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SELECTIVE INSURANCE GROUP INC – 10-Q – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
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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: • Standard Insurance Operations - comprised of both commercial lines ("Commercial Lines") and personal lines ("Personal Lines") insurance products and services that are sold in the standard marketplace;
• Excess and Surplus ("E&S") Insurance Operations - comprised of Commercial
Lines insurance products and services that are unavailable in the standard
market due to market conditions or characteristics of the insured that are caused by the insured's claim history or the characteristics of their business; and • Investments - invests the premiums collected by our Standard and E&S
Insurance Operations, as well as 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 theNational Flood Insurance Program's ("NFIP") write-your-own ("WYO") program. Two of these subsidiaries,Selective Casualty Insurance Company ("SCIC") andSelective Fire and Casualty Insurance Company ("SFCIC"), were created in 2012. These subsidiaries began writing direct premium in 2013 and have been included in our reinsurance pooling agreement as ofJuly 1, 2012 . Our E&S Insurance Operations products and services are sold through a subsidiary that was acquired inDecember 2011 . 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. For additional information regarding our E&S acquisitions, refer to Note 12. "Business Combinations" in Item 8. "Financial Statements and Supplementary Data." contained in our Annual Report on Form 10-K for the year endedDecember 31, 2012 ("2012 Annual Report"). Our ten insurance subsidiaries are collectively referred to as the "Insurance Subsidiaries". 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 2012 Annual Report. In the MD&A, we will discuss and analyze the following: • Critical Accounting Policies and Estimates;
• Financial Highlights of Results for First Quarter 2013 and 2012;
• 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.
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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) deferred policy acquisition costs; (iii) pension and post-retirement benefit plan actuarial assumptions; (iv) other-than-temporary investment impairments; and (v) 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 2012 Annual Report, pages 44 through 53. However, for changes related to actuarial assumptions used in the measurement of our Retirement Income Plan forSelective Insurance Company of America and the Supplemental Excess Retirement Plan (jointly referred to as the "Retirement Income Plan"), see Note 10. "Retirement Plans" of this Form 10-Q.
Financial Highlights of Results for First Quarter 2013 and 20121
Quarter ended March 31, ($ and Shares in thousands, except per share Change amounts) 2013 2012 % or Points Generally Accepted Accounting Principles ("GAAP") measures: Revenues $ 459,949 419,348 10 % Pre-tax net investment income 32,870 32,628 1 Pre-tax net income 27,333 23,191 18 Net income 21,308 18,093 18 Diluted net income per share 0.38 0.33 15 Diluted weighted-average outstanding shares 56,455 55,605 2 GAAP combined ratio 97.1 % 100.4 (3.3 ) pts Statutory combined ratio2 96.8 % 99.1 (2.3 ) Return on average equity 7.7 % 6.8 0.9 Non-GAAP measures: Operating income2 $ 20,124 15,260 32 % Diluted operating income per share3 0.36 0.28
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Operating return on average equity3 7.2 % 5.7
1.5 pts
1 Refer to the Glossary of Terms attached to our 2012 Annual Report as Exhibit
99.1 for definitions of terms used in this Form 10-Q.
2 Includes 1.3 points related to the Retirement Income Plan amendments that
curtail the accrual of additional benefits for all eligible employees participating in the plans afterMarch 31, 2016 .
3 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 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:
Quarter endedMarch 31 , ($ in thousands, except per share amounts) 2013
2012
Operating income$ 20,124
15,260
Net realized gains, net of tax 2,181
2,833
Loss on disposal of discontinued operations, net of tax (997 ) - Net income$ 21,308 18,093 Diluted operating income per share$ 0.36
0.28
Diluted net realized gains per share 0.04
0.05
Diluted net loss on disposal of discontinued operations per share (0.02 ) - Diluted net income per share$ 0.38
0.33
Over the long term, we target a return on average equity that is three points higher than our cost of capital, currently 8%, excluding the impact of realized gains and losses, which is referred to as operating return on equity. Our operating return on 28
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average equity was 7.2% in the First Quarter 2013 and 5.7% in the First Quarter 2012. Our operating return on average equity contribution by component is as follows:
Operating Return on Average Equity Quarter ended
2013 2012 Insurance Operations 2.8 % (0.3 )% Investments 8.9 % 9.3 % Other (4.5 )% (3.3 )% Total 7.2 % 5.7 % The improvement in the operating return on average equity generated from our insurance operations reflects a$13.5 million increase in underwriting profitability, driven primarily by: (i) an$8.5 million improvement in our Standard Insurance Operations, reflecting the impact of earning renewal pure price increases that have been exceeding loss costs trends over the past year; and (ii) underwriting improvement in our E&S Insurance Operations of$5.0 million . The$5.0 million improvement is largely driven by: (i) earned premiums that now reflect the full operations of this business; (ii) a decrease in the initial start-up expenditures of$1.0 million ; and (iii) lower than anticipated supplemental commissions payments to our wholesale agents of$1.1 million for the year 2012. Our investments segment's contribution to operating return on equity was relatively consistent in First Quarter 2013 compared to First Quarter 2012. Net investment income continues to be negatively impacted by the low interest rate environment, which has lowered returns within our fixed maturity securities portfolio when comparing periods. However, higher returns in our other investments portfolio, which were driven by the alternative investments within that portfolio, have partially offset the impact of low interest rates. InFebruary 2013 , we issued$185 million of 5.875% Senior Notes due 2043. A portion of the proceeds was used inMarch 2013 to redeem the$100 million outstanding 7.50% Junior Notes. Concurrent with the redemption of the 7.5% Junior Notes, we expensed the remaining capitalized debt issue costs related to these notes of$3.3 million , pre tax. This expense, as well as a$3.2 million pre-tax increase in our long-term employee compensation expense associated with the increase of our stock price, drove the 1.2% decline in the operating return of average equity from "Other" in the table above. The following table provides a quantitative foundation for analyzing our overall Insurance Subsidiaries underwriting results: All Lines Quarter ended March 31, ($ in thousands) 2013 2012 Change % or Points GAAP Insurance Operations Results: Net premiums written ("NPW")$ 450,124 420,172 7 % Net premiums earned ("NPE") 420,940 378,829 11 Less: Loss and loss expense incurred 269,849 252,906 7 Net underwriting expenses incurred 137,844 126,372 9 Dividends to policyholders 1,086 914 19 Underwriting gain (loss)$ 12,161 (1,363 ) 992 % GAAP Ratios: Loss and loss expense ratio 64.1 % 66.8 (2.7 ) pts Underwriting expense ratio 32.7 33.4 (0.7 ) Dividends to policyholders ratio 0.3 0.2 0.1 Combined ratio 97.1 100.4 (3.3 ) Statutory Ratios: Loss and loss expense ratio 64.1 66.7 (2.6 ) Underwriting expense ratio 32.4 32.2 0.2 Dividends to policyholders ratio 0.3 0.2 0.1 Combined ratio 96.8 % 99.1 (2.3 ) pts
The growth in NPW for our Insurance Subsidiaries in First Quarter 2013 compared to First Quarter 2012 reflects the following in our Standard Insurance Operations: (i) pure price increases that we have achieved; and (ii) strong retention.
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NPE increases in First Quarter 2013 were consistent with the fluctuations in NPW for the twelve-month period endedMarch 31, 2013 as compared to the twelve-month period endedMarch 31, 2012 . The combined ratio improved by 3.3 points to 97.1%, compared to First Quarter 2012. This improvement reflects the earning of renewal pure price increases that averaged 6.3% in our Standard Insurance Operations in 2012 and exceeded loss trends by approximately 3.0 points.
Outlook
In their 2012 year-end review,A.M. Best and Company ("A.M. Best") projected an industry combined ratio of 101.2% for 2013. This projection reflects a more normal level of catastrophe losses as well as the impact of pricing improvements that were achieved in 2012 and are expected to continue in 2013. However,A.M. Best expects that the industry's performance will remain challenged by the continuing sluggish macroeconomic environment, which includes persisting low investment yields, a reduced level of loss reserve redundancies, and the lingering effects of the soft market conditions that have prevailed in recent years. For 2013, we expect to achieve a statutory combined ratio of 96% excluding catastrophes and any favorable or unfavorable prior year development. Our estimate for catastrophe losses in 2013 is three points. In addition, we expect our E&S Insurance Operations to produce a combined ratio between 100% and 102% for 2013 and be at profitability levels similar to our Standard Insurance Operations in 2014. We also expect to achieve a three-year overall statutory combined ratio of 92% by year-end 2014 excluding three points of expected catastrophe losses. Our Insurance Subsidiaries reported a statutory combined ratio of 96.4%, excluding catastrophe losses, for First Quarter 2013, reflecting 1.3 points for the Retirement Income Plan curtailment. A key component of meeting our combined ratio targets is our ability to generate Commercial Lines renewal pure price increases in excess of our predicted loss trends. AlthoughA.M. Best is maintaining its negative outlook for the commercial lines market, it does anticipate that sustained pricing momentum will continue in 2013. We achieved renewal pure price increases of 7.5% for standard Commercial Lines and 8.5% for standard Personal Lines in First Quarter 2013. These increases demonstrate the overall strength of the relationships that we have with our independent retail agents, even in difficult economic and competitive times. As the marketplace continues to drive price, we will continue to capitalize on our relationships with our agents to generate on-going renewal price increases through the use of our granular pricing capabilities. In maintaining their negative outlook for the commercial lines marketplace,A.M. Best cited an expectation that the continuing sluggish macroeconomic environment, including low investment yields, reduced levels of loss reserve redundancies, and the lingering effects of the soft market conditions will lead to more negative rating actions than positive actions in 2013. The continued low interest rate environment has several significant 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. However, the low interest rate environment presents a significant challenge in generating after-tax returns on our investment portfolio as fixed income securities mature and money is re-invested at lower rates. As a result, for 2013, we anticipate after-tax investment income of approximately$90 to$95 million , lower than the$100 million we earned on an after-tax basis in 2012. Through First Quarter 2013, we achieved after-tax investment income of approximately$25 million , which was flat with First Quarter 2012. 30
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Results of Operations and Related Information by Segment
Insurance Operations
Standard Insurance Operations Our Standard Insurance Operations segment, which represents 93% of our combined insurance operations NPW, sells insurance products and services primarily in 22 states in the Eastern and Midwestern U.S. and theDistrict of Columbia , through approximately 1,100 independent retail insurance agencies. This segment consists of two components: (i) Commercial Lines, which markets primarily to businesses and represents approximately 81% of the segment's NPW; and (ii) Personal Lines, including our flood business, which markets primarily to individuals and represents approximately 19% of the segment's NPW. Quarter ended March 31, ($ in thousands) 2013 2012 Change % or Points GAAP Insurance Operations Results: NPW$ 421,744 394,377 7 % NPE 390,881 369,106 6 Less: Loss and loss expense incurred 250,731 245,439 2 Net underwriting expenses incurred 126,989 119,223 7 Dividends to policyholders 1,086 914 19 Underwriting gain$ 12,075 3,530 242 % GAAP Ratios: Loss and loss expense ratio 64.1 % 66.5 (2.4 ) pts Underwriting expense ratio 32.5 32.3 0.2 Dividends to policyholders ratio 0.3 0.2 0.1 Combined ratio 96.9 99.0 (2.1 ) Statutory Ratios: Loss and loss expense ratio1 64.2 66.5 (2.3 ) Underwriting expense ratio1 32.3 31.3 1.0 Dividends to policyholders ratio 0.3 0.2 0.1 Combined ratio1 96.8 % 98.0 (1.2 ) pts
1 Includes 0.3 points in the loss and loss expense ratio, 1.1 points in the
underwriting ratio and 1.4 points in the combined ratio related to the
Retirement Income Plan amendments that curtail the accrual of additional
benefits for all eligible employees participating in the plans after
2016.
The improvements in NPW from First Quarter 2012 to First Quarter 2013 are primarily the result of the following:
Quarter ended March 31, Quarter ended March 31, 2013 2012 Renewal Renewal Pure Price Pure Price ($ in millions) Increase Retention Increase Retention Standard Commercial Lines 7.5 % 83 % 5.1 % 83 % Standard Personal Lines 8.5 87 5.9 87 NPE increases in First Quarter 2013 were consistent with the fluctuations in NPW for the twelve-month period endedMarch 31, 2013 as compared to the twelve-month period endedMarch 31, 2012 . 31
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The GAAP loss and loss expense ratio improved in First Quarter 2013 by 2.4 points compared to First Quarter 2012. The improvement in the ratio reflects the earning of renewal pure price increases that averaged 6.3% in our Standard Insurance Operations in 2012 and exceeded loss trends by approximately 3 points. The following variances are included in the GAAP loss and loss expense ratio despite not having a material impact on the loss and loss expense ratio: First Quarter 2013 First Quarter 2012 Impact on Loss and Impact on Loss and Loss Loss and Loss and Loss Loss Expense Expense Loss Expense Change in ($ in millions) Expense Incurred Ratio Incurred Ratio Ratio Catastrophe losses $ 1.3 0.3 pts 6.9 1.9 pts (1.6 ) Non-catastrophe property losses 60.7 15.5 50.6 13.7 1.8 Favorable prior year casualty development 2 0.6 3 0.8 (0.2 ) The breakdown of favorable prior year casualty development by line of business is as follows: Favorable/(Unfavorable) Prior Year Casualty Development Quarter ended March 31, ($ in millions) 2013 2012 General liability $ 4 - Commercial automobile - 1 Workers compensation (8 ) - Businessowners' policies 3 1 Homeowners 2 1 Personal automobile 1 - Total favorable impact on loss ratio $ 2
$ 3
Favorable impact on loss ratio 0.6 pts 0.8 pts. While the GAAP underwriting expense ratio remained relatively flat compared to last year, the statutory underwriting ratio increased by 1.0 points. This increase was driven by the amendments to the Retirement Income Plan that curtail the accrual of additional benefits for all employees eligible to participate in the plans afterMarch 31, 2016 . On a statutory basis, this curtailment resulted in expense of$5.8 million , or 1.4 points, of which$4.5 million , or 1.1 points, is classified as underwriting expense. The curtailment had no impact to expense on a GAAP basis during First Quarter 2013. For additional information regarding the curtailment, refer to Note 10. "Retirement Plans" in Item 1. "Financial Statements" of this Form 10-Q. 32
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Review of Underwriting Results by Line of Business
Standard Commercial Lines Quarter ended March 31, Change % or ($ in thousands) 2013 2012 Points GAAP Insurance Operations Results: NPW$ 353,189 328,831 7 % NPE 317,845 300,497 6 Less: Loss and loss expense incurred 203,139 197,806
3
Net underwriting expenses incurred 107,518 101,368 6 Dividends to policyholders 1,086 914 19 Underwriting income$ 6,102 409 1,392 % GAAP Ratios: Loss and loss expense ratio 63.9 % 65.8 (1.9 ) pts Underwriting expense ratio 33.9 33.8 0.1 Dividends to policyholders ratio 0.3 0.3 - Combined ratio 98.1 99.9 (1.8 ) Statutory Ratios: Loss and loss expense ratio1 63.9 65.8 (1.9 ) Underwriting expense ratio1 33.4 31.9 1.5 Dividends to policyholders ratio1 0.3 0.3 - Combined ratio 97.6 % 98.0 (0.4 ) pts
1 Includes 0.4 points in the loss and loss expense ratio, 1.0 points in the
underwriting ratio, and 1.4 points in the combined ratio related to the
Retirement Income Plan amendments that curtail the accrual of additional
benefits for all employees eligible to participate in the plans after
2016.
The increase in NPW in First Quarter 2013 compared to First Quarter 2012 is primarily the result of the following:
Quarter ended March 31, 2013 2012 Retention 83 % 83 Renewal pure price increases 7.5 5.1 NPE increases in First Quarter 2013 were consistent with the fluctuations in NPW for the twelve-month period endedMarch 31, 2013 compared to the twelve-month period endedMarch 31, 2012 . The GAAP loss and loss expense ratio improved in First Quarter 2013 by 1.9 points compared to First Quarter 2012. The improvement in the ratio reflects the earning of renewal pure price increases that averaged 6.2% in our standard Commercial Lines in 2012 and exceeded loss trends by approximately 3 points. The following variances also impacted the GAAP loss and loss expense ratio as follows: First Quarter 2013 First Quarter 2012 Losses Impact on Losses Impact on Change in ($ in millions) Incurred Loss Ratio Incurred Loss Ratio Ratio Catastrophe losses$ 0.7 0.2 pts 3.9 1.3 pts (1.1 ) pts Non-catastrophe property losses 37.0 11.6 32.3 10.7 0.9 Favorable/(unfavorable) prior year casualty development - 0.1 2 0.6 (0.5 )
The increase in the statutory underwriting expense ratio in First Quarter 2013 compared to First Quarter 2012 was driven by the Retirement Income Plan amendments that resulted in an increase to the ratio of 1.0 points.
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The following is a discussion of our most significant standard Commercial Lines of business: General Liability Quarter ended March 31, Change % or ($ in thousands) 2013 2012 Points Statutory NPW 109,405 100,628 9 % Direct new business 19,781 19,087 4 Retention 83 % 83 - pts Renewal pure price increases 8.5 % 5.8 2.7 Statutory NPE 97,703 90,143 8 % Statutory combined ratio 95.9 % 100.2 (4.3 ) pts % of total statutory standard commercial NPW 31 % 31
The growth in NPW and NPE for our general liability business in First Quarter 2013 and First Quarter 2012 reflect: (i) renewal pure price increases; (ii) strong retention; and (iii) higher new business.
The statutory combined ratio improvement was due to: (i) the impact of favorable prior year casualty development in First Quarter 2013 of 4.1 points compared to no prior year development in First Quarter 2012; and (ii) the impact of earned renewal pure price increases that have exceeded loss cost trends. Partially offsetting these items was the impact of the Retirement Income Plan curtailment, which increased the overall combined ratio by 1.3 points. Commercial Automobile Quarter ended March 31, Change % or ($ in thousands) 2013 2012 Points Statutory NPW$ 81,872 75,838 8 % Direct new business 14,904 14,691 1 Retention 83 % 83 - pts Renewal pure price increases 7.0 % 4.0 3.0 Statutory NPE 74,347 70,484 5 % Statutory combined ratio 98.0 % 96.6 1.4 pts % of total statutory standard commercial NPW 23 % 23 Renewal pure price increases coupled with strong retention drove the improvement in NPW and NPE in First Quarter 2013 compared to First Quarter 2012. The increase in the statutory combined ratio was driven by: (i) the impact of having no prior year casualty development in First Quarter 2013, while First Quarter 2012 had 1.4 points of favorable development; and (ii) 1.3 points related to the Retirement Income Plan curtailment in First Quarter 2013. Workers Compensation Quarter ended March 31, Change % or ($ in thousands) 2013 2012 Points Statutory NPW$ 75,405 73,188 3 % Direct new business 13,879 15,402 (10 ) Retention 82 % 80 2 pts Renewal pure price increases 8.1 % 6.9 1.2 Statutory NPE 66,084 65,811 - % Statutory combined ratio 118.9 % 110.9 8.0 pts % of total statutory standard commercial NPW 21 % 22
NPW increased 3% in First Quarter 2013 compared to First Quarter 2012, driven by renewal pure price increases and an increase in retention.
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The increase in the statutory combined ratio was primarily attributable to the impact of prior year casualty development as follows: • First Quarter 2013 was unfavorable by 11.1 points, driven primarily by
development on the 2012 accident yearand a single large claim prior to 2003; and
• First Quarter 2012 reflects no prior year casualty development.
In addition, the Retirement Income Plan curtailment increased the workers compensation statutory combined ratio by 1.7 points.
Commercial Property Quarter ended March 31, Change % or ($ in thousands) 2013 2012 Points Statutory NPW$ 57,760 53,027 9 % Direct new business 14,385 14,183 1 Retention 82 % 82 - pts Renewal pure price increases 5.6 % 3.9 1.7 Statutory NPE 53,415 49,371 8 % Statutory combined ratio 86.6 % 83.9 2.7 pts % of total statutory standard commercial NPW 16 % 16
NPW increased in First Quarter 2013 compared to First Quarter 2012, primarily due to: (i) new business; (ii) renewal pure price increases; and (iii) retention.
The increase in the statutory combined ratio in First Quarter 2013 compared to First Quarter 2012 was due to: (i) an increase in non-catastrophe property losses of
Standard Personal Lines
Quarter ended March 31, ($ in thousands) 2013 2012 Change % or Points GAAP Insurance Operations Results: NPW$ 68,555 65,546 5 % NPE 73,036 68,609 6 Less: Loss and loss expense incurred 47,592 47,633 - Net underwriting expenses incurred 19,471 17,855 9 Underwriting gain$ 5,973 3,121 91 % GAAP Ratios: Loss and loss expense ratio 65.2 % 69.4 (4.2 ) pts Underwriting expense ratio 26.6 26.1 0.5 Combined ratio 91.8 95.5 (3.7 ) Statutory Ratios: Loss and loss expense ratio1 65.3 69.4 (4.1 ) Underwriting expense ratio1 27.1 28.3 (1.2 ) Combined ratio1 92.4 % 97.7 (5.3 ) pts
1 Includes 0.1 points in the loss and loss expense ratio, 1.2 points in the
underwriting ratio and 1.3 points in the combined ratio related to the
Retirement Income Plan amendments that curtail the accrual of additional
benefits for all employees eligible to participate in the plans after March
31, 2016.
The improvements in NPW in First Quarter 2013 compared to First Quarter 2012 are primarily the result of the following:
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Table of Contents Quarter ended March 31, ($ in millions) 2013 2012 Retention 87 % 87 % Renewal pure price increase 8.5 5.9 NPE increases in First Quarter 2013 were consistent with the fluctuations in NPW for the twelve-month period endedMarch 31, 2013 as compared to the twelve-month period endedMarch 31, 2012 .
The variance in the loss and loss expense ratio was driven by premiums outpacing loss costs in First Quarter 2013 compared to First Quarter 2012 and the following:
First Quarter 2013 First Quarter 2012 Impact on Impact on Loss and Loss Expense Loss and Loss Loss and Loss Loss and Loss Change in ($ in millions) Incurred Expense Ratio Expense Incurred Expense Ratio Ratio Catastrophe losses $ 0.5 0.7 pts 3.0 4.4 pts (3.7 ) Non-catastrophe property losses 23.8 32.5 18.4 26.8 5.7 Flood claims handling fees (1.5 ) (2.1 ) (0.3 ) (0.4 ) (1.7 ) Favorable prior year casualty development 3 3.5 1 1.4 2.1 The decrease in the statutory underwriting expense ratio of 1.2 points was driven by: (i) higher direct premiums written in our flood business that, coupled with an increase in the flood expense allowance, increased our expense allowance earned by 1.4 points compared to First Quarter 2012; and (ii) the impact of renewal pure price increases that we have achieved over the last several years. Partially offsetting these items is the impact of the Retirement Income Plan curtailment, which increased the statutory underwriting expense ratio by 1.2 points. E&S Insurance Operations Our E&S Insurance Operations segment, which represents 7% of our combined insurance operations NPW, sells Commercial Lines insurance products and services in all 50 states and theDistrict of Columbia through approximately 95 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 are difficult to profitably insure in the standard commercial lines market. 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. Quarter ended March 31, Change % or ($ in thousands) 2013 2012 Points GAAP Insurance Operations Results: NPW$ 28,380 25,795 10 % NPE 30,059 9,723 209 Less: Loss and loss expense incurred 19,118 7,467
156
Net underwriting expenses incurred 10,855 7,149 52 Underwriting gain (loss) $ 86 (4,893 ) 102 % GAAP Ratios: Loss and loss expense ratio 63.6 % 76.8 (13.2 ) pts Underwriting expense ratio 36.1 73.5 (37.4 ) Combined ratio 99.7 150.3 (50.6 ) Statutory Ratios: Loss and loss expense ratio 63.6 76.8 (13.2 ) Underwriting expense ratio 34.6 43.5 (8.9 ) Combined ratio 98.2 % 120.3 (22.1 ) pts 36
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Our E&S business is a small operation whose combined ratios are significantly impacted by premium growth as well as volatility in loss and loss expenses and underwriting expenses. The improvement in the combined ratios in First Quarter 2013 was driven by: (i) earned premiums that now reflect the full operations of this business, which was not the case in First Quarter 2012, (ii) underwriting improvements, including renewal pure price increases of 8.5%, (iii) a decrease in initial start-up expenditures; and (iv) lower than anticipated supplemental commissions payment to our wholesale general agents of$1.1 million . The initial start-up expenses amounted to$1.1 million , or 11.2 points in First Quarter 2012 compared to$0.1 million , or 0.4 points in First Quarter 2013.
Investments
Our investment philosophy includes certain return and risk objectives for the fixed maturity, equity, and other investment portfolios. Although yield and income generation remain the key drivers to our investment strategy, our overall philosophy is to invest with a long-term horizon along with predominantly a "buy-and-hold" approach. The primary fixed maturity portfolio return objective is to maximize after-tax investment yield and income while balancing risk. A secondary objective is to meet or exceed a weighted-average benchmark of public fixed income indices. Within the equity portfolio, the high dividend yield strategy is designed to generate consistent dividend income while maintaining an expected tracking error to the Standard & Poor's Rating Services ("S&P") 500 Index. Additional equity strategies are focused on meeting or exceeding strategy specific benchmarks of public equity indices. The return objective of the other investment portfolio, which includes alternative investments, is to meet or exceed the S&P 500 Index. Total Invested Assets ($ in thousands) March 31, 2013 December 31, 2012 Change % Total invested assets $ 4,421,792 4,330,019 2 % Unrealized gain - before tax 185,225 188,197 (2 ) Unrealized gain - after tax 120,396 122,328 (2 ) The increase in our investment portfolio compared to year-end 2012 was driven primarily by: (i) operating cash flows generated from our insurance operations; (ii) net proceeds from the issuance of 5.875% Senior Notes in February 2013 and the redemption of our 7.5% Junior Subordinated Notes due 2066 in March 2013 ; and (iii) interest income generated by the portfolio. The cash generated from our insurance operations segments, as well as net amounts generated from our capital management strategies executed in First Quarter 2013, were used to invest primarily in structured securities, as well as corporate and municipal bonds within our fixed maturity securities portfolio. 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: March 31, 2013 December 31, 2012 U.S. government obligations 6 % 6 Foreign government obligations 1 1 State and municipal obligations 29 31 Corporate securities 35 34 Mortgage-backed securities ("MBS") 15 14 Asset-backed securities ("ABS") 4 3 Total fixed maturity securities 90 89 Equity securities 4 3 Short-term investments 4 5 Other investments 2 3 Total 100 % 100 37
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Fixed Maturity Securities The average duration of the fixed maturity securities portfolio as ofMarch 31, 2013 was 3.6 years, excluding short-term investments, compared to the Insurance Subsidiaries' liability duration of approximately 3.9 years. The current duration of the fixed maturity 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 are experiencing continued pressure on the yields within our fixed maturity securities portfolio, as higher yielding bonds that are either maturing or have been sold are being replaced with lower yielding bonds that are currently available in the marketplace. 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 maturity 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 maturity securities portfolio had a weighted average credit rating of "AA-" as ofMarch 31, 2013 . The following table presents the credit ratings of our fixed maturity securities portfolio: Fixed Maturity Security Rating March 31, 2013 December 31, 2012 Aaa/AAA 16 % 16 Aa/AA 46 47 A/A 26 25 Baa/BBB 11 10 Ba/BB or below 1 2 Total 100 % 100 38
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The following table summarizes the fair value, unrealized gain (loss) balances, and the weighted average credit qualities of our AFS fixed maturity securities atMarch 31, 2013 andDecember 31, 2012 : March 31, 2013 December 31, 2012 Weighted Weighted 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 obligations$ 245.7 15.9 AA+ 259.1 17.2 AA+ Foreign government obligations 30.2 1.4 AA- 30.2 1.4 AA- State and municipal obligations 849.9 39.6 AA 818.0 44.1 AA Corporate securities 1,532.8 76.4 A 1,450.3 81.3 A MBS 635.5 15.8 AA 609.8 19.0 AA ABS 171.9 1.9 AAA 128.6 2.3 AAA Total AFS fixed maturity portfolio$ 3,466.0 151.0 AA- 3,296.0 165.3 AA- State and Municipal Obligations: General obligations$ 380.9 18.3 AA+ 352.3 20.5 AA+ Special revenue obligations 469.0 21.3 AA 465.7 23.6 AA Total state and municipal obligations$ 849.9 39.6 AA 818.0 44.1 AACorporate Securities : Financial$ 422.3 21.1 A 438.0 23.2 A Industrials 125.5 8.0 A- 104.2 7.4 A- Utilities 134.2 6.6 A- 124.2 6.6 BBB+ Consumer discretionary 173.6 8.1 A- 134.7 8.3 BBB+ Consumer staples 168.1 8.0 A 163.6 8.6 A Healthcare 182.5 10.0 A+ 178.2 11.0 A+ Materials 87.1 4.8 A- 71.9 4.6 A- Energy 80.5 3.6 A- 77.4 4.3 A- Information technology 94.9 3.1 A 100.1 3.2 A Telecommunications services 56.1 2.3 BBB+ 46.7 2.8 BBB+ Other 8.0 0.8 AA+ 11.3 1.3 AA+ Total corporate securities$ 1,532.8 76.4 A 1,450.3 81.3 A MBS: Government guaranteed agency commercial mortgage-backed securities ("CMBS")$ 42.3 1.8 AA+ 48.9 2.3 AA+ Other agency CMBS 9.5 - AA+ 1.2 - AA+ Non-agency CMBS 94.8 0.6 AA 87.1 1.1 AA- Government guaranteed agency residential MBS ("RMBS") 85.0 2.9 AA+ 91.0 3.3 AA+ Non-agency RMBS 44.9 0.9 A- 44.3 0.9 A- Other agency RMBS 353.1 9.4 AA+ 331.3 11.3 AA+ Alternative-A ("Alt-A") RMBS 5.9 0.2 A+ 6.0 0.1 AA- Total MBS$ 635.5 15.8 AA 609.8 19.0 AA ABS: ABS$ 170.6 1.7 AAA 127.2 2.0 AAA Alt-A ABS2 0.8 0.1 D 0.8 0.2 D Sub-prime ABS1, 2 0.5 0.1 D 0.6 0.1 D Total ABS$ 171.9 1.9 AAA 128.6 2.3 AAA
1 We define sub-prime exposure as exposure to direct and indirect investments in
non-agency residential mortgages with average FICO® scores below 650. 2 Alt-A ABS and subprime ABS each consist of one security whose issuer is currently expected by rating agencies to default on its obligations. 39
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The following tables provide information regarding our held-to-maturity ("HTM") fixed maturity securities and their credit qualities at March 31, 2013 and December 31, 2012 : March 31, 2013 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 Portfolio: Foreign government obligations $ 5.7 5.5 0.2 0.2 0.4 AA+ State and municipal obligations 481.2 454.3 26.9 5.6 32.5 AA Corporate securities 39.6 35.3 4.3 (0.7 ) 3.6 A MBS 10.2 6.9 3.3 (1.1 ) 2.2 AA ABS 6.9 5.8 1.1 (1.0 ) 0.1 A Total HTM portfolio $ 543.6 507.8 35.8 3.0 38.8 AA State and Municipal Obligations: General obligations $ 160.1 152.1 8.0 3.1 11.1 AA Special revenue obligations 321.1 302.2 18.9 2.5 21.4 AA Total state and municipal obligations $ 481.2 454.3 26.9 5.6 32.5 AA Corporate Securities: Financial $ 9.6 8.5 1.1 (0.5 ) 0.6 BBB+ Industrials 11.8 10.3 1.5 (0.2 ) 1.3 A+ Utilities 15.1 13.4 1.7 (0.1 ) 1.6 A+ Consumer discretionary 3.1 3.1 - 0.1 0.1 AA Total corporate securities $ 39.6 35.3 4.3 (0.7 ) 3.6 A
MBS:
Non-agency CMBS$ 10.2 6.9 3.3 (1.1 ) 2.2 AA Total MBS$ 10.2 6.9 3.3 (1.1 ) 2.2 AA ABS: ABS$ 4.4 4.0 0.4 (0.2 ) 0.2 BBB+ Alt-A ABS 2.5 1.8 0.7 (0.8 ) (0.1 ) AAA Total ABS$ 6.9 5.8 1.1 (1.0 ) 0.1 A 40
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Table of ContentsDecember 31, 2012 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$ 5.9 5.5 0.4 0.2 0.6 AA+ State and municipal obligations 526.9 498.0 28.9 6.8 35.7 AA Corporate securities 42.1 37.5 4.6 (0.8 ) 3.8 A MBS 12.7 7.2 5.5 (1.2 ) 4.3 AA- ABS 7.1 5.9 1.2 (1.1 ) 0.1 A Total HTM portfolio$ 594.7 554.1 40.6 3.9 44.5 AA State and Municipal Obligations: General obligations$ 174.4 166.0 8.4 3.8 12.2 AA Special revenue obligations 352.5 332.0 20.5 3.0 23.5 AA Total state and municipal obligations$ 526.9 498.0 28.9 6.8 35.7 AA Corporate Securities: Financial$ 9.6 8.3 1.3 (0.7 ) 0.6 BBB+ Industrials 11.9 10.4 1.5 (0.2 ) 1.3 A+ Utilities 15.1 13.4 1.7 - 1.7 A+ Consumer discretionary 3.5 3.4 0.1 0.1 0.2 AA Materials 2.0 2.0 - - - BBB Total corporate securities$ 42.1 37.5 4.6 (0.8 ) 3.8 A MBS: Non-agency CMBS$ 12.7 7.2 5.5 (1.2 ) 4.3 AA- Total MBS$ 12.7 7.2 5.5 (1.2 ) 4.3 AA- ABS: ABS$ 4.7 4.2 0.5 (0.3 ) 0.2 BBB+ Alt-A ABS 2.4 1.7 0.7 (0.8 ) (0.1 ) AAA Total ABS$ 7.1 5.9 1.2 (1.1 ) 0.1 A
A portion of our AFS and HTM municipal bonds contain insurance enhancements. The following table provides information regarding these insurance-enhanced securities as of
Insurers of
Ratings Ratings with without ($ in thousands) Fair Value Insurance InsuranceNational Public Finance Guarantee Corporation , a subsidiary of MBIA, Inc.$ 290,390 AA- AA- Assured Guaranty 173,229 AA AA- Ambac Financial Group, Inc. 83,812 AA- AA- Other 8,852 AA A+ Total$ 556,283 AA- AA- To manage and mitigate exposure, we perform analysis 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 determining 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. 41
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The following table details the top 10 state exposures of the municipal bond portion of our fixed maturity securities portfolio at
Weighted General Obligation Average Special Fair Credit ($ in thousands) Local State Revenue Value Quality Texas$ 70,631 1,113 43,245 114,989 AA+ Washington 43,178 7,114 51,270 101,562 AA New York 7,281 - 71,276 78,557 AA+ Arizona 8,320 - 58,799 67,119 AA Florida - 9,885 52,441 62,326 AA- Colorado 33,168 - 21,680 54,848 AA- Ohio 13,050 13,893 20,459 47,402 AA+ North Carolina 13,651 6,166 24,015 43,832 AA California 3,445 - 34,528 37,973 AA- Missouri 16,725 - 20,233 36,958 AA+ Other 122,776 118,220 335,551 576,547 AA 332,225 156,391 733,497 1,222,113 AA Pre-refunded/escrowed to maturity bonds 46,996 7,816 54,158 108,970 AA+ Total$ 379,221 164,207 787,655 1,331,083 AA There has been concern regarding the stress on state and local governments emanating from declining revenues, large unfunded liabilities, and entrenched cost structures. We are comfortable with the quality, composition, and diversification of our$1.3 billion municipal bond portfolio. Our municipal bond portfolio is very high quality with an average AA rating and is well laddered with 44% maturing within three years, and another 23% maturing between three and five years. The weightings of the municipal bond portfolio are: (i) 59% of high-quality revenue bonds that have dedicated revenue streams; (ii) 29% of local general obligation bonds; and (iii) 12% of state general obligation bonds. In addition, approximately 8% of the municipal bond portfolio has been pre-refunded, meaning assets have been placed in trust to fund the debt service and maturity of the bonds. Our largest state exposure is toTexas , at 9% excluding the impact of pre-refunded bonds. Of the$71 million in localTexas general obligation bonds,$26 million represents investments inTexas Permanent School Fund bonds, which are considered to have lower risk. The sector composition and credit quality of our special revenue bonds did not significantly change fromDecember 31, 2012 . For details regarding our special revenue bond sectors and additional information regarding credit risk associated with our portfolio, see Item 7A. "Quantitative and Qualitative Disclosures About Market Risk." of our 2012 Annual Report.
Our top Eurozone exposures as of
Government ($ in millions) Corporate Securities Securities Equity Securities Total Exposure Country: Netherlands $ 9.2 - 1.3 10.5 Luxembourg 8.6 - - 8.6 Germany - 5.7 - 5.7 Ireland - - 4.7 4.7 France 2.7 - - 2.7 Total $ 20.5 5.7 6.0 32.2 Uncertainty about the ability of certain sovereign issuers to fully repay their debt triggered significant turbulence in global financial markets in 2012 and continues to cause market volatility in 2013. The sovereign debt crisis has been particularly concentrated in the Eurozone, and a number of member countries have been repeatedly downgraded by the major ratings agencies. The crisis has placed strains on the stability of the Euro currency, as theEuropean Central Bank struggles to supply liquidity to member nations and their banks. As ofMarch 31, 2013 , we had no direct exposure to issuers domiciled inItaly ,Greece ,Portugal , orSpain , four of the more economically troubled nations in the Eurozone. We do not own any derivative exposures such as credit default swaps. Outside of the effect foreign economies have on the underlying investments, we have minimal exposure to Euro depreciation or appreciation. 42
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Equity Securities Our equity securities portfolio was 4% of invested assets as ofMarch 31, 2013 , up slightly from year-end 2012, while dividend income remained flat in First Quarter 2013 compared to First Quarter 2012. In First Quarter 2013, we rebalanced our holdings within this portfolio, generating purchases of$41.4 million and sales of$35.6 million , with resulting net realized gains of$5.5 million . Other Investments As ofMarch 31, 2013 , other investments represented 2% of our total invested assets. The following table outlines a summary of our other investment portfolio by strategy and the remaining commitment amount associated with each strategy: Other Investments Remaining Carrying Value Commitment March 31, March 31, ($ in thousands) 2013 December 31, 2012 2013 Alternative Investments: Secondary private equity$ 27,780 28,032 7,466 Energy/power generation 18,218 18,640 7,825 Private equity 17,732 18,344 4,697 Distressed debt 12,406 12,728 2,922 Real Estate 12,214 11,751 10,292 Mezzanine financing 12,179 12,692 21,337 Venture capital 7,370 7,477 400 Total alternative investments 107,899 109,664 54,939 Other securities 1,956 4,412 1,412 Total other investments$ 109,855 114,076 56,351 In addition to the capital that we have already invested to date, we are contractually obligated to invest up to an additional$56.4 million in our other investments portfolio through commitments that currently expire at various dates through 2022. For a description of our seven alternative investment strategies outlined above, as well as redemption, restrictions, and fund liquidations, refer to Note 5. "Investments" in Item 8. "Financial Statements and Supplementary Data." of our 2012 Annual Report. In addition, for information on current year activity, refer to Note 5. "Investments" in Item 1. "Financial Statements" of this Form 10-Q. Net Investment Income The components of net investment income earned were as follows: Quarter ended March 31, ($ in thousands) 2013 2012 Fixed maturity securities$ 30,089 31,350 Equity securities 1,207 1,237 Short-term investments 52 38 Other investments 3,602 2,000 Miscellaneous income - 39 Investment expenses (2,080 ) (2,036 ) Net investment income earned - before tax 32,870
32,628
Net investment income tax expense (8,031 ) (7,853 ) Net investment income earned - after tax$ 24,839
24,775
Effective tax rate 24.4 %
24.1
Annual after-tax yield on fixed maturity securities 2.3
2.6
Annual after-tax yield on investment portfolio 2.3
2.4
Net investment income earned, before tax, remained consistent with First Quarter 2012. Higher income from our alternative investments within our other investment portfolio was primarily offset by the impact of lower reinvestment yields on our fixed maturity securities. 43
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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 March 31, ($ in thousands) 2013 2012 HTM fixed maturity securities Gains $ - 153 Losses (37 ) (81 ) AFS fixed maturity securities Gains 951 405 Losses (253 ) (43 ) AFS equity securities Gains 5,671 4,775 Losses (168 ) (428 ) Short-term investments Gains - - Losses - (2 ) Other Investments Gains - - Losses (860 ) - Total other net realized investment gains 5,304 4,779
Total OTTI charges recognized in earnings (1,949 ) (421 ) Total net realized gains
$ 3,355 4,358 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. In First Quarter 2013 and 2012, certain equity securities were sold at a loss that were in a continuous loss position for three months or less prior to their sale. The fair value of these securities as of their sale date was$2.2 million and$3.2 million in First Quarter 2013 and First Quarter 2012, respectively, with related net realized losses of$0.2 million and$0.3 million , respectively.
For additional discussion regarding realized gains and losses, see Note 5. "Investments" in Item 1. "Financial Statements" of this Form 10-Q.
Other-than-Temporary Impairments The following table provides information regarding our OTTI charges recognized in earnings: Quarter ended March 31, ($ in thousands) 2013 2012 AFS securities: ABS $ - 32 CMBS - 108 RMBS 8 110 Total fixed maturity AFS securities 8 250 Equity securities 217 171 Total AFS securities 225 421 Other investments 1,724 - Total OTTI charges recognized in earnings $ 2,174 842 44
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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 OTTI methodology, see Note 2. "Summary of Significant Accounting Policies" in Item 8. "Financial Statements and Supplementary Data." of our 2012 Annual Report.
Unrealized/Unrecognized Losses As evidenced by the table below, our unrealized/unrecognized loss positions increased by$1.2 million as ofMarch 31, 2013 compared toDecember 31, 2012 as follows: ($ in thousands) March 31, 2013 December 31, 2012 Unrealized Number of Unrealized Number of Unrecognized Issues % of Market/Book Unrecognized Loss Issues % of Market/Book Loss 174 80% - 99% $ 3,918 100 80% - 99% 2,701 1 60% - 79% 244 1 60% - 79% 233 - 40% - 59% - - 40% - 59% - - 20% - 39% - - 20% - 39% - - 0% - 19% - - 0% - 19% - $ 4,162 2,934 We have reviewed the securities in the table 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 2012 Annual Report. We have concluded that these securities are temporarily impaired as ofMarch 31, 2013 . For additional information regarding the unrealized/unrecognized losses between our AFS and HTM portfolios, see Note 5. "Investments," in Item 1. "Financial Statements" of this Form 10-Q. Contractual Maturities The following table presents amortized cost and fair value information for our AFS fixed maturity securities that were in an unrealized loss position atMarch 31, 2013 by contractual maturity: Amortized Fair ($ in thousands) Cost Value One year or less$ 8,603 8,091
Due after one year through five years 132,199 131,379 Due after five years through ten years 228,779 226,496 Due after ten years
6,264 6,227 Total$ 375,845 372,193
The following table presents amortized cost and fair value information for our HTM fixed maturity securities that were in an unrealized/unrecognized loss position at
Amortized Fair ($ in thousands) Cost Value One year or less$ 901 888 Due after one year through five years 3,277 3,221 Total$ 4,178 4,109 45
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Federal Income Taxes The following table provides information regarding federal income taxes from continuing operations: Quarter ended March 31, ($ in million) 2013 2012
Federal income tax expense from continuing operations
23 % 22 The increase in federal income tax expense in First Quarter 2013 compared to First Quarter 2012 was primarily due to an improvement in underwriting results as compared to last year. For a discussion of our underwriting results, see the "Results of Operations and Related Information by Segment" section above. Financial Condition, Liquidity, Short-term Borrowings, andCapital 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 atMarch 31, 2013 was comprised of$43 million atSelective Insurance Group, Inc. (the "Parent") and$121 million at the Insurance Subsidiaries. This amount was lower than our$215 million cash and short-term investment position atDecember 31, 2012 , as we were previously maintaining higher liquid assets to fund claim payments related to Hurricane Sandy. As those claims continue to be paid, cash and short-term assets have declined. Short-term investments are generally maintained in AAA rated money market funds approved by theNational Association of Insurance Commissioners . During First Quarter 2013, the Parent continued to build a fixed maturity security investment portfolio containing high-quality, highly-liquid government and corporate fixed maturity investments to generate additional yield. This portfolio amounted to$45 million atMarch 31, 2013 compared to$41 million atDecember 31, 2012 . 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$32 million in total dividends to the Parent in 2013, of which$12 million was paid through First Quarter 2013, including approximately$8 million of cash dividends that are deemed extraordinary underNew Jersey insurance regulations. The determination of whether a dividend is considered ordinary or extraordinary is calculated over the most recent fiscal twelve-month period and is based on a regulatory threshold. One of our Insurance Subsidiaries,Selective Insurance Company of America ("SICA"), in the third quarter of 2012, paid an extraordinary dividend of$134 million that was used by the Parent to provide capitalization for other Insurance Subsidiaries, including two newly-formedNew Jersey domiciled companies. Accordingly, SICA paid dividends above the ordinary dividend threshold over the past twelve months, and its First Quarter 2013 dividend is considered extraordinary. As ofMarch 31, 2013 , our allowable ordinary maximum dividend is approximately$107 million for 2013. 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 precedingDecember 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 2012 Annual Report. In First Quarter 2013, we issued$185 million of 5.875% Senior Notes due 2043. The Senior Notes pay interest onFebruary 15 ,May 15 ,August 15 , andNovember 15 of each year beginning onMay 15, 2013 , and on the date of maturity. The notes are callable by us on or afterFebruary 8, 2018 , at a price equal to 100% of their principal amount, plus accrued and unpaid interest. A portion of the proceeds from this debt issuance was used to fully redeem the$100 million aggregate principal amount of our 7.5% Junior Subordinated Notes due 2066. Of the remaining net proceeds,$57.1 million was used to make capital contributions to the Insurance Subsidiaries while the balance was used for general corporate purposes. For additional information related to our outstanding debt, refer to Note 10. "Indebtedness" in Item 8. "Financial Statements and Supplementary Data" of our 2012 Annual Report. 46
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The Parent had no private or public issuances of stock during First Quarter 2013 or borrowings under its$30 million line of credit ("Line of Credit"). We have two Insurance Subsidiaries domiciled inIndiana ("Indiana Subsidiaries") that are members of the Federal Home Loan Bank ofIndianapolis ("FHLBI"), Selective Insurance Company ofSouth Carolina ("SICSC") andSelective 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$496.7 million for SICSC and$380.5 million for SICSE as ofDecember 31, 2012 , for a borrowing capacity of approximately$88 million . As our outstanding borrowing with the FHLBI is currently$58 million , the Indiana Subsidiaries have the ability to borrow approximately$30 million more until the Line of Credit borrowing limit is met, of which$22 million could be loaned to the Parent under lending agreements approved by theIndiana 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 maturity portfolio, excluding short-term investments, was 3.6 years as ofMarch 31, 2013 , while the liabilities of the Insurance Subsidiaries have a duration of 3.9 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 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. 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 include$13 million in 2014 and$45 million in 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 withWells Fargo Bank, National Association , as administrative agent, andBranch Banking andTrust Company (BB&T), has 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 onJune 13, 2014 . There were no balances outstanding under this credit facility atMarch 31, 2013 or at any time during First Quarter 2013. 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 Line of Credit 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. 47
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The table below outlines information regarding certain of the covenants in the Line of Credit: Required as of Actual as of March 31, 2013 March 31, 2013 Consolidated net worth$838 million $1.1 billion Statutory surplus Not less than$750 million $1.2 billion Debt-to-capitalization ratio1 Not to exceed 35% 25.8% 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. AtMarch 31, 2013 , we had statutory surplus of$1.2 billion , GAAP stockholders' equity of$1.1 billion , and total debt of$392.4 million , which equates to a debt-to-capital ratio of approximately 25.7%. 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.
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$20.46 as ofMarch 31, 2013 from$19.77 as ofDecember 31, 2012 , primarily driven by: (i) an after-tax increase in equity of$29.8 million , or$0.54 per share, which included$28.6 million from the curtailment and re-measurement of the Retirement Income Plan; and (ii) net income of$0.38 per share. Partially offsetting these increases was dividends paid to shareholders of$0.13 per share. 48
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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 fromA.M. Best . In the second quarter of 2012,A.M. Best lowered our rating to "A (Excellent)," their third highest of 13 financial strength ratings, with a "stable" outlook. The change resulted from their assessment of our operating performance over the most recent five-year period relative to the commercial casualty composite index despite recognizing that recent performance has been negatively impacted by record catastrophic and weather-related losses. They cited our solid risk-adjusted capitalization, disciplined underwriting focus, increasing use of predictive modeling technology, and strong independent retail agency relationships in support of the "A (Excellent)" rating. We have been rated "A" or higher byA.M. Best for the past 82 years. A downgrade fromA.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 specifiedA.M. Best minimum rating; or (ii) be an event of default under our Line of Credit.
Ratings by other major rating agencies are as follows:
• S&P - Our "A" financial strength rating was reaffirmed in the third quarter of 2012 by S&P, which cited our strong competitive position in Mid-Atlantic markets, financial flexibility, and relationships with independent agents. Our outlook was revised to "negative" reflecting a
modest decline in available capital and increased charges for underwriting
risk, asset risk, and property catastrophe exposure as measured by S&P's
capital adequacy model.
• Moody's Investor Service ("Moody's") - Our "A2" financial strength rating
was reaffirmed on
regional franchise with established independent agency support, along with
solid risk adjusted capitalization and strong invested asset quality. Our
outlook was revised to negative, citing that our underwriting results have
lagged similarly rated peers. • Fitch Ratings ("Fitch") - Our "A+" rating and outlook of stable was
reaffirmed in the fourth quarter of 2012, citing our conservative balance
sheet with solid capitalization and reserve strength, strong independent
agency relationships, and improved diversification through our continued
efforts to reduce our concentration in
Our S&P, Moody's, and Fitch financial strength and associated credit 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. Off-Balance Sheet Arrangements AtMarch 31, 2013 andDecember 31, 2012 , 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. 49
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Contractual Obligations, Contingent Liabilities, and Commitments Our future cash payments associated with loss and loss expense reserves, as well as contractual obligations pursuant to operating leases for office space and equipment, have not materially changed sinceDecember 31, 2012 . Our future cash payments associated with contractual obligations pursuant to our notes payable as ofMarch 31, 2013 are summarized below: Contractual Obligations Payment Due by Period Less than 1-3 3-5 More than ($ in millions) Total 1 year Years years 5 years Notes payable$ 393.0 - 13.0 45.0 335.0 Interest on debt obligations 562.6 22.3 43.9 42.8 453.6 Total$ 955.6 22.3 56.9 87.8 788.6
We expect to have the capacity to repay and/or refinance all of our contractual obligations as they come due.
AtMarch 31, 2013 , we had contractual obligations that expire at various dates through 2022 that may require us to invest up to an additional$56.4 million in alternative and other 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 2012 Annual Report.
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