quarter and Nine Months 2014 were driven by improving claim trends within our general liability line of business attributable to the 2007 through 2013 accident years, partially offset by unfavorable prior year casualty development in our E&S Insurance Operations of $4 million attributable to the 2012 and 2013 accident years. Also contributing to Nine Months 2014 Insurance Operations results, was the March 2014 sale of the renewal rights to our self-insured group's book of pooled public entity business ("SIG"), which contributed $8 million to other income and reduced the combined ratio by 0.6 points. Although we did not solicit buyers, we decided to sell this small and specialized book of business when the opportunity presented itself because it had significant production outside of our standard lines footprint, and proved difficult to grow. We, however, have retained our substantial individual risk public entity book of business and we will continue to look for opportunities to grow it. 29-------------------------------------------------------------------------------- Table of Contents The remaining fluctuation in our Third Quarter 2014 operating return on average equity compared to Third Quarter 2013 was driven by lower long-term employee compensation expense associated with fluctuations in our stock price. This item is captured within the "Other" component in the table above. The following table provides a quantitative foundation for analyzing our overall Insurance Subsidiaries' underwriting results, the significant changes of which are described above: All Lines Quarter ended September 30, Nine Months ended September 30, Change Change % or % or ($ in thousands) 2014 2013 Points 2014 2013 Points GAAP Insurance Operations Results: Net premiums written ("NPW") $ 495,121 492,748 - % $ 1,451,694 1,405,049 3 % Net premiums earned ("NPE") 462,639 437,568 6 1,382,759 1,284,760 8 Less: Loss and loss expense incurred 270,932 283,317 (4 ) 889,273 832,760 7 Net underwriting expenses incurred 156,114 142,774 9 450,037 421,812 7 Dividends to policyholders 1,156 1,326 (13 ) 3,943 3,393 16 Underwriting gain $ 34,437 10,151 239 % $ 39,506 26,795 47 % GAAP Ratios: Loss and loss expense ratio 58.6 % 64.7 (6.1 ) pts 64.3 % 64.8 (0.5 ) pts Underwriting expense ratio 33.8 32.7 1.1 32.5 32.8 (0.3 ) Dividends to policyholders ratio 0.2 0.3 (0.1 ) 0.3 0.3 - Combined ratio 92.6 97.7 (5.1 ) 97.1 97.9 (0.8 ) Statutory Ratios: Loss and loss expense ratio 58.4 64.7 (6.3 ) 64.2 64.8 (0.6 ) Underwriting expense ratio 32.9 31.3 1.6 32.1 31.8 0.3 Dividends to policyholders ratio 0.2 0.3 (0.1 ) 0.3 0.3 - Combined ratio 91.5 % 96.3 (4.8 ) pts 96.6 % 96.9 (0.3 ) pts Outlook In its financial review issued on September 19, 2014, A.M. Best and Company ("A.M. Best") noted that increased catastrophe and non-catastrophe losses and lower levels of favorable development of prior years' loss reserves drove the U.S. property and casualty industry to break-even underwriting results through the first six months of 2014. Overall, catastrophe losses accounted for 5.3 points on the industry combined ratio, an increase over the 4.6-point impact in the first six months of 2013. Partially offsetting the decline in loss experience was an improvement in industry premiums, which grew 4% during the first six months of 2014 compared to the same period last year. The overall result of these changes was a modest underwriting loss, producing an industry combined ratio of 99.1% for the first six months of 2014, up from 96.6% for the first six months of 2013. A.M. Best, in their Segment Review of U.S. Surplus Lines issued in September 2014, views the surplus lines segment as "stable but believes profit margins may shrink in the near term as average rate increases diminish on various lines of coverage." However, "the surplus lines market still appears to be in a good position to produce healthy returns and net operating profits in 2014." A.M. Best's estimate for the 2014 property and casualty industry combined ratio was 99.4%, as noted in their 2013 year-end review. Their report cited: "In looking ahead to 2014, A.M. Best expects premiums to continue growing through price increases, but the pace of these rate changes are expected to slow and temper growth in premium." We believe standard commercial lines renewal pure pricing is under pressure industry-wide. Commercial lines pricing for the industry was up only 3% for the second quarter of 2014, according to the Towers Watson Commercial Lines Insurance Price Survey. For Third Quarter 2014, our Standard Commercial Lines renewal pure price increased 5.3%, about 200 basis points higher than the industry's pricing in the second quarter of 2014, which we view as positive compared to our expectations for the industry in the third quarter. 30-------------------------------------------------------------------------------- Table of Contents In early 2012, we laid out a three-year plan to achieve overall annual renewal pure price increases of 5% to 8%. We achieved 5.8% in Nine Months 2014, including 5.8% in our Standard Commercial Lines, 6.5% in our Standard Personal Lines, and 3.8% in our E&S Lines. Overall renewal pure price increases of 7.6% in full-year 2013 and the 5.8% in Nine Months 2014 translated into earned price increases of 6.8% in Nine Months 2014, which is above loss inflation trends of approximately 3%. The 5.5% overall renewal pure price increase that we expect to achieve in 2014 is also above loss inflation trends, and will continue to add to profitability in 2015. Our Insurance Subsidiaries reported a statutory combined ratio, excluding catastrophes, of 91.8% for Nine Months 2014, which is in line with our stated full-year 2014 goal of 92%. Catastrophe losses in the year of $66.9 million added 4.8 points to our statutory combined ratio. These catastrophe losses were primarily related to extreme winter weather in the first quarter of 2014 and Midwest storms in the second quarter of 2014. The yield on the 10-year U.S. Treasury Note fell by 54 basis points in Nine Months 2014. The continued low interest rate environment has several impacts on our business, some of which are beneficial and some of which present a challenge to us. The benefits include lower inflation rates that suppress loss trends, as well as reduce our cost of capital. While the low interest rate environment presents a challenge to us in generating after-tax return, we believe the after-tax yield on our fixed income securities portfolio has stabilized at around 2.25%, as new purchase yields are approximating the average yield on bonds that are currently being disposed. Given the results we have achieved in Nine Months 2014, including the overall renewal pure price increases we have achieved, we currently expect to generate: • A full-year combined ratio of 92% excluding catastrophe losses and any additional prior year casualty reserve development; • 4 to 4.5 points of catastrophe losses for the year; • Renewal pure price increases of approximately 5.5% on an overall company basis; • After-tax investment income of approximately $105 million; and • Weighted-average shares of approximately 57.4 million. 31-------------------------------------------------------------------------------- Table of Contents Results of Operations and Related Information by Segment Insurance Operations Standard Insurance Operations Our Standard Insurance Operations segment, which represents 92% of our combined insurance operations NPW, sells insurance products and services primarily in 22 states in the Eastern and Midwestern U.S. and the District of Columbia, through approximately 1,100 independent retail insurance agencies. This segment consists of two components: (i) Commercial Lines, which markets primarily to businesses and represents approximately 83% of the segment's NPW; and (ii) Personal Lines, including our flood business, which markets primarily to individuals and represents approximately 17% of the segment's NPW. Quarter ended September 30, Nine Months ended September 30, Change Change % or % or ($ in thousands) 2014 2013 Points 2014 2013 Points GAAP Insurance Operations Results: NPW $ 455,486 457,173 - % $ 1,344,215 1,308,428 3 % NPE 426,520 405,676 5 1,279,830 1,192,762 7 Less: Loss and loss expense incurred 246,489 262,697 (6 ) 822,550 771,948 7 Net underwriting expenses incurred 143,067 131,515 9 413,398 388,440 6 Dividends to policyholders 1,156 1,326 (13 ) 3,943 3,393 16 Underwriting gain $ 35,808 10,138 253 % $ 39,939 28,981 38 % GAAP Ratios: Loss and loss expense ratio 57.8 % 64.8 (7.0 ) pts 64.3 % 64.7 (0.4 ) pts Underwriting expense ratio 33.5 32.4 1.1 32.3 32.6 (0.3 ) Dividends to policyholders ratio 0.3 0.3 - 0.3 0.3 - Combined ratio 91.6 97.5 (5.9 ) 96.9 97.6 (0.7 ) Statutory Ratios: Loss and loss expense ratio 57.6 64.7 (7.1 ) 64.2 64.7 (0.5 ) Underwriting expense ratio 32.6 31.0 1.6 31.8 31.6 0.2 Dividends to policyholders ratio 0.3 0.3 - 0.3 0.3 - Combined ratio 90.5 % 96.0 (5.5 ) pts 96.3 % 96.6 (0.3 ) pts NPW is relatively consistent with last year for both the quarter and year-to-date periods. Renewal pure price increases and strong retention have more than offset a reduction in premiums that has resulted from the sale of the SIG renewal rights. SIG NPW was approximately $27 million for Third Quarter 2013 and $28 million for Nine Months 2013. Renewal pure price increases and retention was as follows: Quarter ended September Quarter ended September 30, 2014 30, 2013 Renewal Renewal Pure Price Pure Price ($ in millions) Increase Retention Increase Retention Standard Commercial Lines 5.3 % 83 % 7.9 % 83 % Standard Personal Lines 6.8 81 7.5 86 Nine Months ended Nine Months ended September 30, 2014 September 30, 2013 Renewal Renewal Pure Price Pure Price ($ in millions) Increase Retention Increase Retention Standard Commercial Lines 5.8 % 82 % 7.6 % 82 % Standard Personal Lines 6.5 81 8.0 86 The decrease in the Standard Personal Lines retention was driven by targeted actions that we have taken to reduce our exposure to certain coverages that have historically been less profitable for us. Excluding the impact of these targeted actions, retention remains strong and comparable to last year. 32-------------------------------------------------------------------------------- Table of Contents NPE increases in Third Quarter 2014 and Nine Months 2014 were consistent with the fluctuations in NPW for the twelve-month period ended September 30, 2014 compared to the twelve-month period ended September 30, 2013. The GAAP loss and loss expense ratio improved 7.0 points in Third Quarter 2014 and 0.4 points in Nine Months 2014 compared to the same periods a year ago. In addition to the quantitative information provided below, renewal pure price increases that exceeded our projected loss inflation trend contributed to the improvement in both periods. Quarter ended September 30, 2014 Quarter ended September 30, 2013 Impact on Loss and Loss Impact on Loss and Loss Expense Loss and Loss Loss and Loss Change in ($ in millions) Expense Incurred Ratio Expense Incurred Expense Ratio Ratio Catastrophe losses $ 4.9 1.1 pts $ 10.9 2.7 pts (1.6 ) pts Non-catastrophe property losses 57.0 13.4 54.8 13.5 (0.1 ) Favorable prior year casualty reserve development (12.0 ) (2.7 ) (3.5 ) (0.8 ) (1.9 ) Nine Months ended September 30, Nine Months ended September 30, 2014 2013 Impact on Impact on Loss and Loss and Loss Loss and Loss Loss and Loss Loss Expense Change in ($ in millions) Expense Incurred Expense Ratio Expense Incurred Ratio Ratio Catastrophe losses $ 64.6 5.0 pts $ 29.3 2.5 pts 2.5 pts Non-catastrophe property losses 210.7 16.5 165.7 13.9 2.6 Favorable prior year casualty reserve development (43.5 ) (3.4 ) (9.5 ) (0.8 ) (2.6 ) The breakdown of favorable prior year casualty reserve development in our Standard Insurance Operations by line of business is as follows: (Favorable)/Unfavorable Prior Year Casualty Reserve Development Quarter ended September 30, Nine Months ended September 30, ($ in millions) 2014 2013 2014 2013 General liability $ (11.0 ) (3.0 ) $ (36.0 ) (12.0 ) Commercial automobile - - (4.0 ) - Workers compensation - 3.5 - 14.0 Businessowners' policies 1.0 (2.0 ) 2.5 (8.0 ) Homeowners - (1.0 ) - (2.5 ) Personal automobile (2.0 ) (1.0 ) (6.0 ) (1.0 ) Total favorable prior year casualty reserve development $ (12.0 ) (3.5 ) $ (43.5 ) (9.5 ) Favorable impact on loss ratio (2.7 ) pts (0.8 ) pts (3.4 ) pts (0.8 ) pts Favorable prior year casualty reserve development of $12.0 million in Third Quarter 2014 and $43.5 million in Nine Months 2014 was primarily driven by improving claim trends attributable to the 2007 through 2013 accident years on our general liability line of business coupled with stable workers compensation trends in 2014. The GAAP underwriting expense ratio increased 1.1 points in Third Quarter 2014 compared to Third Quarter 2013 due to higher supplemental commissions to agents. On a year-to-date basis, the underwriting expense ratio decreased 0.3 points due to: (i) an increase in premiums that outpaced expense growth; and (ii) a gain from the SIG sale of $8 million, or 0.6 points. Partially offsetting these items were higher supplemental commissions to agents. For additional information regarding the sale, see Note 8. "Segment Information" in Item 1. "Financial Statements." of this Form 10-Q. 33-------------------------------------------------------------------------------- Table of Contents Review of Underwriting Results by Line of Business Standard Commercial Lines Quarter ended September 30, Nine Months ended September 30, Change Change % or % or ($ in thousands) 2014 2013 Points 2014 2013 Points GAAP Insurance Operations Results: NPW $ 376,438 376,373 - % $ 1,119,648 1,080,213 4 % NPE 352,143 330,962 6 1,056,091 971,464 9 Less: Loss and loss expense incurred 201,352 209,771 (4 ) 660,523 614,226 8 Net underwriting expenses incurred 121,864 111,089 10 351,781 329,224 7 Dividends to policyholders 1,156 1,326 (13 ) 3,943 3,393 16 Underwriting gain $ 27,771 8,776 216 % $ 39,844 24,621 62 % GAAP Ratios: Loss and loss expense ratio 57.2 % 63.4 (6.2 ) pts 62.5 % 63.2 (0.7 ) pts Underwriting expense ratio 34.6 33.5 1.1 33.3 34.0 (0.7 ) Dividends to policyholders ratio 0.3 0.4 (0.1 ) 0.4 0.3 0.1 Combined ratio 92.1 97.3 (5.2 ) 96.2 97.5 (1.3 ) Statutory Ratios: Loss and loss expense ratio 56.9 63.3 (6.4 ) 62.5 63.2 (0.7 ) Underwriting expense ratio 33.7 31.9 1.8 32.6 32.7 (0.1 ) Dividends to policyholders ratio 0.3 0.4 (0.1 ) 0.4 0.3 0.1 Combined ratio 90.9 % 95.6 (4.7 ) pts 95.5 % 96.2 (0.7 ) pts The increase in NPW in Third Quarter 2014 and Nine Months 2014 compared to the same periods last year was driven by renewal pure price increases and strong retention, which were partially offset by the NPW impact of the sale of the SIG renewal rights. Quantitative data on retention and pricing is as follows: Quarter ended September 30, Nine Months ended September 30, ($ in millions) 2014 2013 2014 2013 Retention 83 % 83 82 % 82 Renewal pure price increases 5.3 7.9 5.8 7.6 NPE increases in Third Quarter and Nine Months 2014 were consistent with the fluctuations in NPW for the twelve-month period ended September 30, 2014 compared to the twelve-month period ended September 30, 2013. The GAAP loss and loss expense ratio decreased 6.2 points in Third Quarter 2014 compared to Third Quarter 2013 driven by: (i) renewal pure price increases that averaged 5.8% in Nine Months 2014 and 7.6% in full-year 2013, the earning of which exceeds our projected loss inflation trend by approximately 3 points; and (ii) favorable prior year casualty reserve development. Quantitative information regarding property losses and reserve development is as follows: Quarter ended September 30, 2014 Quarter ended September 30, 2013 Impact on Losses Impact on ($ in millions) Losses Incurred Loss Ratio Incurred Loss Ratio Change in Ratio Catastrophe losses $ 3.3 0.9 pts $ 2.2 0.7 pts 0.2 pts Non-catastrophe property losses 35.3 10.0 34.9 10.5 (0.5 ) Favorable prior year casualty reserve development (10.0 ) (2.7 ) (1.5 ) (0.4 ) (2.3 ) 34-------------------------------------------------------------------------------- Table of Contents On a year-to-date basis, earned pricing that is exceeding loss inflation trends by approximately 4 points and favorable prior year development are significantly offset by higher catastrophe and non-catastrophe property losses. Quantitative information regarding property losses and reserve development are as follows: Nine Months ended September 30, 2014 Nine Months ended September 30, 2013 Impact on Losses Impact on ($ in millions) Losses Incurred Loss Ratio Incurred Loss Ratio Change in Ratio Catastrophe losses $ 41.9 4.0 pts $ 12.1 1.2 pts 2.8 pts Non-catastrophe property losses 137.7 13.0 99.7 10.3 2.7 Favorable prior year casualty reserve development (37.5 ) (3.5 ) (6.0 ) (0.6 ) (2.9 ) The GAAP underwriting expense ratio increased 1.1 points in Third Quarter 2014 compared to Third Quarter 2013 partially due to: (i) higher supplemental commissions to agents; and (ii) expenses that outpaced premium growth in the quarter. The improvement in the GAAP underwriting expense ratio in Nine Months 2014 compared to Nine Months 2013 was primarily driven by the income generated from the sale of our SIG renewal rights for $8 million, or 0.8 points, in the first quarter of 2014. For additional information regarding the sale, see Note 8. "Segment Information" in Item 1. "Financial Statements." of this Form 10-Q. The following is a discussion of our most significant standard Commercial Lines of business and their respective statutory results: General Liability Nine Months ended September Quarter ended September 30, 30, Change Change % or % or ($ in thousands) 2014 2013 Points 2014 2013 Points Statutory NPW $ 117,731 115,866 2 % $ 355,411 335,503 6 % Direct new business 20,738 20,169 3 60,412 60,809 (1 ) Retention 83 % 82 1 pts 82 % 81 1 pts Renewal pure price increases 6.1 % 9.3 (3.2 ) 7.0 % 8.8 (1.8 ) Statutory NPE $ 110,894 100,925 10 % $ 331,303 298,394 11 % Statutory combined ratio 84.2 % 96.2 (12.0 ) pts 81.8 % 95.7 (13.9 ) pts % of total statutory standard Commercial Lines NPW 31 % 31 32 % 31 The growth in NPW and NPE for our general liability business in Third Quarter 2014 and Nine Months 2014 reflects renewal pure price increases and strong retention. Partially offsetting this growth was the reduction in NPW as a result of the SIG renewal rights sale. SIG NPW was approximately $14 million in both Third Quarter 2013 and Nine Months 2013. The statutory combined ratio improvement for Third Quarter 2014 and Nine Months 2014 was driven by renewal pure price increases of 6.1% and 7.0%, respectively, that continue to outpace loss inflation trends on this line as well as the following: Quarter ended September 30, 2014 Quarter ended September 30, 2013 (Benefit) Impact on Impact on Change ($ in millions) Expense Combined Ratio (Benefit) Expense Combined Ratio Points Favorable prior year casualty reserve development $ (11.0 ) (9.9 ) pts $ (3.0 ) (3.0 ) pts (6.9 ) pts Nine Months ended Nine Months ended September 30, 2014 September 30, 2013 Impact on Impact on Change ($ in millions) (Benefit) Expense Combined Ratio (Benefit) Expense Combined Ratio Points Favorable prior year casualty reserve development $ (36.0 ) (10.9 ) pts $ (12.0 ) (4.0 ) pts (6.9 ) pts Gain from SIG renewal rights sale (2.1 ) (0.6 ) - - (0.6 ) 35-------------------------------------------------------------------------------- Table of Contents Favorable prior year casualty reserve development in Third Quarter 2014 and Nine Months 2014 was driven by improving claim trends for the 2013 and prior accident years. Favorable prior year casualty reserve development in Third Quarter 2013 and Nine Months 2013 was driven by accident years 2011 and prior. Commercial Automobile Quarter ended September Nine Months ended September 30, 30, Change Change % or % or ($ in thousands) 2014 2013 Points 2014 2013 Points Statutory NPW $ 90,599 91,715 (1 ) % $ 267,134 257,841 4 % Direct new business 14,275 16,420 (13 ) 42,760 47,490 (10 ) Retention 83 % 83 - pts 82 % 82 - pts Renewal pure price increases 5.1 % 8.0 (2.9 ) 5.8 % 7.4 (1.6 ) Statutory NPE $ 83,536 79,138 6 % $ 249,224 230,191 8 % Statutory combined ratio 92.8 % 97.1 (4.3 ) pts 93.7 % 96.8 (3.1 ) pts % of total statutory standard Commercial Lines NPW 24 % 24 24 % 24 The fluctuation in Third Quarter 2014 and Nine Months 2014 NPW was impacted by the following: (i) renewal pure price increases; (ii) strong retention; and (iii) lower premiums due to the sale of the SIG renewal rights. SIG NPW was approximately $5 million in both Third Quarter 2013 and Nine Months 2013. NPE increases in Third Quarter 2014 and Nine Months 2014 were consistent with the fluctuations in NPW for the twelve-month period ended September 30, 2014 compared to the twelve-month period ended September 30, 2013. The statutory combined ratio improvements for Third Quarter 2014 and Nine Months 2014 were impacted by the following: Quarter ended September 30, Quarter ended September 2014 30, 2013 Impact on (Benefit) Impact on (Benefit) Combined Change ($ in millions) Expense Combined Ratio Expense Ratio Points Catastrophe losses $ 0.2 0.2 pts $ 0.1 0.1 pts 0.1 pts Non-catastrophe property losses 10.0 11.9 13.3 16.8 (4.9 ) Nine Months ended Nine Months ended September 30, 2014 September 30, 2013 Impact on Impact on Combined Change ($ in millions) (Benefit) Expense Combined Ratio (Benefit) Expense Ratio Points Catastrophe losses $ 1.7 0.7 pts $ (0.9 ) (0.4 ) pts 1.1 pts Non-catastrophe property losses 34.0 13.6 36.9 16.0 (2.4 ) Favorable prior year casualty reserve development (4.0 ) (1.6 ) - - (1.6 ) Gain from SIG renewal rights sale (1.5 ) (0.6 ) - - (0.6 ) Favorable prior year casualty development in Nine Months 2014 was driven by the 2008 through 2012 accident years, partially offset by unfavorable prior year casualty development in the 2013 accident year. 36-------------------------------------------------------------------------------- Table of Contents Workers Compensation Quarter ended September Nine Months ended 30, September 30, Change Change % or % or ($ in thousands) 2014 2013 Points 2014 2013 Points Statutory NPW $ 65,740 70,461 (7 ) % $ 206,921 214,455 (4 ) % Direct new business 12,512 14,459 (13 ) 37,239 43,151 (14 ) Retention 81 % 82 (1 ) pts 81 % 82 (1 ) pts Renewal pure price increases 5.1 % 7.9 (2.8 ) 5.2 % 7.8 (2.6 ) Statutory NPE $ 66,732 66,510 - % $ 205,137 197,449 4 % Statutory combined ratio 111.2 % 118.2 (7.0 ) pts 109.6 % 118.4 (8.8 ) pts % of total statutory standard Commercial Lines NPW 17 % 19 18 % 20 Third Quarter 2014 and Nine Months 2014 NPW decreased compared to Third Quarter 2013 and Nine Months 2013 due to a decrease in direct new business. In addition, premiums for this line are down year over year as a result of the SIG renewal rights sale. SIG NPW was approximately $4 million in both Third Quarter 2013 and Nine Months 2013. NPE increases in Third Quarter 2014 and Nine Months 2014 were consistent with the fluctuations in NPW for the twelve-month period ended September 30, 2014 compared to the twelve-month period ended September 30, 2013. While we continue to view workers compensation in the context of an overall account, we remain very focused on improving this competitive line of business through both underwriting and claims initiatives. We achieved renewal pure price increases of 5.1% in Third Quarter 2014 and 5.2% in Nine Months 2014. We are applying all the underwriting tools we have to move pricing higher and write the best risks. In addition, we have centralized the handling of all workers compensation claims alongside our strategic case management unit to facilitate our strategy of early identification, escalation, and mitigation of potentially high-risk claims. We have supplemented our claims expertise within our strategic case management unit with the addition of medical specialists, including nurse practitioners and a physician consultant. The improvement in the statutory combined ratio was primarily attributable to the following: Quarter ended September 30, 2014 Quarter ended September 30, 2013 Impact on (Benefit) Impact on Change ($ in millions) (Benefit) Expense Combined Ratio Expense Combined Ratio Points Unfavorable prior year casualty reserve development $ - - pts $ 3.5 5.3 pts (5.3 ) pts Nine Months ended Nine Months ended September 30, 2014 September 30, 2013 Impact on Impact on (Benefit) Combined Change ($ in millions) (Benefit) Expense Combined Ratio Expense Ratio Points Unfavorable prior year casualty reserve development $ - - pts $ 14.0 7.2 pts (7.2 ) pts Gain from SIG renewal rights sale (1.5 ) (0.7 ) - - (0.7 ) Third Quarter 2013 and Nine Months 2013 unfavorable prior year casualty reserve development was primarily driven by adverse development in several accident years from 2008 and prior. Nine Months 2013 was also adversely impacted by the 2012 accident year. 37-------------------------------------------------------------------------------- Table of Contents Commercial Property Quarter ended September Nine Months ended 30, September 30, Change Change % or % or ($ in thousands) 2014 2013 Points 2014 2013 Points Statutory NPW $ 71,463 69,578 3 % $ 198,189 186,531 6 % Direct new business 16,783 16,966 (1 ) 44,549 45,747 (3 ) Retention 82 % 82 - pts 81 % 81 - pts Renewal pure price increases 4.2 % 5.8 (1.6 ) 4.6 % 5.6 (1.0 ) Statutory NPE $ 61,304 57,004 8 % $ 182,716 165,356 10 % Statutory combined ratio 79.9 % 67.0 12.9 pts 104.1 % 77.8 26.3 pts % of total statutory standard Commercial Lines NPW 19 % 18 18 % 17 NPW and NPE increased in Third Quarter 2014 and Nine Months 2014 compared to Third Quarter 2013 and Nine Months 2013 primarily due to renewal pure price increases and strong retention, partially offset by the reduction in NPW as a result of the SIG renewal rights sale. SIG NPW was approximately $5 million in both Third Quarter 2013 and Nine Months 2013. The increase in the statutory combined ratio in Third Quarter 2014 and Nine Months 2014 compared to the same prior year periods was due to the following: Quarter ended September 30, Quarter ended September 30, 2014 2013 Change (Benefit) Impact on (Benefit) Impact on % or ($ in millions) Expense Combined Ratio Expense Combined Ratio Points Catastrophe losses $ 2.7 4.4 pts $ 0.9 1.6 pts 2.8 pts Non-catastrophe property losses 20.8 34.0 14.8 25.9 8.1 Nine Months ended September Nine Months ended September 30, 2014 30, 2013 Change Impact on (Benefit) Impact on % or ($ in millions) (Benefit) Expense Combined Ratio Expense Combined Ratio Points Catastrophe losses $ 31.7 17.4 pts $ 10.4 6.3 pts 11.1 pts Non-catastrophe property losses 83.4 45.6 48.7 29.5 16.1 Gain from SIG renewal rights sale (1.4 ) (0.7 ) - - (0.7 ) 38-------------------------------------------------------------------------------- Table of Contents Standard Personal Lines Nine Months ended September Quarter ended September 30, 30, Change Change % or % or ($ in thousands) 2014 2013 Points 2014 2013 Points GAAP Insurance Operations Results: NPW $ 79,048 80,800 (2 ) % $ 224,567 228,215 (2 ) % NPE 74,377 74,714 - 223,739 221,298 1 Less: Loss and loss expense incurred 45,137 52,926 (15 ) 162,027 157,722 3 Net underwriting expenses incurred 21,203 20,426 4 61,617 59,216 4 Underwriting gain $ 8,037 1,362 490 % $ 95 4,360 (98 ) % GAAP Ratios: Loss and loss expense ratio 60.7 % 70.8 (10.1 ) pts 72.4 % 71.3 1.1 pts Underwriting expense ratio 28.5 27.4 1.1 27.6 26.7 0.9 Combined ratio 89.2 98.2 (9.0 ) 100.0 98.0 2.0 Statutory Ratios: Loss and loss expense ratio 60.7 70.9 (10.2 ) 72.4 71.4 1.0 Underwriting expense ratio 28.2 26.7 1.5 27.5 26.2 1.3 Combined ratio 88.9 % 97.6 (8.7 ) pts 99.9 % 97.6 2.3 pts The decreases in NPW for both the quarter and year-to-date periods were primarily driven by lower retention compared to the same periods a year ago. The decrease in the year-to-date period was also driven by a 10% decrease in new business. Partially offsetting these decreases were renewal pure price increases. Quantitative information regarding these items is as follows: Quarter ended September 30, Nine Months ended September 30, ($ in millions) 2014 2013 2014 2013 Retention 81 % 86 81 % 86 Renewal pure price increase 6.8 7.5 6.5 8.0 The decrease in retention was driven by targeted actions that we have taken to reduce our exposure to certain coverages that have historically been less profitable for us. Excluding the impact of these targeted actions, retention remains strong and comparable to last year. NPE increases in Third Quarter and Nine Months 2014 compared to Third Quarter and Nine Months 2013 are consistent with the fluctuations in NPW for the twelve-month period ended September 30, 2014 compared to the twelve-month period ended September 30, 2013. The improvement in the GAAP loss and loss expense ratio of 10.1 points in Third Quarter 2014 compared to Third Quarter 2013 was driven by: (i) a decrease in catastrophe losses; and (ii) renewal pure price increases of 6.5% for Nine Months 2014 and 7.8% for full-year 2013, the earning of which exceeds our projected loss inflation trend for the casualty component of our Personal Lines. Partially offsetting these benefits were higher non-catastrophe property losses. Quantitative information regarding property losses and reserve development are as follows: Quarter ended September 30, 2014 Quarter ended September 30, 2013 Impact on Impact on Loss and Loss and Loss Loss and Loss Loss Loss and Loss Expense Expense Expense ($ in millions) Expense Incurred Ratio Incurred Ratio Change in Ratio Catastrophe losses $ 1.6 2.2 pts $ 8.7 11.7 pts (9.5 ) pts Non-catastrophe property losses 21.7 29.2 19.9 26.6 2.6 Favorable prior year casualty development (2.0 ) (2.7 ) (2.0 ) (2.7 ) - 39-------------------------------------------------------------------------------- Table of Contents The increase in the GAAP loss and loss expense ratio of 1.1 points in Nine Months 2014 compared to Nine Months 2013 was driven by storms and fires, resulting in: (i) an increased level of catastrophe losses; and (ii) higher non-catastrophe property losses. Partially offsetting these losses was the earning of renewal pure price increases that exceeded our projected loss inflation trend for the casualty component of our Personal Lines and favorable prior year casualty reserve development. Quantitative information regarding property losses and reserve development is as follows: Nine Months ended September 30, 2014 Nine Months ended September 30, 2013 Impact on Impact on Loss and Loss and Loss Loss Loss and Loss Expense Expense Loss and Loss Expense ($ in millions) Incurred Ratio Expense Incurred Ratio Change in Ratio Catastrophe losses $ 22.6 10.1 pts $ 17.1 7.7 pts 2.4 pts Non-catastrophe property losses 73.0 32.6 66.0 29.8 2.8 Favorable prior year casualty development (6.0 ) (2.7 ) (3.5 ) (1.7 ) (1.0 ) Favorable prior year casualty reserve development in Third Quarter 2014 and Nine Months 2014 was driven by the 2010 through 2012 accident years on our personal auto line of business. The increase in the underwriting expense ratios for each of the periods mentioned above were driven by higher supplemental commissions to agents. E&S Insurance Operations Our E&S Insurance Operations segment, which represents 8% of our combined insurance operations NPW, sells Commercial Lines insurance products and services in all 50 states and the District of Columbia through approximately 85 wholesale general agents. Insurance policies in this segment typically cover business risks with unique characteristics, such as the nature of the business or its claim history, that have not obtained coverage in the standard commercial marketplace. E&S insurers have more flexibility in coverage terms and rates compared to standard market insurers, generally resulting in policies with higher rates, and terms and conditions that are customized for specific risks. Nine Months ended September Quarter ended September 30, 30, Change Change % or % or ($ in thousands) 2014 2013 Points 2014 2013 Points GAAP Insurance Operations Results: NPW $ 39,635 35,575 11 % $ 107,479 96,621 11 % NPE 36,119 31,892 13 102,929 91,998 12 Less: Loss and loss expense incurred 24,443 20,620 19 66,723 60,812 10 Net underwriting expenses incurred 13,047 11,259 16 36,639 33,372 10 Underwriting gain (loss) $ (1,371 ) 13 (10,646 ) % $ (433 ) (2,186 ) 80 % GAAP Ratios: Loss and loss expense ratio 67.7 % 64.7 3.0 pts 64.8 % 66.1 (1.3 ) pts Underwriting expense ratio 36.1 35.3 0.8 35.6 36.3 (0.7 ) Combined ratio 103.8 100.0 3.8 100.4 102.4 (2.0 ) Statutory Ratios: Loss and loss expense ratio 67.6 64.7 2.9 64.9 66.2 (1.3 ) Underwriting expense ratio 35.3 35.8 (0.5 ) 35.4 35.7 (0.3 ) Combined ratio 102.9 % 100.5 2.4 pts 100.3 % 101.9 (1.6 ) pts The increase in the combined ratio in Third Quarter 2014 compared to Third Quarter 2013 was driven by unfavorable prior year casualty reserve development in Third Quarter 2014 of $4.0 million, or 11.0 points, compared to no prior year casualty reserve development in Third Quarter 2013. Partially offsetting this increase was the following: • Significant underwriting actions that we have implemented to increase premiums and improve profitability, including achieving renewal pure price increases of 2.8% in Third Quarter 2014; and • Catastrophe losses of 1.4 points in Third Quarter 2014 compared to 3.1 points in Third Quarter 2013. 40-------------------------------------------------------------------------------- Table of Contents The improvement in the combined ratio in Nine Months 2014 compared to Nine Months 2013 was driven by the following: • Significant underwriting actions mentioned above, including achieving renewal pure price increases of 3.8% in Nine Months 2014; and • Catastrophe losses of 2.3 points in Nine Months 2014 compared to 4.2 points in Nine Months 2013. These year-to-date benefits were partially offset by unfavorable prior year casualty reserve development of $4.0 million, or 3.8 points, in Nine Months 2014 compared to $2.5 million, or 2.7 points, in Nine Months 2013. Reinsurance: Standard Insurance Operations Reinsurance Treaties and Arrangements We have successfully completed negotiations of our July 1, 2014 Standard Insurance Operations excess of loss treaties with some enhancements in terms and conditions and the same structure as the expiring treaties as follows: Property Excess of Loss The property excess of loss treaty ("Property Treaty") continues to provide $38.0 million of coverage in excess of a $2.0 million retention: • The per occurrence cap on the total program is $84.0 million. • The first layer continues to have unlimited reinstatements. The annual aggregate limit for the $30.0 million in excess of $10.0 million second layer is $120.0 million. • The Property Treaty continues to exclude nuclear, biological, chemical, and radiological terrorism losses. Casualty Excess of Loss The casualty excess of loss treaty ("Casualty Treaty") continues to provide $88.0 million of coverage in excess of a $2.0 million retention: • The first through sixth layers provide coverage for 100% of up to $88.0 million in excess of a $2.0 million retention. • The Casualty Treaty excludes nuclear, biological, chemical, and radiological terrorism losses, with the annual aggregate terrorism limits increased to $208.0 million from $201.0 million. 41-------------------------------------------------------------------------------- Table of Contents Investments Our investment philosophy includes certain return and risk objectives for the fixed income, equity, and other investment portfolios. Although yield and income generation remain the key drivers to our investment strategy, our overall philosophy is to invest with a long-term horizon along with predominantly a "buy-and-hold" approach. The primary fixed income portfolio return objective is to maximize after-tax investment yield and income while balancing risk. A secondary objective is to meet or exceed a weighted-average benchmark of public fixed income indices. Within the equity portfolio, the high dividend yield strategy is designed to generate consistent dividend income while maintaining an expected tracking error to the S&P 500 Index. Additional equity strategies are focused on meeting or exceeding strategy-specific benchmarks of public equity indices. The return objective of the other investment portfolio, which includes alternative investments, is to meet or exceed the S&P 500 Index. Total Invested Assets ($ in thousands) September 30, 2014 December 31, 2013 Change % Total invested assets $ 4,803,127 4,583,312 5 % Unrealized gain - before tax 115,439 79,236 46 Unrealized gain - after tax 75,035 51,504 46 The increase in our investment portfolio compared to year-end 2013 was primarily due to: (i) cash flows provided by operating activities of $158.1 million; and (ii) an increase in pre-tax unrealized gains of $36.2 million. These gains were driven by increases in the market value of our fixed income securities portfolio as interest rates decreased during Nine Months 2014. During Nine Months 2014, interest rates on the 10-year U.S. Treasury Note fell by 54 basis points. This decline in interest rates increased the unrealized gain position on our fixed income securities portfolio. While the low interest rate environment presents a challenge to us in generating after-tax return, we believe the after-tax yield on our fixed income securities portfolio has stabilized at around 2.25%, as new purchase yields are approximating the average yield on bonds that are currently being disposed. 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 segments; (iv) consideration of taxes; and (v) preservation of capital. We believe that we have a high quality and liquid investment portfolio. The breakdown of our investment portfolio is as follows: September 30, 2014 December 31, 2013 U.S. government obligations 3 % 4 Foreign government obligations 1 1 State and municipal obligations 32 28 Corporate securities 37 39 Mortgage-backed securities ("MBS") 14 15 Asset-backed securities ("ABS") 3 3 Total fixed income securities 90 90 Equity securities 4 4 Short-term investments 4 4 Other investments 2 2 Total 100 % 100 42-------------------------------------------------------------------------------- Table of Contents Fixed Income Securities The average duration of the fixed income securities portfolio as of September 30, 2014 was 3.6 years, including short-term investments, compared to the Insurance Subsidiaries' liability duration of approximately 3.8 years. The current duration of the fixed income securities portfolio is within our historical range, and is monitored and managed to maximize yield while managing interest rate risk at an acceptable level. We manage liquidity with a laddered maturity structure and an appropriate level of short-term investments to avoid liquidation of available-for-sale ("AFS") fixed income securities 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 maximizing risk-adjusted investment returns in the current market environment while balancing capital preservation. Our fixed income securities portfolio had a weighted average credit rating of "AA-" as of September 30, 2014. The following table presents the credit ratings of this portfolio: Fixed Income Security Rating September 30, 2014 December 31, 2013 Aaa/AAA 16 % 15 Aa/AA 45 45 A/A 25 26 Baa/BBB 13 13 Ba/BB or below 1 1 Total 100 % 100 43-------------------------------------------------------------------------------- Table of Contents The following table summarizes the fair value, unrealized gain (loss) balances, and the weighted average credit qualities of our AFS fixed income securities at September 30, 2014 and December 31, 2013: September 30, 2014 December 31, 2013 Weighted Weighted Average Fair Unrealized Average Credit Fair Unrealized Credit ($ in millions) Value Gain (Loss) Quality Value Gain (Loss) Quality AFS Fixed Income Portfolio: U.S. government obligations $ 151.7 7.9 AA+ 173.4 10.1 AA+ Foreign government obligations 27.9 0.8 AA- 30.6 0.8 AA- State and municipal obligations 1,229.2 32.8 AA 951.6 5.2 AA Corporate securities 1,763.1 38.0 A- 1,734.9 27.0 A ABS 147.0 0.4 AAA 140.9 0.5 AAA MBS 648.7 3.5 AA+ 684.1 (4.0 ) AA+ Total AFS fixed income portfolio $ 3,967.6 83.4 AA- 3,715.5 39.6 AA- State and Municipal Obligations: General obligations $ 564.5 14.6 AA+ 472.0 2.6 AA+ Special revenue obligations 664.7 18.2 AA 479.6 2.6 AA Total state and municipal obligations $ 1,229.2 32.8 AA 951.6 5.2 AA Corporate Securities: Financial $ 541.7 11.5 A 534.1 11.7 A Industrials 141.1 4.3 A- 135.1 3.7 A- Utilities 150.2 2.4 BBB+ 146.5 (0.3 ) A- Consumer discretionary 204.1 5.4 A- 190.6 2.7 A- Consumer staples 176.9 3.6 A- 171.9 3.0 A Healthcare 169.5 4.3 A 168.5 3.1 A Materials 109.8 2.4 BBB+ 101.2 1.4 A- Energy 105.9 1.5 A- 93.7 0.9 A- Information technology 111.9 1.2 A+ 121.2 (0.6 ) A+ Telecommunications services 49.2 1.1 BBB+ 64.7 1.0 BBB+ Other 2.8 0.3 AA 7.4 0.4 AA+ Total corporate securities $ 1,763.1 38.0 A- 1,734.9 27.0 A ABS: ABS $ 146.6 0.3 AAA 140.4 0.4 AAA Sub-prime ABS1 0.4 0.1 D 0.5 0.1 D Total ABS 147.0 0.4 AAA 140.9 0.5 AAA MBS: Government guaranteed agency commercial mortgage-backed securities ("CMBS") $ 17.6 0.3 AA+ 30.0 0.9 AA+ Other agency CMBS 10.6 (0.2 ) AA+ 9.1 (0.3 ) AA+ Non-agency CMBS 137.3 0.4 AA+ 132.2 (1.5 ) AA+ Government guaranteed agency residential MBS ("RMBS") 35.9 1.0 AA+ 55.2 1.4 AA+ Other agency RMBS 406.3 1.3 AA+ 411.5 (5.1 ) AA+ Non-agency RMBS 37.1 0.6 A- 41.4 0.6 A- Alternative-A ("Alt-A") RMBS 3.9 0.1 A 4.7 - A Total MBS $ 648.7 3.5 AA+ 684.1 (4.0 ) AA+ 1Subprime ABS consists of one security whose issuer is currently expected by rating agencies to default on its obligations. We define sub-prime exposure as exposure to direct and indirect investments in non-agency residential mortgages with average FICO® scores below 650. 44-------------------------------------------------------------------------------- Table of Contents The following tables provide information regarding our held-to-maturity ("HTM") fixed income securities and their credit qualities at September 30, 2014 and December 31, 2013: September 30, 2014 Unrealized Gain (Loss) in Accumulated Total Weighted Unrecognized Other Unrealized/ Average Fair Carry Holding Gain Comprehensive Unrecognized Credit ($ in millions) Value Value (Loss) Income ("AOCI") Gain (Loss) Quality HTM Fixed Income Portfolio: Foreign government obligations $ 5.4 5.4 - 0.1 0.1 AA+ State and municipal obligations 317.6 303.6 14.0 2.4 16.4 AA Corporate securities 22.8 20.0 2.8 (0.3 ) 2.5 A+ ABS 3.1 2.6 0.5 (0.5 ) - AAA MBS 5.3 4.5 0.8 (0.5 ) 0.3 AAA Total HTM fixed income portfolio $ 354.2 336.1 18.1 1.2 19.3 AA State and Municipal Obligations: General obligations $ 107.0 103.0 4.0 1.2 5.2 AA Special revenue obligations 210.6 200.6 10.0 1.2 11.2 AA Total state and municipal obligations $ 317.6 303.6 14.0 2.4 16.4 AA Corporate Securities: Financial $ 2.3 1.9 0.4 (0.1 ) 0.3 A- Industrials 6.7 5.7 1.0 (0.1 ) 0.9 A+ Utilities 13.5 12.1 1.4 (0.1 ) 1.3 A+ Consumer staples 0.3 0.3 - - - AA Total corporate securities $ 22.8 20.0 2.8 (0.3 ) 2.5 A+ ABS: ABS $ 0.7 0.7 - - - AA Alt-A ABS 2.4 1.9 0.5 (0.5 ) - AAA Total ABS $ 3.1 2.6 0.5 (0.5 ) - AAA MBS: Non-agency CMBS $ 5.3 4.5 0.8 (0.5 ) 0.3 AAA Total MBS $ 5.3 4.5 0.8 (0.5 ) 0.3 AAA 45-------------------------------------------------------------------------------- Table of Contents December 31, 2013 Total Weighted Unrecognized Unrealized/ Average Fair Carry Holding Gain Unrealized Gain Unrecognized Credit ($ in millions) Value Value (Loss) (Loss) in AOCI Gain (Loss) Quality HTM Portfolio: Foreign government obligations $ 5.6 5.4 0.2 0.1 0.3 AA+ State and municipal obligations 369.8 352.2 17.6 4.0 21.6 AA Corporate securities 30.3 27.8 2.5 (0.3 ) 2.2 A ABS 3.4 2.8 0.6 (0.6 ) - AA+ MBS 7.9 4.7 3.2 (0.9 ) 2.3 AA- Total HTM portfolio $ 417.0 392.9 24.1 2.3 26.4 AA State and Municipal Obligations: General obligations $ 118.5 113.1 5.4 2.0 7.4 AA Special revenue obligations 251.3 239.1 12.2 2.0 14.2 AA Total state and municipal obligations $ 369.8 352.2 17.6 4.0 21.6 AA Corporate Securities: Financial $ 7.3 6.8 0.5 (0.1 ) 0.4 BBB+ Industrials 7.8 6.8 1.0 (0.2 ) 0.8 A+ Utilities 13.2 12.2 1.0 - 1.0 A+ Consumer discretionary 2.0 2.0 - - - AA Total corporate securities $ 30.3 27.8 2.5 (0.3 ) 2.2 A ABS: ABS $ 0.9 0.9 - - - A Alt-A ABS 2.5 1.9 0.6 (0.6 ) - AAA Total ABS $ 3.4 2.8 0.6 (0.6 ) - AA+ MBS: Non-agency CMBS $ 7.9 4.7 3.2 (0.9 ) 2.3 AA- Total MBS $ 7.9 4.7 3.2 (0.9 ) 2.3 AA- 46-------------------------------------------------------------------------------- Table of Contents The sector composition and credit quality of our municipal bonds did not significantly change from December 31, 2013. For details regarding our special revenue bond sectors and additional information regarding credit risk and our management of MBS exposure, see Item 7A. "Quantitative and Qualitative Disclosures About Market Risk." of our 2013 Annual Report. The following table details the top 10 state exposures of the municipal bond portion of our fixed income securities portfolio at September 30, 2014: State Exposures of Municipal Bonds Weighted General Obligation Average Special Fair Credit ($ in thousands) Local State Revenue Value % of Total Quality New York $ 15,874 - 115,374 131,248 9% AA+ Texas1 61,698 5,890 62,726 130,314 9% AA+ Washington 39,316 6,972 50,346 96,634 6% AA California 15,281 7,964 59,371 82,616 5% AA Florida - 15,511 50,086 65,597 4% AA Arizona 11,734 999 43,924 56,657 4% AA Colorado 31,654 - 20,999 52,653 3% AA- Oregon 21,015 - 26,599 47,614 3% AA+ Missouri 15,835 10,114 21,540 47,489 3% AA+ Ohio 8,419 19,109 18,359 45,887 3% AA+ Other 160,045 152,487 335,366 647,898 42% AA 380,871 219,046 804,690 1,404,607 91% AA Pre-refunded/escrowed to maturity bonds 53,972 17,592 70,672 142,236 9% AA+ Total $ 434,843 236,638 875,362 1,546,843 100% AA % of Total Municipal Portfolio 28 % 15 % 57 % 100 % 1 Of the $62 million in local Texas general obligation bonds, $27 million represents investments in Texas Permanent School Fund bonds, which are considered to have lower risk as a result of the bond guarantee program that supports these bonds. A portion of our municipal bonds contain insurance enhancements. The following table provides information regarding these insurance-enhanced securities as of September 30, 2014: Insurers of Municipal Bond Securities Ratings Ratings with without ($ in thousands) Fair Value Insurance Insurance National Public Finance Guarantee Corporation, a subsidiary of MBIA, Inc. $ 162,893 AA- AA- Assured Guaranty 131,341 AA AA- Ambac Financial Group, Inc. 51,292 AA AA- Other 10,486 AA AA- Total $ 356,012 AA AA- Equity Securities Our equity securities portfolio was 4% of invested assets as of both September 30, 2014 and December 31, 2013, while the value of this portfolio increased modestly to $211.3 million from $192.8 million over the same time period. During Nine Months 2014, we rebalanced our high dividend yield strategy holdings within this portfolio, generating purchases of $185.4 million and sales of securities that had an original cost of $159.1 million. 47-------------------------------------------------------------------------------- Table of Contents Unrealized/Unrecognized Losses Our net unrealized/unrecognized loss positions improved by $32.8 million, to $19.3 million, as of September 30, 2014 compared to December 31, 2013. The majority of this improvement was in our fixed income securities portfolio, reflecting declining interest rates in the marketplace during Nine Months 2014. The following table presents amortized cost and fair value information for our AFS fixed income securities that were in an unrealized loss position at September 30, 2014 by contractual maturity: Amortized Fair ($ in thousands) Cost Value Unrealized Loss One year or less $ 9,092 8,984 108Due after one year through five years 486,229 481,165 5,064 Due after five years through ten years 511,727 501,707 10,020 Due after ten years 11,008 10,908 100 Total $ 1,018,056 1,002,764 15,292 The following table presents amortized cost and fair value information for our HTM fixed income securities that were in an unrealized/unrecognized loss position at September 30, 2014 by contractual maturity: Amortized Fair ($ in thousands) Cost Value Unrecognized/Unrealized Loss One year or less $ 461 460 1 Due after one year through five years 2,442 2,428 14 Total $ 2,903 2,888 15 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 2013 Annual Report. We have concluded that these securities were temporarily impaired as of September 30, 2014. For additional information regarding the unrealized/unrecognized losses in our AFS and HTM portfolios, see Note 5. "Investments" in Item 1. "Financial Statements." of this Form 10-Q. Other Investments As of September 30, 2014, other investments of $106.5 million represented 2% of our total invested assets. In addition to the capital that we have already invested to date, we are contractually obligated to invest up to an additional $50.3 million in our other investments portfolio through commitments that currently expire at various dates through 2026. For a description of our seven alternative investment strategies, as well as redemption, restrictions, and fund liquidations, refer to Note 5. "Investments" in Item 8. "Financial Statements and Supplementary Data." of our 2013 Annual Report. 48-------------------------------------------------------------------------------- Table of Contents Net Investment Income The components of net investment income earned for the indicated periods were as follows: Quarter ended September 30, Nine Months ended September 30, ($ in thousands) 2014 2013 2014 2013 Fixed income securities $ 30,706 30,569 95,515 90,956 Equity securities 1,909 1,341 5,094 4,422 Short-term investments 15 21 48 102 Other investments 3,906 2,639 12,677 10,110 Investment expenses (2,244 ) (2,113 ) (6,734 ) (6,260 ) Net investment income earned - before tax 34,292 32,457 106,600 99,330 Net investment income tax expense (8,527 ) (7,947 ) (26,928 ) (24,281 ) Net investment income earned - after tax $ 25,765 24,510 79,672 75,049 Effective tax rate 24.9 % 24.5 25.3 24.4 Annualized after-tax yield on fixed income securities 2.2 2.3 2.3 2.3 Annualized after-tax yield on investment portfolio 2.2 2.2 2.3 2.3 Net investment income before tax increased in Third Quarter 2014 and Nine Months 2014 compared to the same prior year periods. Both the quarter and year-to-date periods were positively impacted by higher income from the alternative investments within our other investments portfolio. In addition, in Nine Months 2014, higher income from our fixed income securities was driven by an increase in the size of this portfolio, which more than offset the lower yield earned this year compared to last. Realized Gains and Losses 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, or to opportunistically trade out of securities to other securities with better economic return characteristics. We typically have a long investment time horizon, and every purchase or sale is made with the intent of maximizing risk-adjusted investment returns in the current market environment while balancing capital preservation. Total net realized gains amounted to $15.2 million in Third Quarter 2014 and $27.0 million in Nine Months 2014, compared to $13.4 million and $21.9 million in the same periods a year ago. These amounts included OTTI charges of $1.4 million in Nine Months 2014, $0.7 million in Third Quarter 2013, and $3.2 million in Nine Months 2013. There were no OTTI charges in Third Quarter 2014. We regularly review our entire investment portfolio for declines in fair value. If we believe that a decline in the value of a particular investment is other than temporary, we record it as an OTTI, through realized losses in earnings for the credit-related portion and through unrealized losses in other comprehensive income ("OCI") for the non-credit related portion. If there is a decline in fair value of an equity security that we do not intend to hold, or if we determine that the decline is other than temporary, we write down the cost of the investment to fair value and record the charge through earnings as a component of realized losses. For discussion of our realized gains and losses as well as our OTTI methodology, see Note 2. "Summary of Significant Accounting Policies" in Item 8. "Financial Statements and Supplementary Data." of our 2013 Annual Report, and for qualitative information about our OTTI charges, see Note 5. "Investments" in Item 1. "Financial Statements." of this Form 10-Q. Federal Income Taxes The following table provides information regarding federal income taxes from continuing operations: Quarter ended September 30, Nine Months ended September 30, ($ in million) 2014 2013 2014 2013 Federal income tax expense from continuing operations $ 22.2 11.8 39.5 27.5 Effective tax rate 29 % 27 28 25 The increase in federal income tax expense in Third Quarter 2014 and Nine Months 2014 compared to the same prior year periods was primarily due to an improvement in underwriting results compared to last year. For a discussion of our underwriting results, see the "Results of Operations and Related Information by Segment" section above. 49-------------------------------------------------------------------------------- Table of Contents 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 the short-term and long-term cash requirements of our business operations. Our cash and short-term investment position of $184.1 million at September 30, 2014 was comprised of $44.9 million at Selective Insurance Group, Inc. (the "Parent") and $139.2 million at the Insurance Subsidiaries. Short-term investments are generally maintained in "AAA" rated money market funds approved by the National Association of Insurance Commissioners. The Parent continues to maintain a fixed income security investment portfolio containing high-quality, highly-liquid government and corporate fixed income securities to generate additional yield. This portfolio amounted to $52 million at September 30, 2014 compared to $56 million at December 31, 2013. Sources of cash for the Parent have historically consisted of dividends from the Insurance Subsidiaries, borrowings under lines of credit and loan agreements with certain Insurance 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. We currently anticipate the Insurance Subsidiaries will pay approximately $57.5 million in total dividends to the Parent in 2014. Cash dividends of $43.1 million were paid in Nine Months 2014. As of December 31, 2013, our allowable ordinary maximum dividend was approximately $127 million for 2014. Any dividends to the Parent are subject to the approval and/or review of the insurance regulators in the respective domiciliary states 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 20. "Statutory Financial Information, Capital Requirements, and Restrictions on Dividends and Transfers of Funds" in Item 8. "Financial Statements and Supplementary Data." of our 2013 Annual Report. The Parent had no private or public issuances of stock during Nine Months 2014 and there were no borrowings under its $30 million line of credit ("Line of Credit") at September 30, 2014 or at any time during Nine Months 2014. We have two Insurance Subsidiaries domiciled in Indiana ("Indiana Subsidiaries") that are members of the Federal Home Loan Bank of Indianapolis ("FHLBI"). These Insurance Subsidiaries are Selective Insurance Company of South Carolina ("SICSC") and Selective Insurance Company of the Southeast ("SICSE"). Membership in the FHLBI provides these subsidiaries with access to additional liquidity. The Indiana Subsidiaries' aggregate investment of $2.9 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. All borrowings from the FHLBI are required to be secured by certain investments. For additional information regarding the required collateral, refer to Note 5. "Investments" in Item 1. "Financial Statements." of this Form 10-Q. 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. Admitted assets amounted to $542.4 million for SICSC and $414.9 million for SICSE as of December 31, 2013, for a borrowing capacity of approximately $96 million. As our outstanding borrowing with the FHLBI is currently $58 million, the Indiana Subsidiaries have the ability to borrow approximately $38 million more until the Line of Credit borrowing limit is met, of which $30 million could be loaned to the Parent under lending agreements approved by the Indiana Department of Insurance. Similar to the Line of Credit agreement, these lending agreements limit borrowings by the Parent from the Indiana Subsidiaries to 10% of the admitted assets of the respective Indiana Subsidiary. For additional information regarding the Parent's Line of Credit, refer to the section below entitled "Short-term Borrowings." 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 laddered to continually provide a source of cash flows for claims payments in the ordinary course of business. The duration of the fixed income securities portfolio including short-term investments was 3.6 years as of September 30, 2014, while the liabilities of the Insurance Subsidiaries have a duration of 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. 50-------------------------------------------------------------------------------- Table of Contents The liquidity generated from the sources discussed above is used, among other things, to pay dividends to our shareholders. 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. On October 29, 2014, our Board of Directors declared, for stockholders of record as of November 14, 2014, a $0.14 per share dividend to be paid on December 1, 2014. This is an 8% increase compared to the dividend declared on July 30, 2014. 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. Upcoming principal payments on our debt include $13 million in December 2014 and $45 million in December 2016. Subsequent to 2016, our next principal repayment is due in 2034. Restrictions on the ability of the Insurance Subsidiaries to declare and pay dividends, without alternative liquidity options, could materially affect our ability to service 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 September 26, 2013 with a borrowing capacity of $30 million, which can be increased to $50 million with the approval of both lending partners. The Line of Credit provides the Parent with an additional source of short-term liquidity. The interest rate on our Line of Credit varies and is based on, among other factors, the Parent's debt ratings. The Line of Credit expires on September 26, 2017. There were no balances outstanding under the Line of Credit at September 30, 2014 or at any time during Nine Months 2014. The Line of Credit agreement contains representations, warranties, and covenants that are customary for credit facilities of this type, including, without limitation, financial covenants under which we are obligated to maintain a minimum consolidated net worth, minimum combined statutory surplus, and maximum ratio of consolidated debt to total capitalization, as well as covenants limiting our ability to: (i) merge or liquidate; (ii) incur debt or liens; (iii) dispose of assets; (iv) make certain 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 September 30, 2014 September 30, 2014 Consolidated net worth $857 million $1.3 billion Not less than $750 Statutory surplus million $1.3 billion Debt-to-capitalization ratio1 Not to exceed 35% 23.9% A.M. Best financial strength rating Minimum of A- A 1 Calculated in accordance with the 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 September 30, 2014, we had statutory surplus of $1.3 billion, GAAP stockholders' equity of $1.3 billion, and total debt of $392.3 million, which equates to a debt-to-capital ratio of approximately 23.6%. Our cash requirements include, but are not limited to, principal and interest payments on various notes payable, 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." 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 our targeted financial strength. 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 in our insurance operations, issuing additional debt and/or equity securities, repurchasing shares of the Parent's common stock, and increasing stockholders' dividends. 51-------------------------------------------------------------------------------- Table of Contents 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 $22.45 as of September 30, 2014, from $20.63 as of December 31, 2013, due to $1.78 in net income coupled with a $0.42 increase in unrealized gains on our investment portfolio. These items were partially offset by $0.40 in dividends to our shareholders. 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. In the second quarter of 2014, A.M. Best reaffirmed our rating of "A (Excellent)," their third highest of 13 financial strength ratings, with a "stable" outlook. The rating reflects our strong risk-adjusted capitalization, disciplined underwriting focus, increasing use of predictive modeling technology, strong independent retail agency relationships, and consistently stable loss reserves. We have been rated "A" or higher by A.M. Best for the past 84 years. A downgrade from A.M. Best to a rating below "A-" is an event of default under our Line of Credit and could 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. Ratings by other major rating agencies are as follows: • Fitch Ratings ("Fitch") - Our "A+" rating was reaffirmed in the second quarter of 2014, citing our improved underwriting results, strong independent agency relationships, solid loss reserve position, and enhanced diversification through continued efforts to reduce our concentration in New Jersey. Our outlook has been revised to stable reflecting operating earnings-based interest coverage that showed improvement in 2013. • Standard & Poor's Ratings Services ("S&P") - On October 8, 2014, S&P reaffirmed our financial strength rating of "A-" and revised our outlook to positive from stable. The rating reflects our strong business risk profile, strong competitive position and very strong capital and earnings. The positive outlook for the rating reflects S&P's view of ongoing efforts to improve the geographic and product diversification and reduce risk concentrations in catastrophe prone areas. In addition, the positive outlook reflects S&P's expectation that we will steadily improve our operating performance and that our capital adequacy will remain redundant at a very strong level. • Moody's Investor Service ("Moody's") - Our "A2" financial strength rating was reaffirmed in Third Quarter 2014 by Moody's, which cited our solid regional franchise with established independent agency support, solid risk adjusted capitalization, strong invested asset quality, and recently improving underwriting profitability. Our outlook remains negative, reflecting challenges in achieving further reductions in segment concentrations and maintaining the pace and consistency of profitability. Our S&P, Moody's, and Fitch financial strength and associated credit ratings affect our ability to access capital markets. The interest rate on our Line of Credit varies and is based on, among other factors, the Parent's debt ratings. 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. Off-Balance Sheet Arrangements At September 30, 2014 and December 31, 2013, we did not have any material 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 material financing, liquidity, market, or credit risk that could arise if we had engaged in such relationships. 52-------------------------------------------------------------------------------- Table of Contents Contractual Obligations, Contingent Liabilities, and Commitments Our future cash payments associated with: (i) loss and loss expense reserves; (ii) contractual obligations pursuant to operating leases for office space and equipment; (iii) notes payable; and (iv) contractual obligations related to our alternative and other investments portfolio have not materially changed since December 31, 2013. We expect to have the capacity to repay and/or refinance these obligations as they come due. 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 2013 Annual Report. |