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UNITED STATES SECURITIES AND
EXCHANGE COMMISSION
Washington, D. C. 20549
FORM 10-Q
[x] Quarterly Report Pursuant to Section 13 or 15 (d) of the Securities
Exchange Act of 1934
For the quarterly period ended September 30, 2004.
------------------
[ ] Transition Report Pursuant to Section 13 or 15 (d) of the Securities
Exchange Act of 1934
For the transition period from to
----------- ----------
Commission File Number 0-05544
OHIO CASUALTY CORPORATION
(Exact name of registrant as specified in its charter)
OHIO 31-0783294
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
9450 Seward Road, Fairfield, Ohio 45014
(Address of principal executive offices) (Zip Code)
(513) 603-2400
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15 (d) of the Securities Exchange Act
of 1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to
such filing requirements for the past 90 days.
Yes X No
Indicate by check mark whether the registrant is an accelerated filer
(as defined in Rule 12b-2 of the Exchange Act).
Yes X No
On November 1, 2004, there were 61,878,783 shares of common stock
outstanding.
Page 1 of 27
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INDEX
Page
----
PART I
Item 1. Financial Statements 2
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations 14
Item 3. Quantitative and Qualitative Disclosures about
Market Risk 26
Item 4. Controls and Procedures 26
PART II
Item 6. Exhibits and reports on Form 8-K 26
Signature 27
Exhibit 31.1 Certification of Chief Executive Officer of
Ohio Casualty Corporation in accordance with SEC
Rule 13(a)-14(a) and Rule 15(d)-14(a)
Exhibit 31.2 Certification of Chief Financial Officer of
Ohio Casualty Corporation in accordance with SEC
Rule 13(a)-14(a) and Rule 15(d)-14(a)
Exhibit 32.1 Certification of Chief Executive Officer of
Ohio Casualty Corporation in accordance with Section
1350 of the Sarbanes-Oxley Act of 2002
Exhibit 32.2 Certification of Chief Financial Officer of
Ohio Casualty Corporation in accordance with Section
1350 of the Sarbanes-Oxley Act of 2002
PART I
ITEM 1. FINANCIAL STATEMENTS
Ohio Casualty Corporation & Subsidiaries
CONSOLIDATED BALANCE SHEETS
September 30, December 31,
(Dollars in millions, except share data) (Unaudited) 2004 2003
- -------------------------------------------------------------------------------------------
Assets
Investments:
Fixed maturities:
Available for sale, at fair value
(amortized cost: $3,118.9 and $2,851.2) $ 3,295.6 $ 3,022.2
Held-to-maturity, at amortized cost
(fair value: $318.7 and $354.2) 316.4 356.1
Equity securities, at fair value
(cost: $86.5 and $77.9) 352.6 329.0
Short-term investments, at fair value 219.7 40.4
- -------------------------------------------------------------------------------------------
Total investments 4,184.3 3,747.7
Cash 22.6 16.5
Premiums and other receivables, net of allowance for bad
debts of $4.2 and $4.2, respectively 364.8 347.9
Deferred policy acquisition costs 170.0 169.3
Property and equipment, net of accumulated depreciation of
$164.4 and $152.9, respectively 84.7 89.2
Reinsurance recoverable, net of allowance of $2.7 and
$2.5, respectively 668.3 592.7
Agent relationships, net of accumulated amortization of
$40.6 and $39.1, respectively 126.1 142.6
Interest and dividends due or accrued 44.5 47.5
Other assets 43.0 15.5
- -------------------------------------------------------------------------------------------
Total assets $ 5,708.3 $ 5,168.9
===========================================================================================
Liabilities
Insurance reserves:
Losses $ 2,276.5 $ 2,163.7
Loss adjustment expenses 481.3 464.1
Unearned premiums 738.1 703.0
Debt 395.3 198.0
Reinsurance treaty funds held 181.5 150.5
Deferred income taxes 36.8 12.8
Other liabilities 342.7 331.0
- -------------------------------------------------------------------------------------------
Total liabilities 4,452.2 4,023.1
Shareholders' Equity
Common stock, $.125 par value
Authorized: 150,000,000
Issued shares: 72,418,344; 72,418,344 9.0 9.0
Accumulated other comprehensive income 282.2 254.7
Retained earnings 1,104.7 1,033.4
Treasury stock, at cost:
(Shares: 10,595,988; 11,461,301) (139.8) (151.3)
- -------------------------------------------------------------------------------------------
Total shareholders' equity 1,256.1 1,145.8
- -------------------------------------------------------------------------------------------
Total liabilities and shareholders' equity $ 5,708.3 $ 5,168.9
===========================================================================================
Accompanying notes are an integral part of these financial statements.
For complete disclosures see Notes to Consolidated Financial Statements
on pages 62-75 of the Corporation's 2003 Form 10-K.
2
Ohio Casualty Corporation & Subsidiaries
CONSOLIDATED STATEMENTS OF INCOME
Three Months
Ended September 30,
(Dollars in millions, except share data) (Unaudited) 2004 2003
- -------------------------------------------------------------------------------------------
Premiums and finance charges earned $ 356.8 $ 360.4
Investment income less expenses 44.9 51.0
Investment gains (losses) realized, net (4.3) 5.9
- -------------------------------------------------------------------------------------------
Total revenues 397.4 417.3
Losses and benefits for policyholders 205.5 220.0
Loss adjustment expenses 38.2 39.4
General operating expenses 115.6 120.8
Amortization of agent relationships 1.7 1.8
Write-down of agent relationships 3.3 1.1
Amortization of deferred policy acquisition costs 91.4 97.3
Deferral of deferred policy acquisiton costs (88.7) (92.8)
Depreciation and amortization expense 3.3 3.8
- -------------------------------------------------------------------------------------------
Total expenses 370.3 391.4
- -------------------------------------------------------------------------------------------
Income before income taxes 27.1 25.9
Income tax expense (benefit):
Current (1.6) 0.6
Deferred 9.1 8.1
- -------------------------------------------------------------------------------------------
Total income tax expense 7.5 8.7
- -------------------------------------------------------------------------------------------
Net income $ 19.6 $ 17.2
===========================================================================================
Average shares outstanding - basic 61,627,447 60,889,649
===========================================================================================
Earnings per share - basic:
Net income, per share $ 0.32 $ 0.28
===========================================================================================
Average shares outstanding - diluted 62,781,223 61,413,662
===========================================================================================
Earnings per share - diluted:
Net income, per share $ 0.31 $ 0.28
===========================================================================================
Accompanying notes are an integral part of these financial statements.
For complete disclosures see Notes to Consolidated Financial Statements
on pages 62-75 of the Corporation's 2003 Form 10-K.
3
Ohio Casualty Corporation & Subsidiaries
CONSOLIDATED STATEMENTS OF INCOME
Nine Months
Ended September 30,
(Dollars in millions, except share data) (Unaudited) 2004 2003
- -------------------------------------------------------------------------------------------
Premiums and finance charges earned $ 1,085.1 $ 1,060.9
Investment income less expenses 144.0 155.6
Investment gains realized, net 2.6 32.0
- -------------------------------------------------------------------------------------------
Total revenues 1,231.7 1,248.5
Losses and benefits for policyholders 603.8 642.5
Loss adjustment expenses 116.6 128.2
General operating expenses 381.6 372.7
Amortization of agent relationships 5.2 5.6
Write-down of agent relationships 11.3 9.8
Amortization of deferred policy acquisition costs 275.6 291.5
Deferral of policy acquisition costs (276.2) (285.2)
Depreciation and amortization expense 9.8 10.5
- -------------------------------------------------------------------------------------------
Total expenses 1,127.7 1,175.6
- -------------------------------------------------------------------------------------------
Income before income taxes 104.0 72.9
Income tax expense:
Current 22.0 11.1
Deferred 8.9 13.7
- -------------------------------------------------------------------------------------------
Total income tax expense 30.9 24.8
Income before cumulative effect of an accounting change 73.1 48.1
Cumulative effect of an accounting change, net of tax 1.6 -
- -------------------------------------------------------------------------------------------
Net income $ 71.5 $ 48.1
===========================================================================================
Average shares outstanding - basic 61,346,664 60,818,375
===========================================================================================
Earnings per share - basic:
Net income, per share $ 1.17 $ 0.79
===========================================================================================
Average shares outstanding - diluted 62,463,454 61,181,263
===========================================================================================
Earnings per share - diluted:
Net income, per share $ 1.14 $ 0.79
===========================================================================================
Accompanying notes are an integral part of these financial statements.
For complete disclosures see Notes to Consolidated Financial Statements
on pages 62-75 of the Corporation's 2003 Form 10-K.
4
Ohio Casualty Corporation & Subsidiaries
CONSOLIDATED STATEMENTS OF
SHAREHOLDERS' EQUITY
Common Accumulated
stock other Total
(Dollars in millions, except Common purchase comprehensive Retained Treasury shareholders'
share data) (Unaudited) stock warrants income earnings stock equity
- -------------------------------------------------------------------------------------------------------------
Balance
January 1, 2003 $ 9.0 $ 21.1 $246.2 $ 936.7 $ (154.3) $1,058.7
Net income 48.1 48.1
Net change in unrealized gain
net of deferred income tax
expense of $16.4 30.4 30.4
---------
Comprehensive income 78.5
Net issuance of treasury
stock (178,510 shares) (0.2) 2.3 2.1
- -------------------------------------------------------------------------------------------------------------
Balance,
September 30, 2003 $ 9.0 $ 21.1 $276.6 $ 984.6 $ (152.0) $1,139.3
=============================================================================================================
Balance
January 1, 2004 $ 9.0 $ - $254.7 $1,033.4 $ (151.3) $1,145.8
Net income 71.5 71.5
Change in unrealized gain,
net of deferred income tax
expense of $7.1 11.1 11.1
Change in minimum pension
liability, net of deferred
income tax benefit of $8.9 16.4 16.4
---------
Comprehensive income 99.0
Issuance of restricted stock
(57,284 shares) (0.6) 0.8 0.2
Net issuance of treasury
stock (865,313 shares) 0.4 10.7 11.1
- -------------------------------------------------------------------------------------------------------------
Balance,
September 30, 2004 $ 9.0 $ - $282.2 $1,104.7 $ (139.8) $1,256.1
=============================================================================================================
Accompanying notes are an integral part of these financial statements.
For complete disclosures see Notes to Consolidated Financial Statements
on pages 62-75 of the Corporation's 2003 Form 10-K.
5
Ohio Casualty Corporation and Subsidiaries
CONSOLIDATED STATEMENTS OF CASH FLOWS
Nine Months
Ended September 30,
(Dollars in millions) (Unaudited) 2004 2003
- -------------------------------------------------------------------------------------------------
Cash Flows from Operating Activities:
Operations
Net income $ 71.5 $ 48.1
Adjustments to reconcile net income to
cash from operations:
Changes in:
Insurance reserves 165.1 172.5
Reinsurance treaty funds held 31.0 13.4
Income taxes (11.7) 19.5
Premiums and other receivables (16.9) (37.5)
Deferred policy acquisition costs (0.7) 6.3
Reinsurance recoverable (75.6) (98.9)
Other assets (6.4) (0.2)
Other liabilities (0.4) 1.8
Amortization and write-down of agent relationships 16.5 15.4
Depreciation and amortization 16.8 15.3
Investment gains (2.6) (32.0)
- -------------------------------------------------------------------------------------------------
Net cash provided by operating activities 186.6 123.7
- -------------------------------------------------------------------------------------------------
Cash Flows from Investing Activities:
Purchase of securities:
Fixed maturity, available-for-sale (1,285.3) (906.6)
Fixed maturity, held-to-maturity (1.7) (6.8)
Equity (12.3) (6.0)
Proceeds from sales of securities:
Fixed maturity, available-for-sale 957.7 687.2
Equity 12.7 35.6
Proceeds from maturities and calls of securities:
Fixed maturity, available-for-sale 81.7 72.2
Fixed maturity, held-to-maturity 38.2 14.8
Equity 3.3 11.8
Property and equipment:
Purchases (3.7) (6.6)
Sales 0.3 1.5
- -------------------------------------------------------------------------------------------------
Net cash used in investing activities (209.1) (102.9)
- -------------------------------------------------------------------------------------------------
Cash Flows from Financing Activities:
Debt:
Payments (0.5) (0.4)
Proceeds from the issuance of senior notes 199.3 -
Payments of issuance costs (1.3) -
Proceeds from exercise of stock options 10.4 1.8
- -------------------------------------------------------------------------------------------------
Net cash provided by financing activities 207.9 1.4
- -------------------------------------------------------------------------------------------------
Net decrease in cash and cash equivalents 185.4 22.2
Cash and short-term investments, beginning of period 56.9 62.2
- -------------------------------------------------------------------------------------------------
Cash and short-term investments, end of period $ 242.3 $ 84.4
=================================================================================================
Accompanying notes are an integral part of these financial statements.
For complete disclosures see Notes to Consolidated Financial Statements
on pages 62-75 of the Corporation's 2003 Form 10-K.
6
Ohio Casualty Corporation & Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
Ohio Casualty Corporation (the Corporation) is the holding company of The
Ohio Casualty Insurance Company (the Company), which is one of six property-
casualty companies that make up the Ohio Casualty Group (the Group). All
dollar amounts presented in the Notes to Consolidated Financial Statements
are in millions unless otherwise noted.
NOTE I - INTERIM ADJUSTMENTS
We prepared the Consolidated Balance Sheet as of September 30, 2004 and the
Consolidated Statements of Income, Shareholders' Equity and Cash Flows all
for the three and nine months ended September 30, 2004 and 2003, without an
audit. In the opinion of management, all adjustments necessary to fairly
present the financial position, results of operations and cash flows at
September 30, 2004 and for all periods presented have been made.
We prepared the accompanying unaudited Consolidated Financial Statements in
accordance with accounting principles generally accepted in the United States
for interim financial information and with the instructions to the Quarterly
Report on Form 10-Q and Article 10 of Regulation S-X.
Certain information and footnote disclosures normally included in financial
statements prepared in accordance with accounting principles generally
accepted in the United States have been omitted. The unaudited Consolidated
Financial Statements should be read together with the financial statements
and notes thereto included in our Annual Report on Form 10-K for the year
ended December 31, 2003. The results of operations for the period ended
September 30, 2004 are not necessarily indicative of the results of
operations for the full year.
The preparation of financial statements in conformity with accounting
principles generally accepted in the United States requires management to
make estimates and assumptions that affect the reported amounts of assets and
liabilities, the disclosure of contingent assets and liabilities at the date
of the financial statements and the reported amounts of revenues and expenses
during the reporting period. Actual results could differ from those
estimates.
NOTE II - STOCK OPTIONS
The Corporation accounts for stock options issued to employees and directors
in accordance with Accounting Principles Board Opinion (APB) No. 25,
"Accounting for Stock Issued to Employees." Under APB 25, the Corporation
recognizes expense based on the intrinsic value of options. Had the
Corporation adopted Financial Accounting Standard Board (FASB) 123
"Accounting for Stock Based Compensation," the Corporation's net income and
earnings per share would have been reduced to the pro forma amounts disclosed
below:
Three Months Ended Nine Months Ended
September 30 September 30
($ in millions) 2004 2003 2004 2003
- -------------------------------------------------------------------------------------
Net income
As reported $19.6 $17.2 $71.5 $48.1
Add: Stock-based employee
compensation reported in net
income, net of related tax effect 0.1 - 0.2 0.1
Deduct: Total stock-based employee
compensation, net of related tax
effects 1.7 1.6 4.5 4.5
----- ----- ----- -----
Pro forma $18.0 $15.6 $67.2 $43.7
Basic EPS
As reported $0.32 $0.28 $1.17 $0.79
Pro Forma $0.30 $0.26 $1.10 $0.72
Diluted EPS
As reported $0.31 $0.28 $1.14 $0.79
Pro Forma $0.29 $0.25 $1.08 $0.71
=====================================================================================
7
NOTE III - EARNINGS PER SHARE
Basic and diluted earnings per share are summarized as follows:
Three Months Ended Nine Months Ended
September 30 September 30
(in millions, except per share data) 2004 2003 2004 2003
- -------------------------------------------------------------------------------
Net income $19.6 $17.2 $71.5 $48.1
Weighted average common shares
outstanding - basic (thousands) 61,627 60,890 61,347 60,818
Income before cumulative effect of
an accounting change $0.32 $0.28 $1.20 $0.79
Cumulative effect of an accounting
change - - $(0.03) -
Basic net income per weighted
average share $0.32 $0.28 $1.17 $0.79
===============================================================================
Weighted average common shares
outstanding (thousands) 61,627 60,890 61,347 60,818
Effect of dilutive securities
(thousands) 1,154 524 1,116 363
- -------------------------------------------------------------------------------f
Weighted average common shares
outstanding - diluted (thousands) 62,781 61,414 62,463 61,181
Income before cumulative effect of
an accounting change $0.31 $0.28 $1.17 $0.79
Cumulative effect of an accounting
change - - $(0.03) -
Diluted net income per weighted
average share $0.31 $0.28 $1.14 $0.79
===============================================================================
NOTE IV -- SEGMENT INFORMATION
The Corporation has determined its reportable segments based upon its method
of internal reporting, which is organized by product line. The property and
casualty segments are Commercial, Specialty, and Personal Lines. These
segments generate revenues by selling a wide variety of personal, commercial
and surety insurance products. The Corporation also has an all other segment
which derives its revenues from investment income.
Each segment of the Corporation is managed separately. The property and
casualty segments are managed by assessing the performance and profitability
of the segments through analysis of industry financial measurements including
statutory loss, loss adjustment and underwriting expense ratios, statutory
combined ratio, premiums written, premiums earned and statutory underwriting
gain/loss. The following tables present information by segment as it is
reported internally to management. Asset information by reportable segment
is not reported, since the Corporation does not produce such information
internally.
8
Nine Months Ended September 30
($ in millions)
Commercial Lines Segment 2004 2003
- --------------------------------------------------------------------------
Net premiums written $635.8 $611.9
% Change 3.9% 5.5%
Net premiums earned 601.9 578.8
% Change 4.0% 8.1%
Underwriting loss (before tax) (13.7) (70.4)
Specialty Lines Segment 2004 2003
- --------------------------------------------------------------------------
Net premiums written $102.6 $124.5
% Change (17.6)% (6.2)%
Net premiums earned 114.5 120.6
% Change (5.1)% 8.4%
Underwriting gain (before tax) 8.4 18.8
Personal Lines Segment 2004 2003
- --------------------------------------------------------------------------
Net premiums written $373.0 $364.0
% Change 2.5% (6.2)%
Net premiums earned 368.4 361.6
% Change 1.9% (17.7)%
Underwriting gain/(loss) (before tax) 2.1 (31.4)
Total Property & Casualty 2004 2003
- --------------------------------------------------------------------------
Net premiums written $1,111.4 $1,100.4
% Change 1.0% 0.0%
Net premiums earned 1,084.8 1,061.0
% Change 2.3% (2.0)%
Underwriting loss (before tax) (3.2) (83.0)
All Other 2004 2003
- --------------------------------------------------------------------------
Revenues $ 6.3 $ 4.7
Write-down and amortization of
agent relationships (16.5) (15.4)
Other expenses (14.3) (8.8)
- --------------------------------------------------------------------------
Net loss before income taxes $(24.5) $(19.5)
Reconciliation of Revenues 2004 2003
- --------------------------------------------------------------------------
Net premiums earned for
reportable segments $1,084.8 $1,061.0
Net investment income 139.4 152.5
Realized gains/(losses), net (0.6) 27.7
- --------------------------------------------------------------------------
Total property and casualty revenues
(Statutory basis) 1,223.6 1,241.2
Property and casualty statutory to
GAAP adjustment 1.8 2.6
- --------------------------------------------------------------------------
Total revenues property and casualty
(GAAP basis) 1,225.4 1,243.8
Other segment revenues 6.3 4.7
- --------------------------------------------------------------------------
Total revenues $1,231.7 $1,248.5
==========================================================================
Reconciliation of Underwriting
Loss (before tax) 2004 2003
- --------------------------------------------------------------------------
Property and casualty underwriting
loss (before tax) (Statutory basis) $(3.2) $(83.0)
Statutory to GAAP adjustment (8.6) (7.5)
- --------------------------------------------------------------------------
Property and casualty underwriting
loss (before tax) (GAAP basis) (11.8) (90.5)
Net investment income 144.0 155.6
Realized gains, net 2.6 32.0
Write-down and amortization of
agent relationships (16.5) (15.4)
Other expenses (14.3) (8.8)
- --------------------------------------------------------------------------
Income before income taxes and
cumulative effect of an
accounting change $104.0 $ 72.9
==========================================================================
9
Three Months Ended September 30
($ in millions)
Commercial Lines Segment 2004 2003
- --------------------------------------------------------------------------
Net premiums written $203.3 $196.8
% Change 3.3% 8.8%
Net premiums earned 201.7 197.6
% Change 2.0% 8.7%
Underwriting loss (before tax) (3.3) (14.7)
Specialty Lines Segment 2004 2003
- --------------------------------------------------------------------------
Net premiums written $28.7 $ 48.4
% Change (40.7)% 1.0%
Net premiums earned 32.0 41.6
% Change (23.1)% (2.6)%
Underwriting gain/(loss) (before tax) (0.9) 4.7
Personal Lines Segment 2004 2003
- --------------------------------------------------------------------------
Net premiums written $128.7 $127.1
% Change 1.3% 4.3%
Net premiums earned 122.8 121.2
% Change 1.3% (8.4)%
Underwriting gain/(loss) (before tax) 4.8 (10.9)
Total Property & Casualty 2004 2003
- --------------------------------------------------------------------------
Net premiums written $360.7 $372.3
% Change (3.1)% 6.2%
Net premiums earned 356.5 360.4
% Change (1.1)% 1.0%
Underwriting gain/(loss) (before tax) 0.6 (20.9)
All Other 2004 2003
- --------------------------------------------------------------------------
Revenues $ 2.6 $ 2.3
Write-down and amortization of
agent relationships (5.0) (2.9)
Other expenses (7.5) (2.9)
- --------------------------------------------------------------------------
Net loss before income taxes $(9.9) $(3.5)
Reconciliation of Revenues 2004 2003
- --------------------------------------------------------------------------
Net premiums earned for
reportable segments $356.5 $360.4
Net investment income 42.2 50.4
Realized gains/(losses), net (4.3) 3.3
- --------------------------------------------------------------------------
Total property and casualty revenues
(Statutory basis) 394.4 414.1
Property and casualty statutory to
GAAP adjustment 0.4 0.9
- --------------------------------------------------------------------------
Total revenues property and casualty
(GAAP basis) 394.8 415.0
Other segment revenues 2.6 2.3
- --------------------------------------------------------------------------
Total revenues $397.4 $417.3
Reconciliation of Underwriting
Loss (before tax) 2004 2003
- --------------------------------------------------------------------------
Property and casualty underwriting
gain/(loss) (before tax)
(Statutory basis) $ 0.6 $(20.9)
Statutory to GAAP adjustment (1.6) (4.3)
- --------------------------------------------------------------------------
Property and casualty underwriting
gain/(loss) (before tax) (GAAP basis) (1.0) (25.2)
Net investment income 44.9 51.0
Realized gains/(losses), net (4.3) 5.9
Write-down and amortization of
agent relationships (5.0) (2.9)
Other expenses (7.5) (2.9)
- --------------------------------------------------------------------------
Income before income taxes and
cumulative effect of an accounting
change $27.1 $ 25.9
==========================================================================
10
NOTE V - AGENT RELATIONSHIPS
The agent relationships asset is an identifiable intangible asset acquired in
connection with the 1998 Great American Insurance Company (GAI) commercial
lines acquisition. The Corporation follows the practice of allocating
purchase price to specifically identifiable intangible assets based on their
estimated values as determined by appropriate valuation methods. In the GAI
acquisition, the purchase price was allocated to agent relationships and
deferred policy acquisition costs. Agent relationships are evaluated
quarterly as events or circumstances indicate a possible inability to recover
their carrying amount. As a result of the evaluation, the agent relationship
asset was written down before tax by $3.3 and $1.1 for the three months ended
September 30, 2004 and 2003, respectively. For the nine months ended
September 30, 2004 and 2003, the asset was written down before tax by $11.3
and $9.8, respectively. The write-downs are a result of agency cancellations
and certain agents determined to be impaired based on updated estimated
future undiscounted cash flows that were insufficient to recover the carrying
amount of the asset for the agent. The remaining portion of the agent
relationships asset will be amortized on a straight-line basis over the
remaining useful period of approximately 20 years. At September 30, 2004 and
December 31, 2003, the unamortized carrying value of the agent relationships
asset is $126.1 and $142.6, respectively.
Future cancellation of agents included in the agent relationships intangible
asset or a diminution of certain former Great American agents' estimated
future revenues or profitability is likely to cause further impairment losses
beyond the quarterly amortization of the remaining asset value over the
remaining useful lives.
NOTE VI - INTERNALLY DEVELOPED SOFTWARE
In accordance with Statement of Position 98-1, "Accounting for the Costs of
Computer Software Developed or Obtained for Internal Use," the Corporation
capitalizes costs incurred during the application development stage for the
development of internal-use software. These costs primarily relate to
payroll and payroll-related costs for employees along with costs incurred for
external consultants who are directly associated with the internal-use
software project. Costs such as maintenance, training, data conversion,
overhead and general and administrative are expensed as incurred. Management
believes the expected future cash flows of the asset exceed the carrying
value. The expected future cash flows are determined using various
assumptions and estimates, changes in these assumptions could result in an
impairment of the asset and a corresponding charge to net income. The costs
associated with the software are amortized on a straight-line basis over an
estimated useful life of 10 years commencing when the software is
substantially complete and ready for its intended use. Capitalized software
costs and accumulated amortization in the consolidated balance sheet were
$54.5 and $10.4 at September 30, 2004 and $52.0 and $7.2 at December 31,
2003, respectively.
NOTE VII - DEBT
In June 2004, the Corporation completed a $200.0 offering of 7.3% Senior
Notes due June 15, 2014. The net proceeds from the offering after issuance-
related fees and discount were $198.0. The Corporation intends to use the
net proceeds of $198.0 from the issuance of the Senior Notes to repay the
$201.3 aggregate principal amount of the Corporation's 5.00% Convertible
Notes due March 19, 2022, which the Corporation has the option to redeem, in
whole or in part, after March 22, 2005. The Corporation may also use the net
proceeds to repurchase shares of its common stock in an amount up to the
equivalent number of shares issued if holders convert their Convertible Notes
into shares of the Corporation's common stock. The repayment of the
Convertible Notes will reduce the potential for significant future share and
earnings dilution. Until the funds are needed for such purposes, the
Corporation has invested the net proceeds in short term marketable
securities. Interest is payable on the Convertible Notes on March 19 and
September 19 and payable on the Senior Notes on June 15 and December 15.
The Convertible and Senior Notes are reported on the consolidated balance
sheet net of unamortized issuance-related costs and discount of $9.3 ($6.8
related to the Convertible Notes and $2.5 related to the Senior Notes) and
$6.9 (all related to the Convertible Notes) at September 30, 2004 and
December 31, 2003, respectively. The Corporation uses the effective interest
rate method to record interest expense, amortization of issuance-related
costs and amortization of discount.
Holders of the Convertible Notes have the option to require the Corporation
to purchase all or a portion of the Convertible Notes on March 19 of 2007,
2012 and 2017 at 100% of the principal amount. Further, if a change in
control of the Corporation occurs anytime prior to maturity, holders may
require the Corporation to purchase for cash all or a portion of the
Convertible Notes at 100% of the principal amount.
11
Under certain conditions, at the option of the holders, the Convertible Notes
may be converted into shares of the Corporation's common stock at the rate of
44.2112 shares per $1,000 principal amount, subject to adjustment in certain
circumstances. If the closing sale price of the Corporation's common stock
for at least twenty of the thirty consecutive trading days ending on the last
trading day of a calendar quarter is more than $24.88, then the Convertible
Notes may be converted during the immediately following calendar quarter.
Additionally, the Convertible Notes may be converted when the credit rating
of the Convertible Notes is below a specified level or withdrawn, or when
certain corporate transactions occur. If all the Convertible Notes were
converted, total outstanding common shares would increase by 8.9 million
shares.
The impact of the Convertible Notes on earnings per share is based on the
"if-converted" method and is contingent upon whether the criteria for
conversion have been met. As of September 30, 2004, none of the conversion
criteria had been met, and no adjustment to diluted outstanding shares was
required. See Note X, Recently Issued Accounting Standards, for further
discussion of the potential effect of Emerging Issues Task Force (EITF) Issue
No. 04-8, "The Effect of Contingently Convertible Debt on Diluted Earnings
Per Share."
After March 22, 2005, the Corporation has the option to redeem all or a
portion of the outstanding Convertible Notes at the following redemption
prices, expressed as percentages of the principal amount of the Convertible
Notes:
During the Twelve Redemption
Months Commencing Price
- ----------------- ----------
March 23, 2005 102%
March 19, 2006 101%
March 19, 2007 until maturity of the Notes 100%
On July 31, 2002, the Corporation entered into a revolving credit agreement.
Under the terms of the credit agreement, the lenders agreed to make loans to
the Corporation in an aggregate amount up to $80.0 for general corporate
purposes. Interest is payable in arrears, and the interest rate on
borrowings under the credit agreement is based on a margin over LIBOR or the
LaSalle Bank Prime Rate, at the option of the Corporation. The Corporation
has capitalized approximately $0.4 in fees related to establishing the line
of credit and amortizes the fees over the term of the agreement with a
remaining unamortized balance at September 30, 2004 and December 31, 2003 of
$0.1 and $0.2, respectively. In addition, the Corporation is obligated to
pay agency and facility fees of up to $0.2 annually. These fees are expensed
when incurred by the Corporation. The agreement requires the Corporation to
maintain minimum net worth of $800.0. The credit facility agreement also
includes a minimum statutory surplus for The Ohio Casualty Insurance Company
of $650.0. The credit agreement will expire on March 15, 2005 and management
is currently evaluating its alternatives related to this agreement.
Additionally, other financial covenants and customary provisions, as defined
in the agreement, exist. At September 30, 2004, the Corporation was in
compliance with all financial covenants and provisions. The outstanding loan
amount of the revolving line of credit was zero at September 30, 2004 and
December 31, 2003.
In addition to the debt described above, the Corporation has a $6.5 low
interest loan with the State of Ohio that is secured by a mortgage on the
Corporation's home office property. As of September 30, 2004 and December
31, 2003, the loan bears a fixed interest rate of 2%, increasing to the
maximum rate of 3% in December 2004. The loan requires annual principal
payments of approximately $0.6 and expires in November 2009. The remaining
balance at September 30, 2004 and December 31, 2003 was $3.4 and $3.9,
respectively.
Interest expense incurred for the nine month period ending September 30, 2004
and 2003 was $11.4 and $7.6, respectively. Interest expense incurred for the
three month period ending September 30, 2004 and 2003 was $6.2 and $2.5,
respectively. The increase in interest expense incurred in the three month
period ending September 30, 2004 is related to the issuance of the Senior
Notes in June 2004.
NOTE VIII - CONTINGENCIES
In the fourth quarter of 2001, Ohio Casualty of New Jersey, Inc. (OCNJ)
entered into an agreement to transfer its obligations to renew private
passenger auto business in New Jersey to Proformance Insurance Company
(Proformance). The transaction effectively exited the Group from the New
Jersey private passenger auto market. The Group continues to write private
passenger auto in other markets. The
12
contract stipulates that a premiums-to-surplus ratio of 2.5 to 1 must be
maintained on the transferred business during the periods of March 2002
through December 2004. If this criteria is not met, OCNJ will have to pay up
to a maximum cumulative amount of $15.6 to Proformance to maintain this
premiums-to-surplus ratio. Based on data provided by Proformance, the Group
has paid $6.8 to Proformance in settlement of this obligation through the
year ended December 31, 2003. At September 30, 2004, the Group has an
additional $3.2 accrued in the consolidated financial statements for any
possible additional liability that may be incurred based upon the final
liability calculation using Proformance's 2004 results.
The Corporation is involved in litigation and administrative proceedings
arising in the ordinary course of business, which, in the opinion of
management, after considering established reserves, are not expected to have
a material adverse effect on the financial condition, liquidity, or results
of operations of the Corporation. Current litigation includes five separate
proceedings making class action claims for which class certification has been
sought in two of the proceedings. No class certification has been granted at
this time in the two proceedings.
NOTE IX - EMPLOYEE BENEFITS
The Corporation has a non-contributory defined benefit retirement plan and a
contributory health care plan. The net periodic pension cost as of September
30 is determined as follows:
Three Months Ended Nine Months Ended
September 30 September 30
(in millions) 2004 2003 2004 2003
- -------------------------------------------------------------------------------------
Service cost earned during the period $ 1.9 $ 1.8 $ 5.9 $ 5.4
Interest cost on projected benefit
obligation 4.1 4.6 12.7 13.8
Expected return on plan assets (5.4) (5.4) (16.1) (16.2)
Amortization of accumulated losses 0.6 - 2.0 -
Amortization of unrecognized prior
service cost (0.6) - (1.3) 0.1
Curtailment cost - - 0.1 -
- --------------------------------------------------------------------------------------
Net periodic pension cost $ 0.6 $ 1.0 $ 3.3 $ 3.1
======================================================================================
The Corporation contributed approximately $7.5 in the first quarter of 2004
to the defined benefit retirement plan.
In March 2004, the Corporation announced changes to the defined benefit
retirement plan which were effective June 30, 2004, which freezes accrued
benefits under the plan's current formula and incorporates a new benefit
formula beginning July 2004. As a result of these changes and staff
reductions announced in the first nine months of 2004, the Corporation
recognized a curtailment charge of $0.1.
The components of the Corporation's net periodic postretirement benefit cost
as of September 30:
Three Months Ended Nine Months Ended
September 30 September 30
(in millions) 2004 2003 2004 2003
- -------------------------------------------------------------------------------------
Service cost $ - $0.7 $ 0.7 $2.1
Interest cost 0.9 1.8 3.2 5.5
Amortization of accumulated losses - 0.1 0.2 0.1
Amortization of unrecognized prior
service cost (1.5) - (3.5) 0.1
Curtailment cost - - 0.1 -
- -------------------------------------------------------------------------------------
Net periodic postretirement benefit
cost $(0.6) $2.6 $ 0.7 $7.8
=====================================================================================
In March 2004, the Corporation announced changes related to the
postretirement health care plan effective July 1, 2004 that limits
eligibility for subsidized retiree medical and dental coverage to then
current retirees and employees with 25 or more years of service. Other
employees are eligible for access to unsubsidized retiree dental coverage and
medical coverage up to age 65. As a result of these changes and staff
reductions announced in the first nine months of 2004, the Corporation
recognized a curtailment charge of $0.1.
13
NOTE X - RECENTLY ISSUED ACCOUNTING STANDARDS
In September 2004, the FASB finalized EITF Issue No. 04-8, "The Effect of
Contingently Convertible Debt on Diluted Earnings per Share". The EITF is
effective for financial periods ending after December 15, 2004. Under the
new rules, the earnings per share treatment of those securities that contain
a contingent conversion feature require all of the shares underlying the
convertible security to be counted as outstanding under the "if-converted"
method. Under certain circumstances, the Corporation's Convertible Notes can
be converted into common stock of approximately 8.9 million shares. Unless
the Corporation modifies the existing Convertible Notes prior to year-end, the
Corporation's 2004 financial statements will reflect the new accounting
treatment and all prior period earnings per share amounts will be restated,
as required, to reflect the provisions of this EITF.
In October 2004, the FASB finalized FASB 123R, "Share-Based Payment,"
effective for public companies for interim and annual periods beginning after
June 15, 2005. The FASB requires all companies to measure compensation cost
for all share-based payments (including employee stock options) at fair
value. Retroactive application of the requirements of FASB 123 to the
beginning of the fiscal year that includes the effective date is permitted,
but not required. The Corporation is currently evaluating the impact, the
implementation strategy and the related timing of implementation of FASB 123R
on the consolidated financial statements.
In March 2004, the FASB approved the consensus reached on the EITF Issue No.
03-1, "The Meaning of Other-Than-Temporary Impairment and Its Application to
Certain Investments." The objective of this consensus is to provide guidance
for identifying impaired investments. EITF 03-1 also provides new disclosure
requirements for investments that are deemed to be temporarily impaired.
Originally, the accounting provisions of EITF 03-1 were effective for all
reporting periods beginning after June 15, 2004, while the disclosure
requirements are effective only for annual periods ending after June 15,
2004. In September 2004, the FASB issued two FASB Staff Positions (FSP), FSP
EITF 03-1-a and FSP EITF 03-1-1, which delayed the measurement and
recognition paragraphs of the consensus for further discussion. The
disclosure requirements remain effective as originally issued under EITF 03-1
and have been adopted by the company. The Corporation has evaluated the
impact of the adoption of EITF 03-1, as written, and does not believe the
impact is significant to the Corporation's overall results of operations or
financial position at September 30, 2004. However, as currently written,
the consensus could have a significant impact on future results. The
Corporation will continue to monitor the developments of the FASB and EITF
regarding the measurement and recognition paragraphs of this consensus.
ITEM 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations
Ohio Casualty Corporation (the Corporation) is the holding company of The
Ohio Casualty Insurance Company (the Company), which is one of six property-
casualty companies that make up the Ohio Casualty Group (the Group). All
dollar amounts in this Management Discussion and Analysis (MD&A) are in
millions unless otherwise noted.
RESULTS OF OPERATIONS
Net income
The Corporation reported net income of $71.5, or $1.14 per share for the nine
months ending September 30, 2004, compared with $48.1, or $0.79 per share in
the same period of 2003. For the three months ended September 30, 2004, net
income was $19.6, or $0.31 per share, compared with net income of $17.2, or
$0.28 per share in the comparable period of 2003.
Investment Results
For the nine months ended September 30, 2004 and 2003, consolidated before-
tax net investment income was $144.0 ($98.8 after tax) and $155.6 ($101.5
after tax) and net realized gains were $2.6 and $32.0, respectively. The
effective tax rate on investment income for the nine months of 2004 was
31.4%,
14
compared with 34.8% for the same period of 2003. Before-tax and after-tax
investment income comparisons are impacted by investments in municipal bonds,
which provide tax-exempt investment income. In 2004, as underwriting
profitability has improved, management has and plans to continue to invest
more funds into tax-exempt securities to maximize after-tax income. This
change in investment strategy will result in the Corporation's before-tax
investment income declining when compared to prior periods when the strategy
was to invest in taxable securities. Conversely, or as a result of this
strategy, the Corporation's effective tax rate on investment income will be
lower when compared to these prior periods.
For the three months ended September 30, 2004 and 2003 consolidated before-
tax investment income was $44.9 ($31.4 after tax) and $51.0 ($32.9 after tax)
and net realized gains/(losses) were $(4.3) and $5.9, respectively. The
investment income effective tax rate for the third quarter of 2004 was 30.0%,
compared with 35.4% in the third quarter of 2003.
The Corporation and the Group did not realize any material losses on any
securities sold during the third quarter of 2004 and 2003 or for the nine
months ended September 30, 2004 and 2003. Management of the Corporation
believes the significant volatility of realized investment gains and losses
limits the usefulness of net income as a measure of current operating
performance. Therefore, management uses the non-GAAP financial measure of
operating income to further evaluate current operating performance.
Operating income is reconciled to net income in the table below:
Three Months Ended Nine Months Ended
September 30 September 30
($ in millions) 2004 2003 2004 2003
- -------------------------------------------------------------------------------------
Operating income $22.4 $13.4 $71.4 $27.3
After-tax net realized gains/(losses) (2.8) 3.8 1.7 20.8
Cumulative effect of accounting change - - (1.6) -
- -------------------------------------------------------------------------------------
Net income $19.6 $17.2 $71.5 $48.1
=====================================================================================
Operating income per
share - diluted $0.36 $0.22 $1.14 $0.45
After-tax net realized gains/(losses)
per share - diluted (0.05) 0.06 0.03 0.34
Cumulative effect of accounting change
per share - diluted - - (0.03) -
- -------------------------------------------------------------------------------------
Net income per share - diluted $0.31 $0.28 $1.14 $0.79
=====================================================================================
Invested assets comprise a majority of the consolidated assets.
Consequently, accounting policies related to investments are critical. See
further discussion of investment accounting policies in the "Critical
Accounting Policies" section on pages 23 and 24 of the Corporation's 2003
Form 10-K. Investments are continually evaluated based on current economic
conditions, credit loss experience and other developments. The difference
between the cost/amortized cost and estimated fair value of investments is
continually evaluated to determine whether a decline in value is temporary or
other than temporary in nature. This determination involves a degree of
uncertainty. If a decline in the fair value of a security is determined to
be temporary, the decline is recorded as an unrealized loss in shareholders'
equity. If a decline in a security's fair value is considered to be other
than temporary, the security is written down to the estimated fair value with
a corresponding realized loss recognized in the current consolidated
statement of income.
The assessment of whether a decline in fair value is considered temporary or
other-than-temporary includes management's judgement as to the financial
position and future prospects of the entity issuing the security. It is not
possible to accurately predict when it may be determined that a specific
security will become impaired. Future impairment charges could be material
to the results of operations. The before tax impairment charge recorded in
the third quarter of 2004 and 2003 was $2.3 and $2.0, respectively, and $7.5
and $11.4 for the nine months ended September 30, 2004 and 2003,
respectively.
15
Management believes that it will recover the cost basis in the securities
held with unrealized losses as it has both the intent and ability to hold the
securities until they mature or recover in value. Securities are sold to
achieve management's investment goals, which include the diversification of
credit risk, the maintenance of adequate portfolio liquidity, the generation
of a competitive investment yield and the management of interest rate risk.
In order to achieve these goals, sales of investments are based upon current
market conditions, liquidity needs and estimates of the future market value
of the individual securities.
The following table summarizes, for all available-for-sale securities and
held-to-maturity securities, the total gross unrealized losses, excluding
gross unrealized gains, by investment category and length of time the
securities have continuously been in an unrealized loss position as of
September 30, 2004:
Available-for-sale with unrealized losses:
(in millions) Less than 12 months 12 months or longer Total
------------------- ------------------- -----------------
Fair Unrealized Fair Unrealized Fair Unrealized
Value Losses Value Losses Value Losses
------------------ ------------------- -----------------
Securities:
States, municipalities and
political subdivisions $103.8 $(0.5) $ - $ - $103.8 $(0.5)
Corporate securities 110.9 (1.4) 20.9 (0.6) 131.8 (2.0)
Mortgage-backed
securities 177.8 (3.8) 33.0 (2.1) 210.8 (5.9)
- -------------------------------------------------------------------------------------------
Total fixed maturities 392.5 (5.7) 53.9 (2.7) 446.4 (8.4)
Equity securities 4.4 (0.4) 1.5 (0.2) 5.9 (0.6)
- -------------------------------------------------------------------------------------------
Total temporarily impaired
securities $396.9 $(6.1) $55.4 $(2.9) $452.3 $(9.0)
===========================================================================================
Held-to-maturity with unrealized losses:
(in millions) Less than 12 months 12 months or longer Total
------------------- ------------------- -----------------
Fair Unrealized Fair Unrealized Fair Unrealized
Value Losses Value Losses Value Losses
------------------ ------------------- -----------------
Securities:
Corporate securities $ 82.0 $(0.9) $ - $ - $ 82.0 $(0.9)
Mortgage-backed
securities 38.4 (0.4) 9.9 (0.1) 48.3 (0.5)
- --------------------------------------------------------------------------------------------
Total temporarily impaired
securities $120.4 $(1.3) $9.9 $(0.1) $130.3 $(1.4)
============================================================================================
As part of the evaluation of the entire $10.4 aggregate unrealized loss on
the investment portfolio, management performed a more intensive review of
securities with a relatively higher degree of unrealized loss. Based on a
review of each security, management believes that unrealized losses on these
securities were temporary declines in value at September 30, 2004. In the
tables above, there are approximately 150 securities represented. Of this
total, 14 securities have unrealized loss positions greater than 5% of their
market values at September 30, 2004, with none exceeding 20%. This group
represents $3.8, or 36.5% of the total unrealized loss position. Of this
group, 6 securities, representing approximately $1.6 in unrealized losses,
have been in an unrealized loss position for less than twelve months. Of the
remaining 8 securities, which have been in an unrealized loss position for
longer than twelve months and total $2.2, management believes that it is
probable that all contract terms of the security will be satisfied; the
unrealized loss position is due to the changes in the interest rate
environment; and that it has positive intent and the ability to hold the
securities until they mature or recover in value.
All securities are monitored by portfolio managers who consider many factors
such as an issuer's degree of financial flexibility, management competence
and industry fundamentals in evaluating whether the decline in fair value is
temporary. In addition, management considers whether it is probable that all
contract terms
16
of the security will be satisfied and whether the unrealized loss position is
due to changes in the interest rate environment. Should management
subsequently conclude the decline in fair value is other than temporary, the
book value of the security is written down to fair value with the realized
loss being recognized in the then current consolidated statement of income.
The amortized cost and estimated fair value of available-for-sale and held-
to-maturity fixed maturity securities in an unrealized loss position at
September 30, 2004, by contractual maturity are shown below. Expected
maturities will differ from contractual maturities because borrowers may have
the right to call or prepay obligations with or without call or prepayment
penalties.
Available-for-sale: Amortized Estimated Unrealized
(in millions) Cost Fair Value Loss
- -----------------------------------------------------------------------------
Due after one year through five years $ 29.9 $ 29.8 $(0.1)
Due after five years through ten years 137.8 136.0 (1.8)
Due after ten years 287.1 280.6 (6.5)
- -----------------------------------------------------------------------------
Total $454.8 $446.4 $(8.4)
=============================================================================
Held-to-maturity: Amortized Estimated Unrealized
(in millions) Cost Fair Value Loss
- -----------------------------------------------------------------------------
Due after one year through five years $ 15.2 $ 15.1 $(0.1)
Due after five years through ten years 49.0 48.6 (0.4)
Due after ten years 67.5 66.6 (0.9)
- -----------------------------------------------------------------------------
Total $131.7 $130.3 $(1.4)
=============================================================================
Agent Relationships
The agent relationships asset is an identifiable intangible asset
representing the excess of cost over fair value of net assets acquired in
connection with the acquisition of the commercial lines business from Great
American Insurance Company (GAI) in 1998. Generally Accepted Accounting
Principles (GAAP) requires the Corporation to perform a periodic comparison
of estimated future cash flows to the carrying value of the intangible asset.
If the estimated future cash flows are less than the carrying value for any
individual agent included in the asset, that portion of the asset must be
written down to its estimated fair value. For the third quarter of 2004, the
before tax agent relationship impairment charge was $3.3 compared to $1.1 for
the third quarter 2003. For the nine months ended September 30, 2004 and
2003, the before tax agent relationship impairment charge was $11.3 and $9.8,
respectively. The calculation of impairment follows accounting guidelines
that do not permit increasing the intangible value for agents who are
projected to generate more profit than was expected at the time of the
initial assignment of the intangible value to each agent. Overall, the
estimated future cash flows for the remaining acquired agents assigned an
intangible value exceed the remaining asset book value of $126.1 recorded at
September 30, 2004. The determination of impairment involves the use of
management estimates and assumptions. Due to the inherent uncertainties and
judgments involved in developing assumptions for each agent and the fact that
the asset cannot be increased for any agent, further reductions in the
valuation of the agent relationships asset are likely to occur in the future.
These reductions could be significant if actual agent revenue production or
profitability differ materially from current assumptions. Management has
considered these and other factors in determining the remaining useful life
of 20 years for this asset.
Statutory Results
Management uses statutory financial criteria to analyze the Group's property
and casualty results of operations and insurance industry regulators require
the Group to report statutory financial measures. Management analyzes
statutory results of operations through the use of insurance industry
financial measures including statutory loss and loss adjustment expense (LAE)
ratios, statutory underwriting expense ratio, statutory combined ratio, net
premiums written and net premiums earned. The statutory combined ratio is a
commonly used gauge of underwriting performance measuring the percentage of
premium dollars used to pay insurance losses and related expenses. The
combined ratio is the sum of the loss, LAE and underwriting expense ratios.
All references to combined ratio or its components in this MD&A are
calculated on a statutory accounting basis and are calculated on a calendar
year basis unless
17
specified as calculated on an accident year basis. Insurance industry
financial measures are included in the next several sections of this MD&A
that discuss results of operations. A discussion of the differences between
statutory accounting and generally accepted accounting principles in the
United States is included in Item 15 pages 73 and 74 of the Corporation's
Form 10-K for the year ended December 31, 2003.
At September 30, 2004 and December 31, 2003, statutory surplus, a financial
measure that is required by insurance regulators and used to monitor
financial strength, was $931.1 and $867.6, respectively. The ratio of twelve
months ended net premiums written to statutory surplus as of September 30,
2004 was 1.6 to 1.0 compared to 1.7 to 1.0 at December 31, 2003.
Premium Revenue Results
Premium revenue reflects premiums earned by the Group. The Group's premiums
are earned principally on a monthly pro rata basis over the term of the
policy. Management analyzes premium revenues primarily by premiums written
in the current period. Net premiums written differs from gross premiums
written by premiums ceded to reinsurers.
The table below summarizes property and casualty premium on a gross and net
basis compared with the same period of the prior year:
Three months ended September 30, Nine months ended September 30,
($ in millions) 2004 2003 % Chg 2004 2003 % Chg
Gross Premiums Written ---- ---- ----- ---- ---- -----
- ----------------------
Commercial Lines $210.5 $202.9 3.7% $ 656.8 $ 636.1 3.3%
Specialty Lines 65.5 75.9 (13.7)% 194.1 204.5 (5.1)%
Personal Lines 130.7 130.0 0.5% 377.2 372.9 1.2%
------ ------ -------- --------
All Lines $406.7 $408.8 (0.5)% $1,228.1 $1,213.5 1.2%
====== ====== ======== ========
Three months ended September 30, Nine months ended September 30,
($ in millions) 2004 2003 % Chg 2004 2003 % Chg
Net Premiums Written ---- ---- ----- ---- ---- -----
- --------------------
Commercial Lines $203.3 $196.8 3.3% $ 635.8 $ 611.9 3.9%
Specialty Lines 28.7 48.4 (40.7)% 102.6 124.5 (17.6)%
Personal Lines 128.7 127.1 1.3% 373.0 364.0 2.5%
------ ------ -------- --------
All Lines $360.7 $372.3 (3.1)% $1,111.4 $1,100.4 1.0%
====== ====== ======== ========
Gross and net premiums written for the Commercial and Personal Lines segments
were favorably impacted by rate and/or renewal price increases, along with
improving policy renewal rates. These increases were partially offset by a
decline in overall new business premium production. Specialty Lines gross
and net premiums written declined, a result of increased reinsurance rates
and an increased accrual for ceded premium of $6.1 on a commercial umbrella
product line reinsurance treaty for the years 1999 through 2001.
Commercial Lines renewal price increases averaged 2.9% in the third quarter
2004 compared to 10.1% in the third quarter 2003, while renewal price
increases averaged 5.3% compared to 11.8% for the first nine months of 2004
and 2003, respectively. The decrease in the renewal price increase period
over period is the result of a broad market trend indicating that competitive
pricing pressure is increasing. Renewal price increase means the average
increase in premium for policies renewed by the Group. The average increase
in premium for each renewed policy is calculated by comparing the total
expiring premium for the policy with the total renewal premium for the same
policy. Renewal price increases include, among other things, the effects of
rate increases and changes in the underlying insured exposures of the policy.
Only policies issued by the Group in the previous policy term with the same
policy identification codes are included. Therefore, renewal price increases
do not include changes in premiums for newly issued policies or business
assumed through reinsurance agreements. Renewal price increases also do not
reflect the cost of any reinsurance purchased on the policies issued.
As mentioned above, the Specialty Lines net premiums written declined as a
result of increased reinsurance rates on commercial umbrella business,
partially offset by growth in the fidelity and surety product line in both
the third quarter and first nine months of 2004. Higher reinsurance rates
are the result of an increase in ceded loss activity related primarily to the
commercial umbrella product line over the last
18
couple of years and an industry wide increase in reinsurance loss trends.
Commercial umbrella, the largest Specialty Lines product, recognized a 5.6%
average renewal price increase for the third quarter 2004 compared to 15.7%
in the same period in 2003. For the nine months ended September 30, 2004,
commercial umbrella recognized a 7.9% average renewal price increase compared
to 19.5% for the same period of 2003.
All Lines Discussion
The following table provides key financial measures for All Lines:
Three Months Ended Nine Months Ended
September 30 September 30
2004 2003 2004 2003
All Lines ($ in millions) ---- ---- ---- ----
- -------------------------
Loss ratio 57.6% 61.1% 55.6% 60.5%
Loss adjustment expense ratio 10.7% 10.9% 10.4% 12.1%
Underwriting expense ratio 31.1% 32.7% 33.5% 34.0%
------ ------ ------ ------
Combined ratio 99.4% 104.7% 99.5% 106.6%
====== ====== ====== ======
The improved loss and LAE ratios for both 2004 periods presented are the
result of reduced claim frequency, a decline in large losses (losses greater
than $250,000 per loss), improved pricing levels and favorable prior year
reserve development, as reflected below.
During the third quarter, underwriting and loss adjustment expenses were
impacted by $0.9 in severance and other related costs. The underwriting
expense ratio was also impacted by an additional $1.0 accrual related to the
2001 sale of New Jersey private passenger auto renewal rights to Proformance
Insurance Company (Proformance). For the first nine months of 2004,
underwriting and loss adjustment expenses were impacted by $10.0 in severance
and other related restructuring costs primarily associated with the Cost
Structure Efficiency (CSE) Initiative discussed below, offset by a statutory
pension curtailment gain of $11.2. In addition, the underwriting expense
ratio for the first nine months of 2004 also includes a $10.0 charge related
to the Proformance transaction.
The CSE Initiative is designed to improve productivity and customer service,
while lowering operating costs by implementing operating efficiencies and/or
technology advances to streamline workflow. As a result of the CSE
Initiative, the Group reduced staff by approximately 470 positions during the
first nine months of 2004. Efficiencies implemented to date are projected to
reduce operating expenses by $5.0 in 2004, net of severance and related
costs, with projected annualized savings of $25.5 in 2005.
The loss and LAE ratio, which measures losses and LAE as a percentage of net
earned premiums, was positively impacted in the third quarter and first nine
months of 2004 by adjustments to estimated losses related to prior years'
business. The loss and LAE ratio component of the accident year combined
ratio measures losses and LAE arising from insured events that occurred in
the respective accident year. The current accident year excludes losses and
LAE for insured events that occurred in prior accident years.
The table below summarizes the impact of changes in provision for all prior
accident year losses and LAE:
Ended September 30 Ended September 30
($ in millions) 2004 2003 2004 2003
- --------------- ---- ---- ---- ----
Statutory net liabilities,
beginning of period $2,168.8 $2,102.9 $2,128.9 $2,078.7
Increase/(decrease) in
provision for prior accident
year claims $(3.1) $5.2 $(15.8) $9.7
Increase/(decrease) in
provision for prior accident
year claims as % of premiums
earned (0.9)% 1.4% (1.5)% 0.9%
In addition to the reasons stated above, the LAE ratio was also favorably
impacted by lower paid expenses as a result of more effective management of
claims litigation expenses and other expense management initiatives.
19
Catastrophe losses impacted the third quarter 2004 combined ratio by 6.4
points, an increase of 1.9 points from the third quarter of 2003 and impacted
the first nine months of 2004 by 3.5 points, a decrease of 0.4 points over
the same period in 2003. The effect of future catastrophes on the
Corporation's results of operations cannot be accurately predicted. As such,
severe weather patterns, acts of war or terrorist activities could have a
material adverse impact on the Corporation's results of operations,
reinsurance pricing and availability of reinsurance. During the third
quarter of 2004, there were eight catastrophes with the largest catastrophe
generating $8.0 in incurred losses as compared with nine catastrophes in the
third quarter of 2003 with the largest catastrophe generating $9.4 in
incurred losses. For additional disclosure of catastrophe losses, refer to
Item 15, Losses and LAE Reserves in the Notes to the Consolidated Financial
Statements on pages 71 and 72 of the Corporation's 2003 Form 10-K.
The table below summarizes the variance in the underwriting expense ratio for
the third quarter 2003 compared to the third quarter 2004:
Underwriting expense ratio variance
-----------------------------------
Underwriting expense ratio - third
quarter 2003 32.7%
Increase in commissions 1.2%
Non-recurring reduction in assessments,
fees and premium taxes (2.0)%
Reduction in personnel related expenses (0.9)%
Contingent liability to Proformance 0.3%
Impact of all other underwriting expense
ratio items (0.2)%
-------
Underwriting expense ratio - third
quarter 2004 31.1%
=======
The expense ratio was favorably impacted by reduced staff costs related to
the CSE Initiative and non-recurring reductions in assessments, fees and
premium taxes. Offsetting these favorable impacts were severance and related
costs, the additional Proformance liability described above and an increase
in agent contingent commissions which resulted from the improvement in the
loss ratio.
Statutory amortization expense related to the capitalization of application
development costs of $1.6 and $1.4 for the third quarter of 2004 and 2003,
respectively and $4.7 and $3.7 for the nine months ended September 30, 2004
and 2003, respectively, was recorded in underwriting expenses. This expense
relates to the rollout of P.A.R.I.S.sm, a new internally developed software
for policy administration and rating. On a statutory accounting basis, the
new application is being amortized over a five-year period (compared to a
ten-year period under GAAP) in accordance with statutory accounting
principles. The rollout has been substantially completed for the Commercial
Lines segment. During 2003, the Group began capitalizing application
development costs associated with the Personal Lines segment, which is
expected to begin rollout in 2005. The Specialty Lines segment is
anticipated to rollout beginning in 2005. The Group is also developing
P.A.R.I.S.sm XP, an internally developed software application which will
enable agents to directly issue policies on the Group's behalf. Development
costs for this software are expensed as incurred as this development effort
is considered an enhancement to the underlying P.A.R.I.S.sm policy
administration and rating software.
The employee count continues to decline as a result of the CSE Initiative.
As of September 30, 2004, the employee count was 2,206, compared with 2,669
at December 31, 2003 and 2,757 at September 30, 2003.
Segment Discussion
The Corporation's organizational structure consists of three operating units:
Commercial, Specialty and Personal Lines. The Corporation also has an all
other segment, which derives its revenue from investment income. The
following tables provide key financial measures for each of the property and
casualty reportable segments:
20
Three Months Ended Nine Months Ended
September 30 September 30
2004 2003 2004 2003
Commercial Lines Segment ---- ---- ---- ----
($ in millions)
- ------------------------
Loss ratio 57.8% 60.2% 54.5% 61.6%
Loss adjustment expense ratio 12.0% 11.1% 12.1% 12.4%
Underwriting expense ratio 31.6% 36.3% 33.8% 36.1%
------ ------ ------ ------
Combined ratio 101.4% 107.6% 100.4% 110.1%
====== ====== ====== ======
Specialty Lines Segment
($ in millions)
Loss ratio 47.2% 35.3% 43.9% 26.7%
Loss adjustment expense ratio 7.0% 8.0% 4.4% 12.9%
Underwriting expense ratio 54.4% 38.9% 49.5% 43.4%
------ ----- ----- -----
Combined ratio 108.6% 82.2% 97.8% 83.0%
====== ===== ===== =====
Personal Lines Segment
($ in millions)
Loss ratio 60.1% 71.3% 61.1% 70.0%
Loss adjustment expense ratio 9.5% 11.7% 9.6% 11.3%
Underwriting expense ratio 25.3% 24.8% 28.4% 27.1%
----- ------ ----- ------
Combined ratio 94.9% 107.8% 99.1% 108.4%
===== ====== ===== ======
Commercial Lines Segment
The 2004 combined ratio, for both the three month and nine month periods
presented, improved due to a significantly lower loss ratio as a result of
lower claim frequency, including lower large losses and favorable development
on prior year reserves. The loss ratio improvement also represents the
result of progress made over the past several years to improve price adequacy
and to underwrite a more profitable book of business. The third quarter 2004
Commercial Lines loss ratio included 7.7 points related to catastrophe losses
compared to 3.2 points in the third quarter of 2003. In both the nine month
periods of 2004 and 2003, the Commercial Lines loss ratio was impacted by 3.1
points related to catastrophe losses. In addition, the Commercial Lines loss
and LAE ratios were favorably impacted by prior year development of 1.7
points in third quarter 2004 compared to adverse prior year development of
1.9 points in third quarter 2003. For the nine months of 2004, Commercial
Lines loss and LAE ratios were favorably impacted by prior year development
of 2.0 points compared to adverse development of 2.4 points for the same
period in 2003. The Group continues to focus on improving and returning to
profitability the general liability and workers' compensation product lines.
The Group has restricted writings in states where the workers' compensation
product line has historically been unprofitable and is focused on growing
this product line in profitable states.
Specialty Lines Segment
Higher reinsurance rates, which reduces net premiums, in the commercial
umbrella product line, along with the $6.1 ceded premium accrual increase
for years 1999 through 2001, have put upward pressure on both the loss and
underwriting expense ratios. Specifically, the loss ratio increased
11.9 points and 17.2 points and the underwriting expense ratio increased 15.5
points and 6.1 points for the third quarter and for the nine months ended
September 30, 2004, respectively. This adverse impact discussed above in
the commerical umbrella product line was partially offset in both the third
quarter and the nine months of 2004 by favorable prior year reserve
development, which lowered the loss and LAE ratios by 6.9 points and 6.5
points. For the comparable periods in 2003, the favorable prior year reserve
development lowered the loss and LAE ratios by 4.6 points and 10.0 points,
respectively.
Personal Lines Segment
The improvement in the third quarter 2004 combined ratio was driven by
favorable claim frequency trends, increased pricing and improved underwriting
(i.e. increasing deductibles on homeowner's policies). Adverse prior year
development added 2.1 and 2.8 points to the loss and LAE ratios for Personal
Lines for the third quarter 2004 and 2003, respectively. For the nine months
of 2004 and 2003, adverse prior year development increased the Personal Lines
loss and LAE ratios by 1.0 point and 2.1 points, respectively. The third
quarter and nine-month 2004 underwriting expense ratio was adversely impacted
by the surplus guarantee contingency related to the Proformance transaction
of $1.0 and $10.0, respectively, of which $6.8 has been paid. The third
quarter 2004 Personal Lines loss ratio included 6.3 points related to
21
catastrophe losses compared to 8.2 points in the third quarter of 2003.
During the nine months of 2004, the Personal Lines loss ratio was impacted by
5.2 points related to catastrophe losses compared to 6.5 points during the
same period in 2003.
Statutory Earned Premium and Combined Ratios
Combined Ratios
Earned ----------------------------------------------------
Premium Calendar Year Accident Year
Year to Date Year to Date Year to Date Calendar Accident
(By operating segment, including Sept 30, Sept 30, Sept 30, Year Year
selected major product lines) 2004 2004 2004(a) 2003 2003(a)
- -----------------------------------------------------------------------------------------------------
Commercial Lines $ 601.9 100.4% 102.4% 112.3% 104.2%
Workers' compensation 99.7 114.3% 111.5% 123.0% 112.5%
Commercial auto 171.6 94.0% 99.2% 105.5% 102.9%
General liability 64.6 101.0% 104.2% 122.6% 109.7%
CMP, fire & inland marine 266.0 99.1% 100.6% 109.7% 100.3%
Specialty Lines 114.5 97.8% 104.3% 77.2% 88.2%
Commercial umbrella 81.5 104.5% 109.6% 80.5% 92.2%
Fidelity & surety 33.0 77.8% 87.7% 68.1% 76.1%
Personal Lines 368.4 99.1% 98.0% 105.6% 101.5%
Personal auto, incl. personal
umbrella 224.5 103.8% 102.2% 107.0% 102.9%
Personal property 143.9 91.8% 91.6% 103.3% 99.1%
- -----------------------------------------------------------------------------------------------------
Total All Lines $1,084.8 99.5% 101.0% 106.1% 101.5%
=====================================================================================================
(a) The loss and LAE ratio component of the accident year combined ratio
measures losses and LAE arising from insured events that occurred in the
respective accident year. The current accident year excludes losses and LAE
for insured events that occurred in prior accident years. The measurement
date for accident year data is September 30, 2004. Partial and complete
accident periods may not be comparable due to seasonality, claim reporting
and development patterns, claim settlement rates and other factors.
LIQUIDITY AND FINANCIAL STRENGTH
Investments
At September 30, 2004, the available-for-sale fixed maturity portfolio had a
market value of $3.3 billion, 97.2% ($3.2 billion) of which was invested in
investment grade securities. The balance of this portfolio includes non-
investment grade and non-rated securities that had a fair value of $93.4.
This compares to a fair value of $98.7, which was 3.3% of the available-for-
sale fixed maturity portfolio at December 31, 2003. The held-to-maturity
fixed maturity portfolio is accounted for at amortized cost, which was $316.4
and $356.1 at September 30, 2004 and December 31, 2003 respectively, and
consists entirely of investment grade securities.
Securities are classified as investment grade or non-investment grade based
upon the higher of the ratings provided by Standard & Poor's Ratings Group
(S&P) and Moody's Investors Service (Moody's). When a security is not rated
by either S&P or Moody's, the classification is based on other rating
services, including the Securities Valuation Office of the National
Association of Insurance Commissioners. The market value of available-for-
sale split-rated fixed maturity securities (i.e., those having an investment
grade rating from one rating agency and a below investment grade rating from
another rating agency) was $26.9 at September 30, 2004 and $24.0 at December
31, 2003.
Investments in below investment grade securities have greater risks than
investments in investment grade securities. The risk of default by borrowers
that issue below investment grade securities is greater because these
borrowers are often highly leveraged and more sensitive to adverse economic
conditions, including a recession or a sharp increase in interest rates.
Additionally, investments in below investment grade securities are generally
unsecured obligations of the issuer. Investment grade securities are also
subject to significant risks, including additional leveraging, changes in
control of the issuer or worse than previously expected operating results.
In most instances, investors are unprotected with respect to these risks, the
negative effects of which can be substantial.
22
Following is a table displaying non-investment grade and non-rated available-
for-sale securities in an unrealized loss position at September 30, 2004 and
December 31, 2003:
Amortized Fair Unrealized
(in millions) Cost Value Loss
- -----------------------------------------------------------
September 30, 2004 $17.2 $16.6 $(0.6)
December 31, 2003 $23.5 $22.6 $(0.9)
At September 30, 2004, the available-for-sale fixed maturity portfolio
contained tax-exempt fixed maturity securities totaling $817.5 or 24.8% of
the available-for-sale fixed maturity portfolio compared to $79.1 or 2.6% at
December 31, 2003. In 2004, as underwriting profitability has improved,
management has and plans to continue to invest more funds into tax-exempt
securities. This change in investment strategy will result in the
Corporation's before tax investment income declining when compared to prior
periods when the strategy was to invest in taxable securities. Conversely,
or as a result of this strategy, the Corporation's effective tax rate on
investment income will be lower when compared to these prior periods.
The investment portfolio includes non-publicly traded securities such as
private placements, non-exchange traded equities and limited partnerships
which are carried at fair value. Fair values are based on valuations from
pricing services, brokers and other methods as determined by management to
provide the most accurate price. The carrying value of this portfolio at
September 30, 2004 was $325.1 compared to $318.8 at December 31, 2003.
The consolidated fixed maturity portfolio has an intermediate duration and a
laddered maturity structure. The duration of the fixed maturity portfolio is
approximately 4.9 years and 4.6 years as of September 30, 2004 and December
31, 2003, respectively. The Corporation and the Group remain fully invested
and do not time markets. The Corporation and the Group also have no off-
balance sheet investments or arrangements as defined by section 401(a) of the
Sarbanes-Oxley Act of 2002.
At September 30, 2004, the short-term portfolio was $219.7 or 5.3% of the
total investment portfolio compared to $40.4 at December 31, 2003. The
increase was due to the investing of the June 2004 Senior Note proceeds in
short-term instruments. Short-term investments are carried at fair market
value on the consolidated balance sheet. For additional information regarding
Liquidity of the Corporation, please refer to the Debt section on page 25 of
this Form 10-Q.
At September 30, 2004, the Group's equity portfolio, which consisted of
preferred and common stock, was $352.6, or 8.4% of the total investment
portfolio compared to $329.0 or 8.8% at December 31, 2003. Equity securities
are carried at fair market value on the consolidated balance sheet. As a
result, shareholders' equity and statutory surplus fluctuate with changes in
the value of the equity portfolio. As of September 30, 2004, the equity
portfolio consisted of stocks in a total of 48 separate entities in 36
different industries. Of this total, 30.8% was invested in five companies
and the largest single position was 7.2% of the equity portfolio. At
December 31, 2003, the equity portfolio consisted of stocks in 44 separate
entities in 35 different industries. Of this total, 32.3% was invested in
five companies and the largest single position was 8.1% of the equity
portfolio.
For further discussion of the Corporation's investments, see Item 1 pages 8
through 10 of the Corporation's Form 10-K for the year ended December 31,
2003.
Loss and Loss Adjustment Expenses
The Group's largest liabilities are reserves for losses and LAE. The
accounting policies related to the loss and LAE reserves are considered
critical. Loss and LAE reserves are established for all incurred claims and
are carried on an undiscounted basis before any credits for reinsurance
recoverable. Loss and LAE reserves are adjusted upward or downward as new
information is received. These reserves amounted to $2.8 billion at
September 30, 2004 and $2.6 billion at December 31, 2003. As of September
30, 2004, the reserves by operating segment were as follows: $1.8 billion in
Commercial Lines, $0.6 billion in Specialty Lines and $0.4 billion in
Personal Lines.
23
Losses and LAE incurred for prior accident years were recognized during the
third quarter of 2004 and 2003 based on new information received during the
third quarter that resulted in a revision to prior estimates for loss and LAE
reserves. Each quarter a loss reserve study is conducted using data and
other information updated and available as of the end of each quarter. Based
on these studies, liabilities for loss and LAE are established for the
estimated ultimate costs of settling claims for insured events, for both
reported claims and incurred but not reported claims.
Results for the three and nine-month periods of 2004 and 2003 were impacted
by losses and LAE for prior accident years as shown in the table below:
Three Months Ended Nine Months Ended
Sept 30 Sept 30 Year
2004 2003 2004 2003 2003
------------------ ----------------- ----
Prior Accident Year Loss & LAE
by Segment (in millions)
- ------------------------------
Commercial Lines $(3.5) $ 3.7 $(12.2) $ 14.1 $ 41.0
Specialty Lines (2.2) (1.9) (7.4) (12.1) (21.3)
Personal Lines 2.6 3.4 3.8 7.7 14.4
------ ------ ------- ------- -------
All Lines Prior Accident
Year Development $(3.1) $ 5.2 $(15.8) $ 9.7 $ 34.1
====== ====== ======= ======= =======
Prior Accident Year Loss & LAE
by Accident Year (in millions)
- ------------------------------
Accident Year 2003 $(9.1) $ - $(31.3) $ - $ -
Accident Year 2002 (2.6) (7.3) (8.1) (33.5) (39.0)
Accident Year 2001 and Prior 8.6 12.5 23.6 43.2 73.1
------ ------ ------- ------- -------
Total Prior Accident
Year Development $(3.1) $ 5.2 $(15.8) $ 9.7 $ 34.1
====== ====== ======= ======= =======
For the Commercial Lines operating segment, the favorable loss and LAE
development for prior accident years recorded during the three month and nine
month periods of 2004 was concentrated in the commercial automobile product
line. Adverse loss and LAE development for Commercial Lines for the three
and nine month periods of 2003 was concentrated in the commercial multiple
peril and general liability product lines.
For the Specialty Lines operating segment, the favorable loss and LAE
development for prior accident years recorded during the three month and nine
month periods of both 2004 and 2003 was concentrated in the bond and
commercial umbrella product lines.
For the Personal Lines operating segment, the adverse loss and LAE
development for prior accident years recorded during the nine months of both
2004 and 2003 was concentrated in the personal auto, including personal
umbrella, product line. The adverse loss and LAE development for prior
accident years recorded during the three month period ending September 30,
2004 was concentrated in the homeowners product line, all of which related
to losses pertaining to New Jersey underground storage tanks. The adverse
loss and LAE development for prior accident years recorded during the three
month period ending September 30, 2003 was concentrated in the personal auto,
including personal umbrella, product line.
There is considerable uncertainty in the estimates of loss and LAE reserves
for reasons such as: the external environment including coverage litigation,
judicial decisions, legislative changes, claimants and jury attitudes with
respect to settlements; claim frequency and severity trends; the emergence of
unusual types or sizes of claims; changes in the underwriting quality of the
book of business over time; and changes in claims handling which could affect
the payment rate or case reserve adequacy.
Because of the inherent uncertainties in estimating the ultimate cost of
claims, the ultimate loss and LAE incurred may deviate substantially from the
amounts recorded. Furthermore, the timing, frequency and extent of
adjustments to the estimated liabilities cannot be predicted since the
conditions and events which established historical loss and LAE development
and which serve as the basis for estimating ultimate claim cost may not occur
in exactly the same manner, if at all.
24
Cash Flow
Net cash generated from operations was $186.6 for the first nine months of
2004 compared with $123.7 for the same period in 2003 resulting from a
reduction in paid losses, a result of the improved loss and LAE ratios
discussed above. Net cash used in investing was $209.1 in the first nine
months of 2004 compared with $102.9 during the first nine months of 2003.
Cash provided by financing operations was $207.9 in the first nine months of
2004 compared with $1.4 in the first nine months of 2003. In the second
quarter of 2004 net proceeds of approximately $198.0 from the issuance of
7.3% Senior Notes were received and are invested in short-term marketable
securities. Liquidity needs of the Group are expected to be met by net cash
generated from operations, maturities of investments, interest and dividend
receipts and current cash balances. For additional information regarding
Liquidity of the Corporation, please refer to the following Debt section in
this Form 10-Q.
Debt
In June 2004, the Corporation completed a $200.0 offering of its 7.3% Senior
Notes due June 15, 2014. The net proceeds from the offering after issuance-
related fees and discount was $198.0. The Corporation intends to use the net
proceeds of $198.0 from the issuance of the Senior Notes to repay the $201.3
aggregate principal amount of the Corporation's 5.00% Convertible Notes due
March 19, 2022, which the Corporation has the option to redeem in whole or in
part after March 22, 2005. The Corporation may also use the net proceeds to
repurchase shares of its common stock in an amount up to the equivalent
number of shares issued if holders convert their Convertible Notes into
shares of the Corporation's common stock. The repayment of the Convertible
Notes will reduce the potential for significant future share and earnings
dilution. Until the funds are needed for such purposes, the Corporation has
invested the net proceeds in short term marketable securities. Interest is
payable on the Convertible Notes on March 19 and September 19 and payable on
the Senior Notes on June 15 and December 15.
For additional information regarding Liquidity of the Corporation, please
refer to Note VII in the Notes to the Consolidated Financial Statements on
page 11 of this Form 10-Q.
At September 30, 2004, the Corporation had cash, short term and marketable
fixed maturity investments totaling $331.4, which compared to $44.5 at
December 31, 2003. In addition to investment income, the Corporation is
dependent on dividend payments from the Company for additional liquidity.
Insurance regulatory authorities impose various restrictions on the payment
of dividends by insurance companies. During 2004, dividend payments from the
Company to the Corporation are limited to approximately $86.8 without prior
approval of the Ohio Insurance Department. During the nine months of 2004,
the Company paid dividends totaling $85.0 to the Corporation resulting in a
dividend payment limitation of $1.8 for the remainder of 2004. This amount
is anticipated to be declared and paid in the fourth quarter of 2004.
Rating Agencies
Regularly the financial condition of the Corporation and the Group is
reviewed by four independent rating agencies, A. M. Best Company (A.M. Best),
Fitch, Inc. (Fitch), Moody's and S&P. These agencies assign ratings and
rating outlooks reflecting the agencies' opinions of the Group's financial
strength and the ability of the Corporation to meet its financial obligations
to its debt security holders. Following are the Corporation's current
ratings and rating outlooks.
A.M. Best Fitch Moody's S&P
--------- ----- ------- ---
Financial strength rating A- A- A3 BBB
Senior unsecured debt rating bbb- BBB- Baa3 BB
Rating outlook Stable Stable Stable Stable
During the first quarter of 2004, S&P changed its rating outlook from
negative to stable. For more information on the most recent rating agency
actions, please refer to Item 7. Management's Discussion and Analysis of
Financial Condition and Results of Operations in the Corporation's Form 10-K
for the year ended December 31, 2003.
25
Forward Looking Statements
Ohio Casualty Corporation publishes forward-looking statements relating to
such matters as anticipated financial performance, business prospects and
plans, regulatory developments and similar matters. The statements contained
in this Management's Discussion and Analysis that are not historical
information, are forward-looking statements within the meaning of The Private
Securities Litigation Reform Act of 1995. The operations, performance and
development of the Corporation's business are subject to risks and
uncertainties which may cause actual results to differ materially from those
contained in or supported by the forward looking statements. The risks and
uncertainties that may affect the operations, performance, development and
results of the Corporation's business include the following: changes in
property and casualty reserves; catastrophe losses; premium and investment
growth; product pricing environment; availability of credit; changes in
government regulation; performance of financial markets; fluctuations in
interest rates; availability and pricing of reinsurance; litigation and
administrative proceedings; rating agency actions; acts of war and terrorist
activities; ability to achieve targeted expense savings; ability to appoint
and retain agents; ability to achieve premium targets and profitability
goals; and general economic and market conditions.
ITEM 3. Quantitative and Qualitative Disclosures about Market Risk
There have been no material changes in the information about market
risk set forth in the Corporation's Annual Report on Form 10-K.
ITEM 4. Controls and Procedures
(a) The Company's Chief Executive Officer and Chief Financial
Officer evaluated the disclosure controls and procedures (as
defined under Rules 13a-15(e) and 15d-15(e) of the Securities
Exchange Act of 1934, as amended) as of the end of the period
covered by this report. Based upon that evaluation, the Chief
Executive Officer and Chief Financial Officer have concluded
that the Company's disclosure controls and procedures are
effective.
(b) There were no significant changes in the Company's internal
control over financial reporting identified in connection with
the foregoing evaluation that occurred during the Company's
last fiscal quarter that have affected, or are reasonably
likely to materially affect, the Company's internal control
over financial reporting.
PART II
ITEM 6. Exhibits and reports on Form 8-K
I. Reports on Form 8-K:
The Corporation filed a Form 8-K on August 3, 2004 to report under
Items 7 and 12 the filing of a press release announcing the second
quarter 2004 earnings and Supplemental Financial Information.
Exhibits to the Form 8-K consisted of the press release dated
August 3, 2004 and the Supplemental Financial Information.
The Corporation filed a Form 8-K on August 19, 2004 to report under
Items 5 and 7 the appointment of Michael L. Wright to its Board of
Directors. Exhibits to the Form 8-K consisted of the press release
dated August 19, 2004.
The Corporation filed a Form 8-K on August 25, 2004 to report under
Items 8.01 and 9.01 the storm loss estimate from Hurricane Charley.
Exhibits to the Form 8-K consisted of the press release dated
August 24, 2004.
26
The Corporation filed a Form 8-K on September 17, 2004 to report
under Items 8.01 and 9.01 an investor presentation and webcast.
Exhibits to the Form 8-K consisted of the slide presentation of the
Corporation dated September 17, 2004.
The Corporation filed a Form 8-K on September 30, 2004 to report
under Items 5.02(b) and 9.01 the departure of Jeffery L. Haniewich,
executive vice president and chief operating officer of the
Commercial Lines Division of The Ohio Casualty Insurance Company.
Exhibits to the Form 8-K consisted of the press release dated
September 30, 2004.
II. Exhibits:
31.1 Certification of Chief Executive Officer of Ohio Casualty
Corporation in accordance with SEC Rule 13(a)-14(a) and
Rule 15(d)-14(a)
31.2 Certification of Chief Financial Officer of Ohio Casualty
Corporation in accordance with SEC Rule 13(a)-14(a) and
Rule 15(d)-14(a)
32.1 Certification of Chief Executive Officer of Ohio Casualty
Corporation in accordance with Section 1350 of the
Sarbanes-Oxley Act of 2002
32.2 Certification of Chief Financial Officer of Ohio Casualty
Corporation in accordance with Section 1350 of the
Sarbanes-Oxley Act of 2002
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
OHIO CASUALTY CORPORATION
-------------------------
(Registrant)
November 2, 2004 /s/Michael A. Winner
----------------------------------
Michael A. Winner, Executive Vice
President and Chief Financial
Officer
27