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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D. C. 20549
FORM 10-K
[x] Annual Report Pursuant to Section 13 or 15 (d) of the Securities
Exchange Act of 1934
For the fiscal year ended December 31, 2004
[ ] Transition Report Pursuant to Section 13 or 15 (d) of the Securities
Exchange Act of 1934
For the transition period from _________ to ____________
Commission File Number 0-5544
OHIO CASUALTY CORPORATION
(Exact name of registrant as specified in its charter)
OHIO 31-0783294
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
9450 SEWARD ROAD, FAIRFIELD, OHIO 45014
(Address of principal executive offices) (Zip Code)
(513) 603-2400
(Registrant's telephone number)
SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:
NONE
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
Common Shares, Par Value $.125 Each
(Title of Class)
Common Share Purchase Rights
(Title of Class)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.
Yes [X] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K [ ].
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act).
Yes [X] No [ ]
The aggregate market value as of June 30, 2004 of the voting stock held by
non-affiliates of the registrant was $1,162,813,516 determined by multiplying
the price at which the common equity was last sold as of the last business day
of the Registrant's most recently completed second fiscal quarter. Such
determination shall not, however, be deemed to be an admission that any person
is an "affiliate" as defined in Rule 405 under the Securities Act of 1933.
On March 1, 2005 there were 62,445,018 common shares outstanding.
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DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Registrant's definitive Proxy Statement for its Annual Meeting
of Shareholders to be held on May 18, 2005, are incorporated by reference into
Parts II and III of this Annual Report on Form 10-K.
2
TABLE OF CONTENTS
Page
----
PART I
Item 1. Business 4
Item 2. Properties 14
Item 3. Legal Proceedings 14
Item 4. Submission of Matters to a Vote of Security Holders 15
PART II
Item 5. Market for Registrant's Common Equity, Related Stockholder Matters
and Issuer Purchases of Equity Securities 16
Item 6. Selected Financial Data 17
Item 7. Management's Discussion and Analysis of Financial Condition and Results 18
of Operation
Item 7A. Quantitative and Qualitative Disclosures about Market Risk 45
Item 8. Financial Statements and Supplementary Data 46
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure 46
Item 9A. Controls and Procedures 46
Item 9B. Other Information 47
PART III
Item 10. Directors and Executive Officers of the Registrant 47
Item 11. Executive Compensation 48
Item 12. Security Ownership of Certain Beneficial Owners and Management 48
Item 13. Certain Relationships and Related Transactions 48
Item 14. Principal Accounting Fees and Services 48
PART IV
Item 15. Exhibits, Financial Statement Schedules 49
Signatures 74
Index to Exhibits
Exhibit 4a Certificate of Adjustment
Exhibit 10.1 Form of Change in Control Agreement
Exhibit 10.2 Amended and Restated Ohio Casualty Corporation Directors
Deferred Compensation Plan
Exhibit 10.3 Form of Stock Option Agreement
Exhibit 21 Subsidiaries of the Registrant
Exhibit 23 Consent of Independent Registered Public Accounting Firm to
incorporation of their opinion by reference in Registration
Statements on Forms S-3 and Form S-8
Exhibit 31.1 Certification of Chief Executive Officer of Ohio Casualty
Corporation in accordance with SEC Rule 13(a)-14(a)/15(d)-14(a)
Exhibit 31.2 Certification of Chief Financial Officer of Ohio Casualty
Corporation in accordance with SEC Rule 13(a)-14(a)/15(d)-14(a)
Exhibit 32.1 Certification of Chief Executive Officer of Ohio Casualty
Corporation in accordance with Section 1350 of the
Sarbanes-Oxley Act of 2002
Exhibit 32.2 Certification of Chief Financial Officer of Ohio Casualty
Corporation in accordance with Section 1350 of the
Sarbanes-Oxley Act of 2002
3
PART I
ITEM 1. BUSINESS
(a) GENERAL DEVELOPMENT OF BUSINESS
Ohio Casualty Corporation (the Corporation) was incorporated in Ohio in 1969.
With its predecessors, the Corporation has been engaged in the property and
casualty insurance business since 1919. The Corporation has six direct and
indirect subsidiaries which are collectively known as the Ohio Casualty Group
(the Group). The Group actively writes commercial, specialty and personal lines
business in over 40 states. The Group consists of:
- - The Ohio Casualty Insurance Company (the Company);
- - West American Insurance Company (West American);
- - Ohio Security Insurance Company (Ohio Security);
- - American Fire and Casualty Company (American Fire);
- - Avomark Insurance Company (Avomark); and
- - Ohio Casualty of New Jersey, Inc. (OCNJ).
On December 1, 1998, the Company acquired substantially all of the assets and
assumed certain liabilities of the commercial lines division of the Great
American Insurance Company (GAI) and certain of its affiliates. The major lines
of business included in the acquisition were workers' compensation, commercial
multi-peril, umbrella, general liability and commercial auto.
During the fourth quarter of 2001, OCNJ entered into an agreement to transfer
its obligation to renew private passenger auto business in New Jersey. This
transaction effectively exited the Group from the New Jersey private passenger
auto market beginning in March of 2002. Under the terms of the transaction, OCNJ
agreed to pay $40.6 million to a third party, Proformance Insurance Company
(Proformance), to transfer its renewal obligations. The before-tax amount of
$40.6 million was charged to income in the fourth quarter of 2001 with payments
made over the course of twelve months beginning in early 2002. The contract
further stipulated that a premiums-to-surplus ratio of 2.5 to 1.0 must be
maintained by Proformance on the transferred business during the periods of
March 2002 through December 2004. If this criteria is not met, OCNJ will have to
pay up to a maximum cumulative amount of $15.6 million to Proformance to
maintain this premiums-to-surplus ratio. For further discussion on this
transaction, see Item 7, Management's Discussion and Analysis of Financial
Conditions and Results of Operation on page 19 of this Annual Report on Form
10-K.
The Corporation continually evaluates the competitive environment within the
insurance industry. Most high performing insurance companies, including a number
of peer companies, have achieved combined ratios in the low 90% to 100% range.
Also, the surplus positions of many of these companies have strengthened, while
at the same time investment income growth has been constrained by the low yields
on new investments. In addition, the industry took less aggressive price
increases in 2004 in most insurance product lines and had an increased focus on
the quality of reinsurers. Recognizing that improved industry results may mean
further price competition, the Corporation has taken steps in 2004 to achieve
improved profitability through expense reduction initiatives while maintaining
disciplined underwriting and pricing.
In September 2003, the Corporation announced its Corporate Strategic Plan for
the 2004-2006 time frame. The plan brings together five broad objectives to help
achieve the Corporation's Vision to be a leading super regional Property and
Casualty carrier providing a broad range of products/services through
independent agents and brokers. The broad objectives include the ability to
generate above market growth, produce competitive loss ratios, create a
competitive expense structure, achieve a competitive return on equity and
improve credit ratings and financial flexibility. Competitive advantages include
strong agency relationships, especially with key agents, and technology
platforms that will provide superior operating flexibility. Technology is being
leveraged to make it easier for agents to do business with the Group and to
increase pricing and underwriting sophistication.
4
ITEM 1. CONTINUED
(b) FINANCIAL INFORMATION ABOUT SEGMENTS
The revenues and operating profit of each reportable segment for the three years
ended December 31, 2004, 2003 and 2002 are set forth in Item 15, Note 13,
Segment Information, in the Notes to the Consolidated Financial Statements on
pages 67 and 68 of this Annual Report on Form 10-K. The combined ratios and
component ratios for each reportable segment for the three years ended December
31, 2004, 2003 and 2002 are presented in Item 7, Management's Discussion and
Analysis of Financial Condition and Results of Operation on pages 29 and 30 of
this Annual Report on Form 10-K.
(c) NARRATIVE DESCRIPTION OF BUSINESS
SEGMENT DESCRIPTION
COMMERCIAL LINES SEGMENT
The Group's Commercial Lines segment accounted for 57.0%, 55.0% and 52.6% of net
premiums written in 2004, 2003 and 2002, respectively, consisting of the
following product lines:
(in millions) 2004 2003 2002
- ------------- ------- ------- -------
Workers' compensation $ 132.9 $ 132.4 $ 143.9
Commercial auto 233.5 228.3 213.4
General liability 89.5 83.4 84.5
CMP, fire and inland marine 372.3 348.5 320.4
------- ------- -------
Total Commercial Lines $ 828.2 $ 792.6 $ 762.2
======= ======= =======
These product lines include:
- - Workers' compensation insurance - insures employers for their obligations
to provide workers' compensation benefits as required by applicable
statutes, including medical payments, rehabilitation costs, lost wages,
and disability and death benefits. These policies also provide coverage to
employees for their liability exposures under the common law;
- - Commercial automobile insurance - insures policyholders against third
party liability related to the ownership and operation of motor vehicles
used in the course of business and property damage to insured vehicles.
These policies may provide uninsured motorist coverage, which provides
coverage to insureds and their employees for bodily injury and property
damage caused by an uninsured party;
- - General liability insurance - insures policyholders against third party
liability for bodily injury and property damage, including liability for
products sold and covers the cost of the defense of claims alleging such
damages; and
- - Commercial multi-peril insurance (CMP) - insures a business against risks
from property, liability, crime and boiler and machinery explosion losses.
SPECIALTY LINES SEGMENT
The Group's Specialty Lines segment accounted for 9.3%, 11.4% and 12.4% of net
premiums written in 2004, 2003 and 2002, respectively, consisting of the
following product lines:
(in millions) 2004 2003 2002
- ------------- ------- ------- -------
Commercial umbrella $ 87.1 $ 120.9 $ 132.6
Fidelity and surety 48.4 43.9 45.6
Farmowners - 0.1 1.7
------- ------- -------
Total Specialty Lines $ 135.5 $ 164.9 $ 179.9
======= ======= =======
5
ITEM 1. CONTINUED
These product lines include:
- - Commercial umbrella insurance - indemnifies policyholders for liability
and defense costs which exceed coverage provided by the underlying primary
policies, typically commercial automobile and general liability policies,
and provides coverage for some items not covered by underlying policies;
and
- - Fidelity and surety - insures against dishonest acts of bonded employees
and the non-performance of parties under contracts, respectively.
PERSONAL LINES SEGMENT
The Group's Personal Lines segment accounted for the remaining 33.7%, 33.6% and
35.0% of net premiums written in 2004, 2003 and 2002, respectively, consisting
of the following product lines:
(in millions) 2004 2003 2002
- ------------- ------- ------- -------
Personal auto incl. personal umbrella $ 294.1 $ 296.8 $ 324.5
Personal property 196.1 187.3 182.0
------- ------- -------
Total Personal Lines $ 490.2 $ 484.1 $ 506.5
======= ======= =======
These product lines include personal automobile and homeowners' insurance sold
to individuals.
MARKETING AND DISTRIBUTION
The Group is represented by approximately 3,400 independent insurance agencies
with approximately 5,300 agents. These agents also represent other unaffiliated
companies which may compete with the Group. The six claim, underwriting and
service offices operated by the Group assist these independent agents in
producing and servicing the Group's business.
Certain agencies that meet established profitability and production targets are
eligible for "key agent" status. At December 31, 2004, these agencies
represented 16.2% of the Group's total agency force and wrote 39.8% of its book
of business. The policies placed by key agents have consistently produced a
lower loss ratio for the Group than policies placed by other agents.
The Group targets small business customers for its Commercial Lines segment. The
Group's typical Commercial Lines customer is a small business with a limited
number of employees that needs to conveniently purchase a package of coverages.
For the year 2004, this Commercial Lines customer group, categorized by
commercial liability premium volume, included approximately 76%
contractors/artisans, 10% mercantile, 8% building/premises, and 6%
manufacturers. The Group believes this small business customer group offers an
opportunity to achieve superior underwriting results through development and
maintenance of strong agent and customer relationships and application of the
Group's underwriting and pricing expertise.
The Group markets its Specialty Lines segment predominately to policyholders who
have purchased commercial automobile and general liability policies and have a
need for additional coverage under umbrella policies to cover costs which might
exceed the underlying policies limits or are not covered under such policies.
The Group markets personal automobile insurance primarily to standard and
preferred risk drivers. Standard and preferred risk drivers are those who have
met certain criteria, including a driving record which reflects a low historical
incidence of at-fault accidents and moving violations of traffic laws. The Group
does not target "non-standard" risk drivers who fall outside these criteria.
6
ITEM 1. CONTINUED
COMPETITION
The property and casualty insurance industry is highly competitive. The Group
competes on the basis of service, price and coverage. According to A.M. Best,
based on net insurance premiums written in 2003, the latest year for which
industry-wide comparison statistics are available:
- - more than $415 billion of net premiums were written by property and
casualty insurance companies in the United States and no one company or
company group had a market share greater than approximately 11.2%; and
- - the Group ranked as the forty-eighth largest property and casualty
insurance group in the United States.
REGULATION
STATE REGULATION
The Corporation's insurance subsidiaries are subject to regulation and
supervision in the states in which they are domiciled and in which they are
licensed to transact business. The Company, American Fire, Ohio Security and
OCNJ are all domiciled in Ohio. West American and Avomark are domiciled in
Indiana. Collectively, the Corporation's subsidiaries are licensed to transact
business in all 50 states and the District of Columbia. Although the federal
government does not directly regulate the insurance industry, federal
initiatives can impact the industry.
The authority of state insurance departments extends to various matters,
including:
- - the establishment of standards of solvency, which must be met and
maintained by insurers;
- - the licensing of insurers and agents;
- - the imposition of restrictions on investments;
- - approval and regulation of premium rates and policy forms for property and
casualty insurance;
- - the payment of dividends and distributions;
- - the provisions which insurers must make for current losses and future
liabilities; and
- - the deposit of securities for the benefit of policyholders.
State insurance departments also conduct periodic examinations of the financial
and business affairs of insurance companies and require the filing of annual and
other reports relating to the financial condition of insurance companies.
Regulatory agencies require that premium rates not be excessive, inadequate or
unfairly discriminatory. In general, the Corporation's insurance subsidiaries
must file all rates for personal and commercial insurance with the insurance
department of each state in which they operate.
State laws also regulate insurance holding company systems. Each insurance
holding company in a holding company system is required to register with the
insurance supervisory agency of its state of domicile and furnish information
concerning the operations of companies within the holding company system that
may materially affect the operations, management or financial condition of the
insurers. Pursuant to these laws, the respective departments may examine the
parent and the insurance subsidiaries at any time and require prior approval or
notice of various transactions including dividends or distributions to the
parent from the subsidiary domiciled in that state.
These state laws also require prior notice or regulatory agency approval of
changes in control of an insurer or its holding company and of other material
transfers of assets within the holding company structure. Under applicable
provisions of Indiana and Ohio insurance statutes, the states in which the
members of the Group are domiciled, a person would not be permitted to acquire
direct or indirect control of the Corporation or any of its
7
ITEM 1. CONTINUED
insurance subsidiaries, unless that person had obtained prior approval of the
Indiana Insurance Commissioner and the Ohio Superintendent of Insurance. For the
purposes of Indiana and Ohio insurance laws, any person acquiring more than 10%
of the voting securities of a company is presumed to have acquired "control" of
that company.
NATIONAL ASSOCIATION OF INSURANCE COMMISSIONERS (NAIC)
The Corporation's insurance subsidiaries are subject to the general statutory
accounting practices and reporting formats established by the NAIC. The NAIC
also promulgates model insurance laws and regulations relating to the financial
condition and operations of insurance companies, including the Insurance
Regulating Information System.
NAIC model laws and rules are not usually applicable unless enacted into law or
promulgated into regulation by the individual states. The adoption of NAIC model
laws and regulations is a key aspect of the NAIC Financial Regulations Standards
and Accreditation Program, which also sets forth minimum staffing and resource
levels for all state insurance departments. Ohio and Indiana are accredited.
The NAIC has developed a "Risk-Based Capital" model for property and casualty
insurers. The model is used to establish standards, which relate insurance
company statutory surplus to risks of operations and assist regulators in
determining solvency requirements. The standards are designed to assess capital
adequacy and to raise the level of protection that statutory surplus provides
for policyholders. The Risk-Based Capital model measures the following four
major areas of risk to which property and casualty insurers are exposed:
- - asset and liability risk;
- - credit risk;
- - underwriting risk; and
- - off-balance sheet risk.
The Risk-Based Capital model law requires the calculation of a ratio of total
adjusted capital to Authorized Control Level risk-based capital. Insurers with a
ratio below 200% are subject to different levels of regulatory intervention and
action. Based upon their 2004 statutory financial statements, all insurance
companies in the Group exceeded the necessary statutory capital requirements.
REGULATIONS ON DIVIDENDS
The Corporation is dependent on dividend payments from its insurance
subsidiaries in order to meet operating expenses, debt obligations and to pay
dividends. Insurance regulatory authorities impose various restrictions and
prior approval requirements on the payment of dividends by insurance companies
and holding companies. This regulation allows dividends to equal the greater of
(1) 10% of policyholders' surplus or (2) 100% of the insurer's net income, each
determined as of the preceding year end, without prior approval of the insurance
department.
Dividend payments to the Corporation from the Company are limited to
approximately $138.3 million during 2005 without prior approval of the Ohio
insurance department based on 100% of the Company's net income for the year
ending December 31, 2004. Additional restrictions limiting the amount of
dividends paid by the Company to the Corporation may result from the minimum net
worth and surplus requirements in the Corporation's revolving credit agreement
as disclosed in Item 15, Note 16, Debt, on pages 69 and 70 of this Annual Report
on Form 10-K.
8
ITEM 1. CONTINUED
POOLING AGREEMENT
All of the Company's insurance subsidiaries, except OCNJ, have entered into an
intercompany reinsurance pooling agreement with the Company. The purpose of this
agreement is to:
- - pool or share proportionately the results of property and casualty
insurance underwriting operations through reinsurance;
- - reduce administration expenses; and
- - broaden each participating insurance subsidiary's distribution of risk.
Under the terms of the intercompany reinsurance pooling agreement, all of the
participants' outstanding underwriting liabilities as of January 1, 1984, and
all subsequent insurance transactions were pooled. The participating insurance
subsidiaries share in losses in 2004, 2003 and 2002 were based on the following
percentages:
Insurance Subsidiary Percentage of Losses
- -------------------- --------------------
The Company 46.75%
West American 46.75
American Fire 5.00
Ohio Security 1.00
Avomark 0.50
Effective January 1, 2005, the intercompany reinsurance pooling agreement was
revised. The Company, the lead company of the pool, will assume and retain 100%
of the pool's underwriting experience, therefore there will be no retrocessions
to the Company's insurance subsidiaries.
INVESTMENTS
The distribution of the Corporation's and the Group's invested assets is
determined by a number of factors, including:
- - rates of return;
- - investment risks;
- - insurance law requirements;
- - diversification;
- - liquidity needs;
- - tax planning;
- - general market conditions; and
- - business mix and liability payout patterns.
Periodically, the investment portfolios are reallocated subject to the
parameters set by management, under the direction of the Finance Committee of
the Board of Directors. Management evaluates the investment portfolio on a
regular basis to determine the optimal investment strategy based upon the
factors mentioned above. Throughout 2002 equity securities were sold, many of
which had substantially appreciated in value compared to earlier periods. This
sale program was in response to a decision to reduce equity holdings in favor of
investment grade fixed maturities.
Assets relating to property and casualty operations are invested to maximize
after-tax returns with appropriate diversification of risk. As a result of
improved underwriting profitability, the Corporation and Group began to increase
funds invested in tax exempt fixed maturities in 2004. This change will result
in lower before-tax
9
ITEM 1. CONTINUED
investment income, but will also be accompanied by a lower effective tax rate on
investment income, due to the tax-exempt status of the securities.
The portfolio strategy, with respect to common stocks, is to focus on large
companies with dominant market positions, excellent profitability and strong
balance sheets. Equity securities are marked to fair value on the consolidated
balance sheets. As a result, shareholders' equity and statutory surplus
fluctuate with changes in the value of the equity portfolio. The effect of
future stock market volatility is managed by maintaining an appropriate ratio of
equity securities to shareholders' equity and statutory surplus.
See further detailed information and discussion on the results and liquidity of
the Corporation and Group's investment portfolio in the "Investment Results"
section on pages 20-23 and the "Investment Portfolio" section on pages 43 and 44
of Item 7, Management's Discussion and Analysis of Financial Condition and
Results of Operation, of this Annual Report on Form 10-K.
LIABILITIES FOR UNPAID LOSSES AND LOSS ADJUSTMENT EXPENSES
Liabilities for losses and loss adjustment expenses (LAE) are established for
the estimated ultimate costs of settling claims for insured events, both
reported claims and incurred but not reported claims, based on information known
as of the evaluation date. The estimated liabilities include direct costs of the
loss under terms of insurance policies, as well as legal fees and general
expenses of administering the claims adjustment process. Because of the inherent
future uncertainties in estimating ultimate costs of settling claims, actual
losses and LAE may deviate substantially from the amounts recorded in the
Corporation's consolidated financial statements. Furthermore, the timing,
frequency and extent of adjustments to the estimated liabilities cannot be
accurately predicted since conditions, events and trends which led to historical
loss and LAE development and which serve as the basis for estimating ultimate
claims cost may not occur in the future in exactly the same manner, if at all.
As more information becomes available and claims are settled, the estimated
liabilities are adjusted upward or downward with the effect of increasing or
decreasing net income at the time of the adjustments. The effect of these
adjustments may have a material adverse impact on the results of operations of
the Group.
The following tables present an analysis of losses and LAE and related
liabilities for the periods indicated. The first table represents the impact of
current and prior accident years on calendar year losses and LAE. The second
table displays the development of losses and LAE liabilities as of successive
year-end evaluations for each of the past ten years.
Reconciliation of Liabilities for Losses and Loss Adjustment Expenses
(in millions)
2004 2003 2002
--------- --------- ---------
Net liabilities, balance as of January 1 $ 2,131.3 $ 2,079.3 $ 1,982.0
Incurred related to:
Current year 958.1 993.3 1,045.4
Prior years (21.8) 34.1 84.4
--------- --------- ---------
Total incurred 936.3 1,027.4 1,129.8
Paid related to:
Current year 354.1 388.6 423.6
Prior years 527.4 586.8 608.9
--------- --------- ---------
Total paid 881.5 975.4 1,032.5
Net liabilities, balance as of December 31 2,186.1 2,131.3 2,079.3
Reinsurance recoverable 570.3 496.5 354.4
--------- --------- ---------
Gross liabilities, balance as of December 31 $ 2,756.4 $ 2,627.9 $ 2,433.7
========= ========= =========
10
ITEM 1. CONTINUED
Analysis of Development of Loss and Loss Adjustment Expense Liabilities
(In millions)
Year Ended December 31 1994 1995 1996 1997 1998 1999
- -------------------------------- ---------- ---------- ---------- ---------- ---------- ----------
Net liability as originally
estimated: $ 1,606.5 $ 1,557.1 $ 1,486.6 $ 1,421.8 $ 1,865.6 $ 1,823.3
Life Operations Liability 1.0 3.9 3.7 0.1 0.1 -
P&C Operations Liability $ 1,605.5 $ 1,553.2 $ 1,482.9 $ 1,421.7 $ 1,865.5 $ 1,823.3
Net cumulative payments as of:
One year later 510.2 486.2 483.6 449.8 640.2 614.0
Two years later 803.3 772.7 747.4 751.2 999.1 960.5
Three years later 997.0 944.3 950.1 919.3 1,223.3 1,226.2
Four years later 1,106.4 1,080.4 1,058.3 1,016.9 1,385.2 1,399.5
Five years later 1,203.7 1,151.0 1,121.3 1,088.7 1,485.7 1,504.1
Six years later 1,257.3 1,198.3 1,171.2 1,137.6 1,548.2
Seven years later 1,293.5 1,239.3 1,207.0 1,171.3
Eight years later 1,329.0 1,271.2 1,233.5
Nine years later 1,357.4 1,293.2
Ten years later 1,376.9
Gross cumulative payments as of:
One year later 522.8 500.1 498.3 469.9 654.2 636.5
Two years later 827.2 798.1 781.9 775.4 1,022.2 1,007.1
Three years later 1,030.7 988.7 983.4 950.4 1,261.1 1,281.4
Four years later 1,158.8 1,123.2 1,098.7 1,057.5 1,426.5 1,492.0
Five years later 1,254.5 1,200.6 1,171.2 1,131.5 1,532.4 1,616.7
Six years later 1,314.6 1,257.4 1,223.2 1,187.0 1,601.0
Seven years later 1,359.9 1,300.6 1,265.3 1,226.7
Eight years later 1,397.7 1,338.8 1,297.2
Nine years later 1,432.4 1,366.2
Ten years later 1,457.0
Year Ended December 31 2000 2001 2002 2003 2004
- -------------------------------- ---------- ---------- ---------- ---------- ----------
Net liability as originally
estimated: $ 1,907.3 $ 1,982.0 $ 2,079.3 $ 2,131.3 $ 2,186.1
Life Operations Liability - - - - -
P&C Operations Liability $ 1,907.3 $ 1,982.0 $ 2,079.3 $ 2,131.3 $ 2,186.1
Net cumulative payments as of:
One year later 609.1 608.9 586.7 527.4
Two years later 1,002.7 1,015.2 951.5
Three years later 1,290.4 1,281.9
Four years later 1,465.9
Five years later
Six years later
Seven years later
Eight years later
Nine years later
Ten years later
Gross cumulative payments as of:
One year later 647.1 636.8 674.9 609.9
Two years later 1,060.6 1,122.7 1,111.6
Three years later 1,404.5 1,455.5
Four years later 1,620.5
Five years later
Six years later
Seven years later
Eight years later
Nine years later
Ten years later
11
ITEM 1. CONTINUED
Analysis of Development of Loss and Loss Adjustment Expense Liabilities
(continued)
(In millions)
Year Ended December 31 1994 1995 1996 1997 1998 1999
- --------------------------------- ---------- ---------- ---------- ---------- ---------- ----------
Net liability re-estimated as of:
One year later 1,500.5 1,474.8 1,428.0 1,355.6 1,888.4 1,880.2
Two years later 1,501.5 1,441.1 1,403.1 1,386.4 1,885.2 1,907.6
Three years later 1,486.5 1,445.7 1,439.0 1,400.7 1,901.8 1,997.6
Four years later 1,507.3 1,478.8 1,456.9 1,392.0 1,975.8 2,032.9
Five years later 1,546.8 1,497.6 1,448.0 1,441.7 1,993.4 2,058.9
Six years later 1,566.3 1,492.0 1,489.8 1,459.7 2,018.0
Seven years later 1,560.9 1,532.2 1,504.2 1,469.1
Eight years later 1,597.8 1,548.0 1,510.7
Nine years later 1,614.6 1,554.0
Ten years later 1,620.1
Decrease (increase) in
original estimates: $ (14.6) $ (0.9) $ (27.8) $ (47.3) $ (152.4) $ (235.6)
Net liability as originally
estimated: $ 1,605.5 $ 1,553.1 $ 1,482.9 $ 1,421.7 $ 1,865.5 $ 1,823.3
Reinsurance recoverable on
unpaid losses and LAE 65.3 71.1 64.7 60.0 80.2 85.1
Gross liability as originally
estimated: $ 1,671.8 $ 1,631.2 $ 1,556.7 $ 1,483.8 $ 1,956.9 $ 1,908.5
Life Operations Liability 1.0 7.0 9.1 2.2 11.2 -
P&C Operations Liability 1,670.9 1,624.2 1,547.6 1,481.7 1,945.8 1,908.5
One year later 1,574.2 1,546.0 1,496.1 1,447.0 1,972.9 1,981.1
Two years later 1,579.9 1,515.0 1,507.4 1,477.9 1,975.7 2,041.7
Three years later 1,565.6 1,561.7 1,537.4 1,495.8 2,006.1 2,189.9
Four years later 1,630.3 1,585.5 1,559.5 1,495.6 2,114.3 2,261.6
Five years later 1,657.0 1,608.3 1,558.2 1,571.1 2,155.4 2,291.8
Six years later 1,680.6 1,609.8 1,623.2 1,618.8 2,175.4
Seven years later 1,682.8 1,671.4 1,667.9 1,624.6
Eight years later 1,739.3 1,718.2 1,672.6
Nine years later 1,787.4 1,722.6
Ten years later 1,791.5
Decrease (increase) in
original estimates: (120.6) (98.4) (125.0) (142.9) (229.6) (383.3)
Year Ended December 31 2000 2001 2002 2003 2004
- --------------------------------- ---------- ---------- ---------- ---------- ----------
Net liability re-estimated as of:
One year later 1,965.8 2,066.4 2,115.2 2,109.5
Two years later 2,066.1 2,139.5 2,128.5
Three years later 2,131.1 2,165.1
Four years later 2,157.5
Five years later
Six years later
Seven years later
Eight years later
Nine years later
Ten years later
Decrease (increase) in
original estimates: $ (250.2) $ (183.1) $ (49.2) $ 21.8
Net liability as originally
estimated: $ 1,907.3 $ 1,982.0 $ 2,079.3 $ 2,131.3 $ 2,186.1
Reinsurance recoverable on
unpaid losses and LAE 96.2 168.7 354.4 496.5 570.3
Gross liability as originally
estimated: $ 2,003.5 $ 2,150.7 $ 2,433.7 $ 2,627.8 $ 2,756.4
Life Operations Liability - - - - -
P&C Operations Liability 2,003.5 2,150.7 2,433.7 2,627.8 2,756.4
One year later 2,129.9 2,346.9 2,558.2 2,615.5
Two years later 2,310.6 2,502.4 2,576.1
Three years later 2,432.4 2,536.2
Four years later 2,465.3
Five years later
Six years later
Seven years later
Eight years later
Nine years later
Ten years later
Decrease (increase) in
original estimates: (461.8) (385.4) (142.4) 12.4
12
ITEM 1. CONTINUED
The accounting policies used to estimate liabilities for losses and LAE are
considered critical accounting policies and are further discussed in the
"Critical Accounting Policies" and "Loss and LAE" sections of Item 7,
Management's Discussion and Analysis of Financial Condition and Results of
Operation, on pages 31 and 39-41 in this Annual Report on Form 10-K. In addition
loss and LAE liabilities are further discussed in Note 1J, Summary of
Significant Accounting Policies and Note 9, Losses and Loss Reserves, in the
Notes to the Consolidated Financial Statements on pages 55 and 66 of this Annual
Report on Form 10-K.
REINSURANCE
Reinsurance is a contract by which one insurer, called a reinsurer, agrees to
cover, under certain defined circumstances, a portion of the losses incurred by
a primary insurer in the event a claim is made under a policy issued by the
primary insurer. The Group purchases reinsurance to protect against large or
catastrophic losses. Reinsurance contracts do not relieve the Group of their
obligations to policyholders. The collectibility of reinsurance depends on the
solvency of the reinsurers at the time any claims are presented. The Group
monitors each reinsurer's financial health and claims settlement performance
because reinsurance protection is an important component of the Corporation's
financial plan. Each year, the Group reviews financial statements and calculates
various ratios used to identify reinsurers who no longer meet appropriate
standards of financial strength. Reinsurers who fail these tests are reviewed
and those that are determined by the Group to have insufficient financial
strength are removed from the program at renewal. Additionally, a large number
of reinsurers are utilized to mitigate concentration of risk. The Group also
records an estimated allowance for uncollectible reinsurance amounts, as deemed
necessary. During the last three fiscal years, no reinsurer accounted for more
than 15% of total ceded premiums. As a result of these controls, amounts of
uncollectible reinsurance have not been significant. There are several programs
that provide reinsurance coverage and the programs in effect for 2005 are
discussed in the "Reinsurance Programs" section of Item 7, Management's
Discussion and Analysis of Financial Condition and Results of Operation, on page
42 of this Annual Report on Form 10-K.
SEASONALITY
The Group's insurance business experiences modest seasonality with regard to
premiums written, which are usually highest in January and July and lowest
during the fourth quarter. Although written premium experiences modest
seasonality, premiums are earned ratably over the period of coverage. Losses and
LAE incurred tend to remain consistent throughout the year, unless a catastrophe
occurs. Catastrophes can occur at any time during the year from weather-related
events that include, but are not limited to, hail, tornadoes, hurricanes and
windstorms.
EMPLOYEES
At December 31, 2004, the Company had 2,190 employees of which approximately
1,300 were located in the Fairfield and Hamilton, Ohio offices.
13
ITEM 1. CONTINUED
(d) FINANCIAL INFORMATION ABOUT GEOGRAPHIC AREAS
The Group's business is geographically concentrated in the Mid-West and
Mid-Atlantic regions. The following table shows consolidated direct premiums
written for the Group's ten largest states:
Ten Largest States
Direct Premiums Written
($ in millions)
Percent Percent Percent
2004 of Total 2003 of Total 2002 of Total
-------- -------- ------- -------- ------- --------
New Jersey $ 168.5 10.7 New Jersey $ 166.9 10.6 New Jersey $ 186.6 12.1
Pennsylvania 139.6 8.8 Ohio 140.1 8.9 Ohio 142.7 9.3
Ohio 135.7 8.6 Pennsylvania 129.1 8.2 Pennsylvania 119.0 7.8
Kentucky 131.5 8.3 Kentucky 122.0 7.8 Kentucky 115.4 7.5
Illinois 75.6 4.8 Illinois 81.1 5.2 Illinois 79.5 5.2
North Carolina 75.5 4.8 North Carolina 77.7 4.9 North Carolina 75.2 4.9
Maryland 73.2 4.6 Maryland 70.2 4.5 Indiana 63.2 4.1
Texas 70.2 4.4 Texas 65.7 4.2 Maryland 61.8 4.0
Indiana 56.6 3.6 New York 63.3 4.0 New York 57.9 3.8
New York 54.9 3.5 Indiana 60.9 3.9 Texas 55.9 3.6
-------- ----- ------- ------ ------- -----
$ 981.3 62.1 $ 977.0 62.2 $ 957.2 62.3
======== ===== ======= ====== ======= =====
(e) AVAILABLE INFORMATION
The Corporation's internet website is www.ocas.com. The Corporation provides a
hyperlink to the website of the Securities and Exchange Commission, www.sec.gov,
where the Corporation's Annual Report on Form 10-K, Quarterly Reports on Form
10-Q, Current Reports on Form 8-K, and all amendments to these reports (SEC
Reports) are available as soon as reasonably practicable after the Corporation
has electronically filed or furnished them to the SEC. The information contained
on the Corporation's website is not incorporated by reference into this Annual
Report on Form 10-K and should not be considered part of this report except as
stated in Part III, Item 10.
ITEM 2. PROPERTIES
The Corporation owns and leases office space in various parts of the country.
The principal office buildings consist of facilities owned in Fairfield and
Hamilton, Ohio. These office buildings service all of the Corporation's
segments. The Fairfield, Ohio office building is subject to a mortgage with an
outstanding balance of $3.2 million as of December 31, 2004. For additional
information related to the mortgage, refer to Footnote 16 in Item 15 on pages 69
and 70 of this Annual Report on Form 10-K.
ITEM 3. LEGAL PROCEEDINGS
A proceeding entitled Carol Murray v. Ohio Casualty Corporation, The Ohio
Casualty Insurance Co., Avomark Insurance Co., Ohio Security Insurance Co., West
American Insurance Co. (West American), American Fire and Casualty Insurance
Co., and OCNJ was filed in the United States District Court for the District of
Columbia on February 5, 2004. A motion to change venue was granted on May 25,
2004 with the proceeding assigned to the U.S. District Court for the Southern
District of Ohio, Eastern Division, Columbus, Ohio. The plaintiff, a former
automobile physical damage claim adjuster, originally sought to certify a
nationwide collective action consisting of all current and former salaried
employees since February 5, 2001 who are/were employed to process claims by
policyholders and other persons for automobile property damage. The plaintiff
has filed motions to expand the definition to include claim specialists,
representative trainees, and representatives performing claims adjusting
services. The complaint seeks overtime compensation for the plaintiff and the
class of persons plaintiff seeks to represent. The defendants deny the
allegations made in the complaint and are vigorously defending themselves.
14
ITEM 3. CONTINUED
A proceeding entitled Carol Lazarus v. The Ohio Casualty Group was brought
against West American in the Court of Common Pleas Cuyahoga County, Ohio on
October 25, 1999. The Court ordered the case to proceed solely against West
American on July 10, 2003. The complaint alleges West American improperly
charged for uninsured motorists coverage following an October 1994 decision of
the Supreme Court of Ohio in Martin v. Midwestern Insurance Company. The Martin
decision was overruled legislatively in September 1997. West American filed a
motion for summary judgment on December 16, 2003. Plaintiff filed a motion for
class certification on February 23, 2004. West American has responded to the
motion for class certification stating the motion is untimely (filed more than
four years after the initial complaint) and that Carol Lazarus failed to provide
sufficient evidence to satisfy the requirements for class certification.
A proceeding entitled Douglas and Carla Scott v. The Ohio Casualty Insurance
Company, West American, American Fire and Casualty Company, and Ohio Security
Company was filed in the District Court of Tulsa County, State of Oklahoma and
served on January 3, 2005. The proceeding challenges the use of a certain vendor
in valuing total loss automobiles. Plaintiff alleges that use of the database
results in valuations to the detriment of the insureds. Plaintiff is seeking
class status and alleges breach of contract, fraud and bad faith. The lawsuit is
in its early stages and will be vigorously defended.
The proceedings described above and various other legal and regulatory
proceedings are currently pending that involve the Corporation and specific
aspects of the conduct of its business. The outcome of these proceedings is
currently unpredictable. However, at this time, based on their present status,
it is the opinion of management that the ultimate liability, if any, in one or
more of these proceedings in excess of amounts currently reserved is not
expected to have a material adverse effect on the financial condition, liquidity
or results of operation of the Corporation.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SHAREHOLDERS
There were no matters submitted during the fourth quarter of the Corporation's
2004 fiscal year to a vote of Shareholders through the solicitation of proxies
or otherwise.
15
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND
ISSUER PURCHASES OF EQUITY SECURITIES
(a) The Corporation's common shares, par value $0.125 per share, are traded on
the Nasdaq Stock Market under the symbol OCAS. The following table shows
the high and low sales prices for the Corporation's common shares for each
quarterly period within the Corporation's last three most recent fiscal
years:
High/Low Market Price Per Share
(in dollars)
Quarter 1st 2nd 3rd 4th
----- ----- ----- -----
2004 High 20.25 20.93 20.95 23.53
Low 17.00 17.80 18.47 19.30
2003 High 13.25 14.66 15.14 17.79
Low 11.38 11.58 12.95 14.13
2002 High 19.50 22.24 20.90 18.40
Low 15.00 18.21 15.56 11.01
(b) On March 1, 2005, the Corporation's common shares were held by 4,724
shareholders of record.
(c) The Corporation's Board of Directors discontinued the Corporation's
regular quarterly dividend in February, 2001. For further discussion
regarding restrictions on the payment of dividends by the Corporation,
refer to Item 7, Management Discussion and Analysis of Financial Condition
and Results of Operation on page 33 of this Annual Report on Form 10-K.
(d) Incorporated by reference herein from those portions of the Corporation's
Proxy Statement for the Annual Meeting of Shareholders of the Corporation
for 2005 under the heading "Equity Compensation Plans."
16
ITEM 6. SELECTED FINANCIAL DATA
FIVE-YEAR SUMMARY OF OPERATIONS
(ALL AMOUNTS ARE IN ACCORDANCE WITH GAAP UNLESS OTHERWISE NOTED; NUMBER OF
WEIGHTED AVERAGE SHARES AND DOLLARS IN MILLIONS, EXCEPT SHARE AND PER SHARE
DATA)
2004 2003 2002 2001 2000
--------- --------- --------- --------- ---------
CONSOLIDATED OPERATIONS
Premiums and finance charges earned $ 1,446.8 $ 1,424.4 $ 1,450.5 $ 1,506.7 $ 1,534.0
Investment income, less expenses 201.2 208.7 207.1 212.4 205.1
Investment gains (losses) realized, net 23.0 35.9 45.2 182.9 (2.4)
--------- --------- --------- --------- ---------
Total revenues 1,671.0 1,669.0 1,702.8 1,902.0 1,736.7
Total expenses 1,484.5 1,561.4 1,709.5 1,775.6 1,866.4
Income (loss) before cumulative effect
of an accounting change 130.0 75.8 (0.9) 98.6 (79.2)
--------- --------- --------- --------- ---------
Cumulative effect of accounting change (1.6) - - - -
--------- --------- --------- --------- ---------
NET INCOME (LOSS) $ 128.4 $ 75.8 $ (0.9) $ 98.6 $ (79.2)
========= ========= ========= ========= =========
INCOME (LOSS) AFTER TAXES PER AVERAGE SHARE
OUTSTANDING - DILUTED*
Income (loss) before cumulative effect
of an accounting change $ 1.91 $ 1.18 $ (0.01) $ 1.64 $ (1.32)
Cumulative effect of accounting change (0.02) - - - -
--------- --------- --------- --------- ---------
NET INCOME (LOSS) $ 1.89 $ 1.18 $ (0.01) $ 1.64 $ (1.32)
========= ========= ========= ========= =========
Average shares outstanding - diluted* 71.5 70.2 60.5 60.2 60.1
Total assets $ 5,715.0 $ 5,168.9 $ 4,779.0 $ 4,524.6 $ 4,489.4
Total debt 383.3 198.0 198.3 210.2 220.8
Shareholders' equity 1,294.9 1,145.8 1,058.7 1,080.0 1,116.6
Book value per share 20.82 18.80 17.43 17.97 18.59
Dividends per share - - - - 0.59
PROPERTY AND CASUALTY OPERATIONS
Net premiums written(1) $ 1,453.9 $ 1,441.6 $ 1,448.6 $ 1,472.2 $ 1,505.4
Net premiums earned 1,446.8 1,424.4 1,450.5 1,506.7 1,533.4
Statutory loss ratio(2) 53.8% 59.7% 62.2% 66.5% 72.8%
Statutory loss adjustment expense ratio(3) 10.7% 12.3% 15.7% 13.4% 11.6%
Statutory underwriting expense ratio(4) 33.9% 34.1% 34.9% 35.4% 34.8%
Statutory combined ratio(5) 98.4% 106.1% 112.8% 115.3% 119.2%
Property and casualty reserves
Unearned premiums $ 715.5 $ 703.0 $ 668.7 $ 666.8 $ 696.4
Losses 2,269.6 2,163.7 1,978.8 1,746.8 1,627.6
Loss adjustment expenses 486.8 464.1 454.9 403.9 376.0
Statutory policyholders' surplus(6) $ 972.0 $ 867.6 $ 725.7 $ 767.5 $ 812.1
(1) Net premiums written are premiums for all policies sold during a specific
accounting period less premiums returned.
(2) Statutory loss ratio measures net losses incurred as a percentage of net
premiums earned based upon statutory accounting principals.
(3) Statutory loss adjustment expense ratio measures loss adjustment expenses as
a percentage of net premiums earned based upon statutory accounting
principals.
(4) Statutory underwriting expense ratio measures underwriting expenses as a
percentage of net premiums written based upon statutory accounting
principals.
(5) Statutory combined ratio measures the percentage of premium dollars used to
pay insurance losses, loss adjustment expenses and underwriting expenses
based upon statutory accounting principals.
(6) Statutory policyholders' surplus is equal to an insurance company's admitted
assets minus liabilities based upon statutory accounting principals.
* Adjusted for effect of EITF Issue No. 04-8 in 2004, 2003 and 2002, see
Footnote 10, Earnings Per Share.
17
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATION
Ohio Casualty Corporation (the Corporation) is the holding company of The Ohio
Casualty Insurance Company (the Company), which is one of six property-casualty
companies that make up the Ohio Casualty Group (the Group). All dollar amounts
in this Management Discussion and Analysis (MD&A) are in millions unless
otherwise noted.
The following discussion of financial condition and results of operation
highlights significant factors influencing the consolidated results and
financial position of the Corporation. This discussion should be read in
conjunction with the consolidated financial statements and related notes, all of
which are integral parts of the following analysis of the results of operations
and financial position.
EXECUTIVE-LEVEL OVERVIEW
The Corporation earns revenue by providing businesses and consumers with
competitive insurance products with high quality service and by income on funds
invested. In 2004, the Corporation achieved meaningful improvement in financial
performance. Net income increased in 2004 compared to 2003 as a result of a
better priced book of business through realization of price increases in certain
lines and an improved risk profile as a result of more disciplined underwriting.
The statutory expense ratio continued to improve as a result of expense
management initiatives. The statutory combined ratio was the best since 1980.
The 2004 All Lines statutory combined ratio improved to 98.4% compared to 106.1%
in 2003 as a result of significantly improved loss experience, including lower
loss adjustment expenses (LAE) because of our cost reduction programs, which are
continuing into 2005. The improved loss experience is the result of disciplined
underwriting and enhanced pricing methodologies the Corporation continues to
develop and implement. In addition, the Corporation experienced favorable prior
years reserve development for the first year since 1998. While full year 2004
premiums increased only slightly when compared to the prior year, the Group's
risk profile has improved as the focus was on disciplined underwriting,
improving pricing methodologies and driving operational efficiencies and expense
reductions throughout the organization. The results of this focus and effort are
discussed throughout the following sections.
In September 2003, the Corporation announced its Corporate Strategic Plan for
the 2004-2006 time frame. The plan brings together five broad objectives to help
achieve the Corporation's Vision to be a leading super regional Property and
Casualty carrier providing a broad range of products/services through
independent agents and brokers. The broad objectives include abilities to
generate above market growth, produce competitive loss ratios, create a
competitive expense structure, achieve a competitive return on equity and
improve credit ratings and financial flexibility. Competitive advantages include
strong agency relationships, especially with key agents, and technology
platforms that provide operating flexibility. Technology is being leveraged to
make it easier for agents to do business with the Group and to increase pricing
and underwriting sophistication. The Corporation continues to execute against
this plan and the Corporation's results in 2004 are an indication that the plan
and its execution are working.
The key financial indicators management utilizes consist of statutory combined
ratios and component ratios on both a calendar year and accident year basis,
gross and net written premium growth, impact of catastrophes, renewal price
increases and investment income growth.
RESULTS OF OPERATIONS
NET INCOME
The Corporation reported net income of $128.4, or $1.89 per share, for 2004,
compared with $75.8, or $1.18 per share, for the year 2003, and a net loss of
$0.9, or $0.01 per share, in 2002. The Corporation reported operating income of
$115.1, or $1.71 per share, for 2004, compared with $52.5, or $0.84 per share,
for the year 2003 and an operating loss of $30.3, or $0.50 per share, for 2002.
18
ITEM 7. CONTINUED
Management of the Corporation believes the significant volatility of realized
investment gains and losses limits the usefulness of net income (loss) as a
measure of current operating performance. Accordingly, management uses the
non-GAAP financial measure of operating income (loss) to further evaluate
current operating performance. Operating income (loss), both in dollar amount
and per share amount, is reconciled to net income (loss) in the table below:
December 31
2004 2003 2002
------- ----- -------
Operating income (loss) $115.1 $52.5 $ (30.3)
After-tax net realized gains 14.9 23.3 29.4
Cumulative effect of accounting change (1.6) - -
------ ----- -------
Net income (loss) $128.4 $75.8 $ (0.9)
====== ===== =======
Operating income/(loss) per
share - diluted $ 1.71 $0.84 $ (0.50)
After-tax net realized gains
per share - diluted 0.20 0.34 0.49
Cumulative effect of accounting change
per share - diluted (0.02) - -
------ ----- -------
Net income (loss) per share - diluted $ 1.89 $1.18 $ (0.01)
====== ===== =======
The Corporation adopted the Emerging Issues Task Force ("EITF") Consensus 04-8
"The Effect of Contingently Convertible Debt on Diluted Earnings per Share" in
December 2004 and as required by the EITF restated the average diluted shares
outstanding and diluted net income per share for each of the three years
presented in this MD&A using the "if-converted" method. The impact of the
adoption of the EITF was a reduction to diluted net income per share of $0.16
and $0.06 for the years ended December 31, 2004 and 2003, respectively. The
impact of this EITF on operating income per share was a reduction of $0.13 and
$0.02 for the years ended December 31, 2004 and 2003, respectively. The year
ended December 31, 2002 was not restated for either net income or operating
income per share as the Corporation incurred a net loss during that year, which
resulted in the calculation being anti-dilutive.
The improved financial results for 2004 were driven by significantly improved
loss experience, including lower LAE, a result of cost reduction programs that
have been implemented. The improved loss and LAE ratios are the result of
disciplined underwriting and improved pricing methodologies, reduced claim
frequency, a decline in large losses (losses greater than $250,000 per loss) and
favorable prior years reserve development. Catastrophe losses decreased $0.3 in
2004 to $43.5. During 2004, underwriting and loss adjustment expenses were
impacted by increased severance and other related costs, primarily associated
with the Cost Structure Efficiency (CSE) initiative and expenses related to the
Proformance transaction. As previously discussed, in 2001 OCNJ entered into a
transaction which effectively exited the Group from the New Jersey private
passenger auto market. Based upon data through December 31, 2003 as provided by
Proformance in the first quarter of 2004, the Group estimated and accrued $9.0
(of which $6.8 was paid in July 2004) related to this obligation. During the
second half of 2004, the Group accrued an additional $6.6. At December 31, 2004,
the Group has $8.8 accrued in the consolidated financial statements for any
possible additional liability that may be incurred based upon the final
liability calculation using Proformance's 2004 results. This amount, which is
management's best estimate of the liability, reflects the maximum additional
amount that could be required to be paid to Proformance. The Group expects to
resolve the final settlement to be paid to Proformance relative to the surplus
guarantee in the first half of 2005. For additional information on this
transaction, see Item 15, Notes to Consolidated Financial Statements, Footnote 8
on pages 64 and 65 of this Annual Report on Form 10-K.
Decreases in personnel and sales related expenses led to the improved results
for 2003 compared with 2002. Staff reductions of 11.2% in 2003 compared to 2002
were the result of the claim department reorganization and the Lexington and
Indianapolis underwriting offices being consolidated into other locations. The
loss ratio improved in 2003 due to tighter underwriting standards and an
improved risk profile. In addition, development on prior accident years' losses
and LAE decreased $50.3 before tax from 2002 to $34.1 before tax in 2003. These
improved results were offset by increased catastrophe losses during 2003.
Catastrophe losses before tax more than doubled to $43.8 in 2003 from $20.8 in
2002 resulting from storms that swept through the Midwest
19
ITEM 7. CONTINUED
and the effects of Hurricane Isabel. During 2002, the increase in provision for
prior accident years' losses and LAE totaled $84.4 before tax and was
concentrated in the general liability, commercial auto and personal auto product
lines. The majority of the charge, $62.2 before tax, occurred in the third
quarter and was primarily related to construction defect claims for residential
developers and contractors. The Group continues to address this specific type of
business for non-renewal. For further discussion, refer to the "Loss and Loss
Adjustment Expenses" section under "Liquidity and Capital Resources" on pages
39-41 of this MD&A.
INVESTMENT RESULTS
Consolidated before-tax net investment income was $201.2 in 2004, compared with
$208.7 in 2003 and $207.1 in 2002. The decrease in 2004 consolidated before-tax
net investment income of $7.5 is attributable to reinvestment yields being below
average portfolio yields, the strategic decision to invest, or reinvest, more of
the portfolio into tax exempt fixed maturities, increased investment expenses
attributable to outside management fees and the allocation of interest income
pertaining to investments held in the reinsurance treaty fund as part of the
Group's reinsurance program. This decrease is partially offset by larger average
portfolio holdings during 2004 than in 2003 and a favorable amortization
adjustment on certain fixed income securities, with a portion of this adjustment
representing a reclassification from realized gains. The change in investment
strategy to invest more into tax exempt securities is the result of improved
profitability. This change in investment strategy will result in the
Corporation's and the Group's before-tax investment income declining when
compared to prior periods when the strategy was to invest in taxable securities.
As a result of this strategy, the Corporation's and the Group's effective tax
rate on investment income will be lower when compared to these prior periods.
The increase in 2003 consolidated before-tax net investment income of $1.6 is
attributable to an increase in investment assets held, partially offset by
increased investment expenses attributable to the implementation of a new
investment accounting system, lower average yields on its fixed income
portfolio, and increased investment management fees from expanded use of outside
investment managers. As part of a conversion to a new investment accounting
system in 2003, before tax investment income was reduced by $5.9 as a result of
a change in accounting estimate relating to amortization of interest only
mortgage-backed and asset-backed securities. Offsetting most of this charge was
a $5.3 credit for interest received on a federal income tax settlement.
Consolidated before-tax realized net investment gains amounted to $23.0, $35.9
and $45.2 for the years ended 2004, 2003 and 2002, respectively. During 2004,
2003 and 2002, there were no significant realized losses on sales of securities.
In the first quarter of 2003, management decided to transfer a portion of its
fixed maturity securities from the available-for-sale classification into the
held-to-maturity classification. This transfer was made as the Corporation and
the Group have both the ability to hold the securities to maturity and the
positive intent to do so. At December 31, 2004, the amortized cost of the
held-to-maturity portfolio was $301.4.
Invested assets comprise a majority of the consolidated assets. Consequently,
accounting policies related to investments are critical. See further discussion
of important investment accounting policies in the "Critical Accounting
Policies" section of this MD&A and in Item 15, Notes to Consolidated Financial
Statements, Footnote 1C on page 54 of this Annual Report on Form 10-K. The
Corporation and the Group continually evaluate all of their investments based on
current economic conditions, credit loss experience and other developments. The
difference between the cost and estimated fair value of investments is
continually evaluated to determine whether a decline in value is temporary or
other than temporary in nature. This determination involves a degree of
uncertainty. If a decline in the fair value of a security is determined to be
temporary, the decline is recorded as an unrealized loss, net of tax, in
shareholders' equity. If there is a decline in a security's fair value that is
considered to be other than temporary, the security is written down to the
estimated fair value with a corresponding realized loss recognized in the
consolidated statements of income.
The assessment of whether a decline in fair value is considered temporary or
other-than-temporary includes management's judgement as to the financial
position and future prospects of the entity issuing the security. It is not
possible to accurately predict when it may be determined that a specific
security will become impaired.
20
ITEM 7. CONTINUED
Future impairment charges could be material to the results of operations. The
amount of the before-tax other-than-temporary impairment charge recorded was
$8.7, $10.5 and $10.9 for the years ended 2004, 2003 and 2002, respectively.
This impairment charge represents less than 0.5% of the market value of the
investment portfolio at December 31, 2004, 2003 and 2002, respectively. Included
in both the 2004 and 2003 impairment charges were $5.1 and $5.9, respectively,
related to fixed maturity securities issued by companies in the airline
industry, Delta Air Lines, Inc. and AMR Corporation specifically.
The following tables summarize for all available-for-sale and held-to-maturity
securities, the total gross unrealized losses, excluding gross unrealized gains,
by investment category and length of time the securities have continuously been
in an unrealized loss position as of December 31, 2004 and December 31, 2003:
2004
Available-for-sale securities with unrealized losses:
Less than 12 months 12 months or longer Total
---------------------- ---------------------- ----------------------
Fair Value Unrealized Fair Value Unrealized Fair Value Unrealized
Losses Losses Losses
---------- ---------- ---------- ---------- ---------- ----------
Securities:
States, municipalities and
political subdivisions $187.8 $(0.7) $ - $ - $187.8 $(0.7)
Corporate securities 97.7 (1.1) 9.8 (0.3) 107.5 (1.4)
Mortgage-backed
securities:
Other 88.4 (1.2) 16.5 (0.3) 104.9 (1.5)
------ ----- ------- ----- ------ -----
Total fixed maturities 373.9 (3.0) 26.3 (0.6) 400.2 (3.6)
Equity securities 9.6 (0.7) - - 9.6 (0.7)
Short term investments 177.4 (0.8) - - 177.4 (0.8)
------ ----- ------- ----- ------ -----
Total temporarily impaired
securities $560.9 $(4.5) $ 26.3 $(0.6) $587.2 $(5.1)
====== ===== ======= ===== ====== =====
Held-to-maturity securities with unrealized losses:
Less than 12 months 12 months or longer Total
---------------------- ---------------------- ----------------------
Fair Value Unrealized Fair Value Unrealized Fair Value Unrealized
Losses Losses Losses
---------- ---------- ---------- ---------- ---------- ----------
Securities:
Corporate securities $ 85.8 $ (1.0) $ - $ - $ 85.8 $ (1.0)
Mortgage-backed
securities:
Other 66.8 (0.7) 9.9 (0.1) 76.7 (0.8)
---------- --------- ---------- --------- ---------- ---------
Total temporarily impaired
securities $ 152.6 $ (1.7) $ 9.9 $ (0.1) $ 162.5 $ (1.8)
========== ========= ========== ========= ========== =========
21
ITEM 7. CONTINUED
2003
Available-for-sale securities with unrealized losses:
Less than 12 months 12 months or longer Total
---------------------- ---------------------- ----------------------
Unrealized Unrealized Unrealized
Fair Value Losses Fair Value Losses Fair Value Losses
---------- ---------- ---------- ---------- ---------- ----------
Securities:
U.S. Government $ 14.8 $ (0.1) $ - $ - $ 14.8 $ (0.1)
States, municipalities and
political subdivisions 9.0 (0.2) - - 9.0 (0.2)
Corporate securities 248.4 (6.5) 37.0 (1.9) 285.4 (8.4)
Mortgage-backed
securities:
Other 242.2 (6.8) 19.2 (1.2) 261.4 (8.0)
---------- --------- ---------- --------- ---------- ---------
Total temporarily impaired
securities $ 514.4 $ (13.6) $ 56.2 $ (3.1) $ 570.6 $ (16.7)
========== ========= ========== ========= ========== =========
Held-to-maturity securities with unrealized losses:
Less than 12 months 12 months or longer Total
---------------------- ---------------------- ----------------------
Unrealized Unrealized Unrealized
Fair Value Losses Fair Value Losses Fair Value Losses
---------- ---------- ---------- ---------- ---------- ----------
Securities:
Corporate securities $ 106.0 $ (1.8) $ 5.0 $ (0.2) $ 111.0 $ (2.0)
Mortgage-backed
securities:
Other 115.7 (1.9) 27.7 (0.6) 143.4 (2.5)
---------- --------- ---------- --------- ---------- ---------
Total temporarily impaired
securities $ 221.7 $ (3.7) $ 32.7 $ (0.8) $ 254.4 $ (4.5)
========== ========= ========== ========= ========== =========
Management believes that it will recover the cost basis in the securities held
with unrealized losses as it has both the intent and ability to hold the
securities until they mature or recover in value. Securities are sold to achieve
management's investment goals, which include the diversification of credit risk,
the maintenance of adequate portfolio liquidity, a competitive investment yield
and the management of interest rate risk. In order to achieve these goals, sales
of investments are based upon current market conditions, liquidity needs and
estimates of the future market value of the individual securities.
As part of its evaluation of the aggregate $6.9 unrealized loss on securities in
the investment portfolio at December 31, 2004, management performed a more
intensive review of securities with a higher unrealized loss percentage when
compared with their cost or amortized cost. Based on this review of each
security, management believes that unrealized losses on these securities were
temporary declines in value at December 31, 2004. In the table above, there are
approximately 180 securities represented. Of this total, 7 securities have
unrealized loss positions greater than 5% of their market values at December 31,
2004, with none exceeding 25%. This group represents $0.8, or 11.6% of the total
unrealized loss position. Of this group, 3 securities representing approximately
$0.6 in unrealized losses have been in an unrealized loss position for less than
twelve months. Of the remaining 4 securities in an unrealized loss position for
longer than twelve months totaling $0.2, management believes they will recover
the cost basis of these securities, and has both the intent and ability to hold
the securities until they mature or recover in value. All securities are
monitored by portfolio managers who consider many factors such as an issuer's
degree of financial flexibility, management competence and industry fundamentals
in evaluating whether the decline in fair value is temporary. In addition,
management considers whether it is probable that all contract terms of the
security will be satisfied and whether
22
ITEM 7. CONTINUED
the unrealized loss position is due to changes in the interest rate environment.
Should management subsequently conclude the decline in fair value is other than
temporary, the book value of the security is written down to fair value with the
realized loss recognized in the consolidated statements of income.
The amortized cost and estimated fair value of fixed maturity securities
classified as available-for-sale and held-to-maturity with an unrealized loss
position at December 31, 2004, by contractual maturity, are shown below.
Expected maturities will differ from contractual maturities because borrowers
may have the right to call or prepay obligations with or without call or
prepayment penalties.
2004
Available-for-sale:
Amortized Estimated Unrealized
Cost Fair Value Loss
--------- ---------- ----------
Due in one year or less $ - $ - $ -
Due after one year through five years 27.3 27.2 (0.1)
Due after five years through ten years 156.4 155.4 (1.0)
Due after ten years 113.7 112.7 (1.0)
Mortgage-backed securities 106.4 104.9 (1.5)
--------- ---------- ---------
Total $ 403.8 $ 400.2 $ (3.6)
========= ========== =========
Held-to-maturity:
Amortized Estimated Unrealized
Cost Fair Value Loss
--------- ---------- ----------
Due in one year or less $ 2.1 $ 2.1 $ (0.0)
Due after one year through five years 24.0 23.8 (0.2)
Due after five years through ten years 52.3 51.7 (0.6)
Due after ten years 8.4 8.2 (0.2)
Mortgage-backed securities 77.5 76.7 (0.8)
--------- ---------- ---------
Total $ 164.3 $ 162.5 $ (1.8)
========= ========== =========
For additional discussion relative to the Corporation's investment portfolio,
see the "Investment Portfolio" section under "Liquidity and Capital Resources"
on pages 43 and 44 of this MD&A.
AGENT RELATIONSHIPS ASSET
The Corporation maintains an identifiable intangible asset referred to as "Agent
Relationships." See the "Critical Accounting Policies" section of this MD&A on
page 32 for additional information. In 2004, the before-tax amortization and
impairment costs related to this asset were $20.6 compared with $18.7 in 2003
and $79.7 in 2002. At December 31, 2004, the largest individual agent asset
carrying value was $5.6, which represents the maximum future impairment charge
for an individual agent, compared to $5.9 at December 31, 2003. Based upon
historical performance of this agent, it is unlikely the agent will become
impaired or cancelled in the near term. For the approximately 250 individual
agents remaining that represent the total agent relationships intangible asset,
the average asset carrying value as of December 31, 2004, was $0.5 which
compares to approximately 300 agents with an average asset carrying value of
$0.5 at December 31, 2003. The larger than usual impairment charge in 2002 was
due primarily to the recognition that certain agents experienced sustained
premium revenue trends that were significantly different from prior estimates,
resulting in changes in estimated future cash flows for those agents.
INTERNALLY DEVELOPED SOFTWARE
The Group has introduced into production, for certain lines of business, an
internally developed software application for issuing and maintaining insurance
policies named P.A.R.I.S.(sm), a policy administration, rating and issuance
system. During 2004 and 2003, the Group capitalized application development
costs associated with the Personal Lines segment, which is expected to begin
rollout in 2006. In addition, in December 2004, the Group began rollout for the
Specialty Lines segment. The Specialty Lines segment rollout is expected to
continue throughout 2005. During 2002, the Group substantially completed the
rollout for the Commercial Lines operating segment. A rollout begins when the
application has been placed into service for one or more states for an
individual major product line and ends when the application is placed into
service for the final state. The rollout period can exceed one year for an
individual major product line. The Group capitalizes costs incurred during the
application development stage, primarily relating to payroll and payroll-related
costs for employees,
23
ITEM 7. CONTINUED
along with costs incurred for external consultants who are directly associated
with the internal-use software project. The cost associated with this
application is amortized on a straight-line basis over the estimated useful life
of ten years from the date placed into service with before-tax amortization
expense of $3.1, $2.6 and $1.3 for 2004, 2003 and 2002, respectively.
Capitalized internally developed software costs (including P.A.R.I.S.(sm) and
other internally developed software) and accumulated amortization are summarized
in the table below:
2004 2003
----- -----
Cost $55.2 $52.0
Accumulated amortization 11.4 7.2
----- -----
Carrying value $43.8 $44.8
===== =====
For additional information relative to the internally developed software, see
the "Critical Accounting Policies" section of this MD&A on page 32.
ALL LINES DISCUSSION
STATUTORY RESULTS
Management uses statutory financial data to analyze the Group's property and
casualty results and insurance industry regulators require the Group to report
statutory financial measures. Management analyzes statutory results of
operations through the use of insurance industry financial measures including
statutory loss and LAE ratios, statutory underwriting expense ratio, statutory
combined ratio, net premiums written and net premiums earned. The statutory
combined ratio is a commonly used gauge of underwriting performance measuring
the percentage of premium dollars used to pay insurance losses and related
expenses. The combined ratio is the sum of the loss, LAE and underwriting
expense ratios. All references to combined ratio or its components in the MD&A
are calculated on a statutory accounting basis and are calculated on a calendar
year basis unless specified as calculated on an accident year basis. A
discussion of the differences between statutory accounting and generally
accepted accounting principles in the United States is included in Item 15,
Notes to Consolidated Financial Statements, Footnote 15 on page 69 of this
Annual Report on Form 10-K.
Insurance industry financial measures are included in the next several sections
of this MD&A that discuss results of operations. Statutory surplus, a financial
measure that is required by insurance regulators and used to monitor financial
strength, is discussed in the "Statutory Surplus" section of the "Liquidity and
Capital Resources" section on page 37 of this MD&A.
PREMIUM REVENUE RESULTS
Premium revenue reflects premiums earned by the Group. The Group's premiums are
earned principally on a monthly pro rata basis over the term of the policy.
Management analyzes premium revenues primarily by premiums written in the
current period. Net premiums written differ from gross premiums written by
premiums ceded to reinsurers.
The table below summarizes property and casualty premiums on a gross and net
basis compared with the same period of the prior year for 2004, 2003 and 2002,
respectively:
% Chg % Chg
December 31, 2004 2003
2004 2003 2002 vs. 2003 vs. 2002
--------- ------------ -------- -------- --------
GROSS PREMIUMS WRITTEN
Commercial Lines $ 856.2 $ 824.4 $ 796.6 3.8% 3.5%
Specialty Lines 251.5 271.9 235.2 (7.5)% 15.6%
Personal Lines 496.7 494.1 520.6 0.5% (5.1)%
--------- ------------ --------
All Lines $ 1,604.4 $ 1,590.4 $1,552.4 0.9% 2.4%
========= ============ ========
24
ITEM 7. CONTINUED
% Chg % Chg
December 31, 2004 2003
2004 2003 2002 vs. 2003 vs. 2002
--------- ------------ -------- -------- --------
NET PREMIUMS WRITTEN
Commercial Lines $ 828.2 $ 792.6 $ 762.2 4.5% 4.0%
Specialty Lines 135.5 164.9 179.9 (17.8)% (8.3)%
Personal Lines 490.2 484.1 506.5 1.3% (4.4)%
--------- ------------ --------
All Lines $ 1,453.9 $ 1,441.6 $1,448.6 0.8% (0.5)%
========= ============ ========
Statutory net premiums written increased $12.3 in 2004 to $1,453.9. The increase
in statutory net premiums written over 2003 reflects the Group's improved
retention ratios and price increases. Net premiums written for 2004 include
negative impacts for higher reinsurance costs and lower new business production.
Net premiums written totaled $1,441.6 in 2003 and $1,448.6 in 2002. The slight
decline of net premiums written in 2003 when compared to 2002 is primarily
attributable to the Group's withdrawal from select markets and implementation of
stricter underwriting guidelines, including the non-renewal of certain
construction defect related risks. In addition, the decline in net premiums
written from 2002 to 2003 reflects the impact of higher reinsurance costs.
The Group's business is geographically concentrated in the Mid-West and
Mid-Atlantic regions. The following table shows consolidated net premiums
written for the Group's five largest states for each of the last three years:
All Lines Net Premiums Written Distributed by Top States
2004 2003 2002
----- ----- -----
New Jersey 11.5% 11.1% 12.5%
Pennsylvania 9.1% 8.5% 7.9%
Ohio 8.9% 9.2% 9.4%
Kentucky 8.8% 8.2% 7.7%
Illinois 4.9% 5.3% 5.3%
New Jersey remains the Group's largest state, with 11.5% of the total net
premiums written during 2004, even after the Group ceased writing in the New
Jersey private passenger auto and personal umbrella markets in early 2002. The
Group continues to underwrite other product lines in the New Jersey market.
Commercial Lines gross and net premiums written increased in 2004 and 2003, a
result of policy renewal rate increases as new business gross written premium
has remained relatively flat. Renewal pricing increased during 2004, 2003 and
2002, but the rate of increase slowed as the Commercial Lines segment approached
price adequacy and competitive pricing pressures in the marketplace have
increased. The 2004 average renewal price increase 1 was 5.0% for Commercial
Lines direct premiums written, compared with 11.4% and 16.3% average renewal
price increases in 2003 and 2002, respectively.
Specialty Lines gross and net premiums written decreased in 2004, a result of
lower new business production and higher reinsurance costs in the commercial
umbrella product line partially offset by growth in the fidelity and surety
product line. Net premiums written for the commercial umbrella product line
decreased $33.8 or 28.0% in 2004 to $87.1, compared with $120.9 in 2003 and
$132.7 in 2002. Fidelity and surety net premiums written increased 10.2% to
$48.4 million, compared to $43.9 million and $45.6 million in 2003 and 2002,
respectively. Stricter underwriting guidelines for certain classes of business
and market prices falling below what the Group believes are acceptable levels,
contributed to the decline in new business production for the commercial
umbrella product line. The net premiums written decline from 2002 to 2003 was
impacted by higher reinsurance costs, including the addition of a ceding
commission and increased reinsurance rates per dollar of premium. The addition
of ceding commissions on the 2003 and 2004 reinsurance contracts causes a
corresponding increase to ceded premiums. Average renewal price increases for
the commercial umbrella product line were 8.0%, compared to 18.1% in 2003 and
37.6% in 2002.
(1) When used in this report, renewal price increase means the average increase
in premium for policies renewed by the Group. The average increase in premiums
for each renewed policy is calculated by comparing the total expiring premium
for the policy with the total renewal premium for the same policy. Renewal price
increases include, among other things, the effects of rate increases and changes
in the underlying insured exposures of the policy. Only policies issued by the
Group in the previous policy term with the same policy identification codes are
included. Therefore, renewal price increases do not include changes in premiums
for newly issued policies and business assumed through reinsurance agreements,
including Great American business not yet issued in the Group's systems in 2002.
Renewal price increases also do not reflect the cost of any reinsurance
purchased on the policies issued.
25
ITEM 7. CONTINUED
Personal Lines gross premiums written remained relatively flat during 2004 and
net premiums written increased $6.1. Both gross and net premiums written were
reduced in 2004 due to a refund of escrowed premiums for North Carolina personal
auto of $2.2. The personal auto including personal umbrella product line net
premiums written decreased $2.7 to $294.1 in 2004 compared to $296.8 and $324.6
in 2003 and 2002, respectively. The decrease in Personal Lines gross and net
premiums written from 2002 to 2003 is driven by the withdrawal from New Jersey
private passenger auto, which began in 2002, and the Group's continued effort to
narrow the geographic focus for Personal Lines products.
The following table provides key financial measures for All Lines for each of
the last three years:
December 31
2004 2003 2002
---- ----- -----
All Lines
Loss ratio 53.8% 59.7% 62.2%
Loss adjustment expense ratio 10.7% 12.3% 15.7%
Underwriting expense ratio 33.9% 34.1% 34.9%
---- ----- -----
Combined ratio 98.4% 106.1% 112.8%
==== ===== =====
The All Lines combined ratio improved 7.7 points driven by a 7.5 point
improvement in the loss and LAE ratios. The loss and LAE ratio was impacted by
favorable prior year reserve development of $21.7 in 2004 compared to adverse
reserve development of $34.1 in 2003, which reduced the 2004 loss and LAE ratio
by 1.4 points and increased the 2003 loss and LAE ratio by 2.4 points. The
remaining improvement of 3.7 points in the 2004 loss and LAE ratio over 2003 was
due to improved price adequacy, more disciplined underwriting standards and
improved claims efficiency. The underwriting expense ratio improved 0.2 points
as a result of operational efficiencies implemented throughout 2003 and 2004,
somewhat offset by $15.6, or 1.1 points of expense related to the Proformance
surplus guarantee.
The All Lines combined ratio improved 6.7 points in 2003 compared to 2002 with
an improved underwriting expense ratio as well as lower loss and LAE ratios each
contributing to the improvement. The All Lines combined ratio was impacted by
$34.1 of adverse prior year reserve development, a $50.3 reduction from 2002.
The 2003 combined ratio benefited from a reduction in personnel and sales
related expenses, somewhat offset by increased expenses for technology including
amortization of internally developed software.
The loss and LAE ratio components of the accident year combined ratio measure
losses and LAE arising from insured events that occurred in the respective
accident year. The current accident year excludes losses and LAE for insured
events that occurred in prior accident years.
The table below summarizes the impact of changes in provision for all prior
accident year losses and LAE for each of the last three years:
2004 2003 2002
-------- -------- --------
Statutory net liabilities, beginning of period $2,128.9 $2,078.7 $1,982.0
Increase in provision for prior accident
year claims $ (21.7) $ 34.1 $ 84.4
Increase in provision for prior accident
year claims as % of premiums earned (1.4)% 2.4% 5.8%
In 2004, the impact of the favorable development for prior accident years'
losses and LAE was concentrated in the Commercial and Specialty Lines operating
segments. In 2004, the Specialty Lines segment experienced significant favorable
development for prior years' losses and LAE, primarily due to a reduction in
estimated future costs for claims adjuster related expenses. The total provision
reduction for prior years' losses and LAE of $21.7 before-tax represents 1.0% of
loss and LAE reserves as of year-end 2003.
During 2003, the Group reported adverse development of $34.1 for prior years'
losses and LAE, representing 1.6% of loss and LAE reserves as of year-end 2002.
This adverse development was concentrated in the Commercial and Personal Lines
operating segments.
26
ITEM 7. CONTINUED
The comparable amount of adverse development for prior years' losses and LAE
recognized during 2002 was $84.4 before tax. This represents 4.3% of loss and
LAE reserves as of year-end 2001. The adverse development was concentrated in
the Commercial Lines operating segment.
The 2002 combined ratio includes a reallocation of LAE reserve estimates related
to claims adjuster salaries, benefits and similar costs from the Commercial and
Specialty Lines segments, to the Personal Lines segment. This increased the 2002
Personal Lines segment combined ratio by 1.5 points and decreased the Commercial
and Specialty Lines segments combined ratios by 0.6 and 2.4 points,
respectively.
Catastrophe losses in 2004, 2003 and 2002 were $43.5, $43.8 and $20.8,
respectively. The Group was impacted by 22 separate catastrophes in 2004,
compared with 21 catastrophes in 2003 and 25 in 2002. The Group uses the serial
number assigned by Property Claims Services, a unit of the Insurance Services
Office, to define and track losses for specific catastrophes. Property Claims
Services defines catastrophes as industry events that cause $25.0 or more in
direct insured losses to property. The effects of future catastrophes on the
Corporation's results cannot be accurately predicted. As such, severe weather
patterns, acts of war or terrorist activities could have a material adverse
impact on the Corporation's results, reinsurance pricing and availability of
reinsurance.
Catastrophe losses, net of reinsurance, for each of the last three years were:
Catastrophe Losses
(before tax) 2004 2003 2002
- ------------------ ------- ------- -------
Dollar Impact $ 43.5 $ 43.8 $ 20.8
Statutory Combined
Ratio Impact 3.0% 3.1% 1.4%
The seven-year historical catastrophe impact on the loss ratio compared to 2004
actual for all lines of business was:
Loss Ratio Point Impact Q1 Q2 Q3 Q4 Annual
- ---------------------------- ---- ---- ---- ---- ------
1997-2003 Historical Average 1.6% 4.7% 3.1% 0.8% 2.6%
2004 Actual 0.8 3.2 6.4 1.5 3.0
The underwriting expense ratio, which measures underwriting expenses as a
percentage of net premiums written, decreased by 0.2 points in 2004. The 2004
underwriting expense ratio was favorably impacted by a reduction in employee
related costs, a non-recurring reduction in assessments, fees and premium taxes
and by other operating efficiencies. These improvements were partially offset by
1.1 points of expense related to the Proformance surplus guarantee, previously
discussed. The employee count continued to decline in 2004 with an approximate
18.0% reduction from 2003 as a result of the CSE initiative. The employee count
was 2,190, 2,669 and 3,004 as of December 31, 2004, 2003 and 2002, respectively.
The 2003 underwriting expense ratio was favorably impacted by a reduction in
employee related costs and lower sales related expenses as a percentage of
premiums, and was partially offset by higher expenses related to investments in
technology. Sales related expenses for 2003 included the resumption of a ceding
commission for certain layers of commercial umbrella reinsurance and agent bonus
commission levels which were higher than 2002.
The year 2002 underwriting expense ratio experienced upward pressure due to two
factors with a total impact of approximately 1.6 points. These two factors were
the non-renewal of the New Jersey private passenger auto business, which had
lower commission rates and lower variable processing costs than most other
business and the elimination of ceding commissions on umbrella premiums ceded to
reinsurers, which had reduced expenses in previous years. The 2002 commission
expense ratio, a component of the underwriting expense ratio, was at a
relatively high level due to higher than expected umbrella net premiums written,
which had a relatively high commission rate on a net of reinsurance basis and to
higher than expected accruals for agent bonus commissions.
27
ITEM 7. CONTINUED
The 2004, 2003 and 2002 statutory underwriting expenses also included $6.3, $5.2
and $2.6 of software amortization expense before tax, respectively, related to
the rollout of P.A.R.I.S.(sm). On a statutory accounting basis, the new
application is being amortized over a five-year period (compared to ten-year
period under GAAP) in accordance with statutory accounting principles. The
additional amortization expense is expected to be offset in part by reduced
labor costs related to underwriting and policy processing.
In 2001, the Group introduced into operation, after more than three years of
development, the Policy Administration Rating and Issuance System
(P.A.R.I.S.(sm)) for Commercial Lines. At the end of 2004, P.A.R.I.S.(sm) was
deployed for the Specialty Lines commercial umbrella excess capacity product
line. Further implementation for other Specialty and Personal Lines products is
expected during 2005 and 2006.
The P.A.R.I.S.(sm) system provides the policy administration environment used
internally by the Group's associates. An extension of P.A.R.I.S.(sm) called
P.A.R.I.S. Express(sm) leverages the P.A.R.I.S.(sm) system to provide
functionality to our agents. P.A.R.I.S. Express(sm) is a proprietary internet
interface that uses the P.A.R.I.S.(sm) system to provide real-time functionality
through a web browser to our agents. In addition, the Group is simultaneously
introducing P.A.R.I.S. Connect(sm) which allows agents to transact with the
Group directly from their agency management system.
For Commercial Lines, P.A.R.I.S. Express(sm) and P.A.R.I.S. Connect(sm)
currently provide agents with on-line quoting capability. In February of 2005
P.A.R.I.S. Express(sm) was extended to support issuance and endorsement
processing for selected pilot agents; nationwide roll-out is expected during
2005. Personal Lines currently offers on-line and real time quoting and issuance
for new business and endorsements through existing (non- P.A.R.I.S.(sm))
systems.
Agents want a cost effective, timely and simple system for issuing and
maintaining insurance policies. P.A.R.I.S. Express(sm) and P.A.R.I.S.
Connect(sm) are the cornerstone in the Group's strategy of focusing on superior
agent service. The success of this strategic plan depends in part on the ability
to provide agents with the technological advantages of these tools. If they do
not work as expected, or fail to satisfy agents' needs, the Group may lose
business to insurers with preferred technologies.
SEGMENT DISCUSSION
The Corporation is organized around three business units: Commercial, Specialty
and Personal Lines. These business units represent the Corporation's operating
segments as well as its reportable segments. Within each operating segment are
distinct insurance product lines that generate revenues by selling a variety of
commercial, surety and personal insurance products. The Commercial Lines
operating segment sells commercial multiple peril, commercial auto, general
liability and workers' compensation insurance as its primary products. The
Specialty Lines operating segment sells commercial umbrella, excess insurance
and fidelity and surety insurance as its primary products. The Personal Lines
operating segment sells personal automobile and homeowners insurance as its
primary products. The Corporation also has an all other segment, which derives
its revenue from investment income. The following table provides key financial
measures for each of the property and casualty reportable segments and product
lines:
28
ITEM 7. CONTINUED
STATUTORY EARNED PREMIUM AND COMBINED RATIOS
Combined Ratios
------------------------------------------------------------
2004 Accident Accident Accident
(by operating segment, including Earned Year Year Year
selected major product lines) Premium 2004 2004(a) 2003 2003(a) 2002 2002(a)
- -------------------------------- --------- ----- -------- ----- -------- ----- --------
Commercial Lines $ 807.9 99.3% 101.1% 112.3% 103.7% 115.1% 100.0%
Workers' compensation 132.6 115.4% 112.3% 123.0% 111.8% 129.2% 112.9%
Commercial auto 229.6 90.3% 98.2% 105.5% 101.1% 110.2% 94.9%
General liability 86.6 105.0% 105.6% 122.6% 109.5% 171.3% 109.9%
CMP, fire & inland marine 359.1 97.5% 97.7% 109.7% 100.8% 95.8% 94.6%
Specialty Lines 150.3 97.2% 103.3% 77.2% 88.5% 94.0% 87.1%
Commercial umbrella 105.1 103.8% 108.7% 80.5% 92.6% 97.7% 92.2%
Fidelity & surety 45.2 78.9% 88.1% 68.1% 76.0% 81.7% 71.9%
Personal Lines 488.4 97.6% 97.2% 105.6% 101.4% 114.1% 111.5%
Personal auto incl. personal
umbrella 295.7 104.7% 103.3% 107.0% 102.8% 116.5% 113.5%
Personal property 192.7 86.8% 87.6% 103.3% 98.9% 108.6% 107.2%
--------- ----- ----- ----- ----- ----- -----
Total All Lines $ 1,446.6 98.4% 99.8% 106.1% 101.2% 112.8% 103.5%
========= ===== ===== ===== ===== ===== =====
(a) The loss and LAE ratio component of the accident year combined ratio
measures losses and LAE arising from insured events that occurred in the
respective accident year. The current accident year excludes losses and LAE for
insured events that occurred in prior accident years. Accident year 2004 as of
December 31, 2004 measures insured events for the twelve months of 2004.
Accident year 2003 as of December 31, 2004 measures insured events for the
twelve months of 2003 with remaining related liabilities estimated as of
December 31, 2004. Accident year 2002 as of December 31, 2004 measures insured
events for the twelve months of 2002 with remaining related liabilities
estimated as of December 31, 2004. Accident periods may not be comparable due to
seasonality, claim reporting and development patterns, claim settlement rates
and other factors.
COMMERCIAL LINES SEGMENT
2004 2003 2002
---- ------ ------
Commercial Lines Segment
Loss ratio 52.9% 61.4% 60.8%
Loss adjustment expense ratio 12.1% 14.5% 18.0%
Underwriting expense ratio 34.3% 36.4% 36.3%
---- ------ ------
Combined ratio 99.3% 112.3% 115.1%
==== ====== ======
The Commercial Lines combined ratio for the year 2004 decreased 13.0 points due
to a significantly lower loss ratio as a result of improved pricing and
underwriting quality in addition to favorable development on prior year
reserves. Favorable claim frequency trends, driven in part by underwriting
actions, and improved pricing helped to offset the Commercial Lines claim
severity trend. The 2004 combined ratio included 1.9 points of favorable
development on loss and LAE reserves from prior years, compared to adverse
development of 5.3 points in 2003 on loss and LAE reserves from prior years. The
decline in the combined ratio also included a 2.1 point improvement in the
underwriting expense ratio primarily as a result of staff reductions and
employee benefit changes.
The combined ratio improved from 2002 to 2003 by 2.8 points, in spite of $41.0
or 5.3 points of adverse development on loss and LAE reserves. The 2002 combined
ratio was impacted by $73.9 or 10.2 points of adverse prior year development of
loss and LAE reserves. Of this amount, approximately $51.6 related to
construction defect issues, which added 7.1 points to the combined ratio for
2002.
Commercial Lines results for 2004 included higher than expected catastrophe
losses which added 2.4 points to the Commercial Lines combined ratio in 2004,
compared to 2.6 points and 0.5 points in 2003 and 2002, respectively.
The workers' compensation product line combined ratio was 115.4% in 2004 a
decline of 7.6 points compared to 123.0% in 2003 and 129.2% in 2002. Although
the Group has taken actions to improve workers' compensation results with higher
pricing and a conservative underwriting posture, this product line continues to
perform at an
29
ITEM 7. CONTINUED
unprofitable level. The current results continue to be negatively impacted by
assessments for the National Workers' Compensation Pool (NWCP) residual market.
The impact of the NWCP residual market added 4.8 points to the workers'
compensation combined ratio in 2004 compared to 4.5 points in 2003. The NWCP
residual market lowered the 2002 combined ratio by 1.5 points. The Group's
assessments have a larger percentage impact than those reported by the industry
due to historical concentration of business in states with inactive pools. In
addition, the concentration of the Group's business in a few states with limited
pricing flexibility provides less opportunity to address issues specific to the
workers' compensation product line. These issues are offset by the Group's
approach to writing workers' compensation as part of an overall Commercial Lines
account, where underwriters look to ensure that the pricing for the entire
account is adequate.
The general liability product line combined ratio was 105.0% in 2004 a decline
of 17.6 points compared to 122.6% in 2003 and 171.3% in 2002. This line is
exposed to construction defect issues which are being addressed through strict
underwriting standards for certain classes of business that are more prone to
construction defect claims. In addition, the Group has introduced policy
language changes to limit exposure to broadening court interpretations of
additional insured and contractual general liability provisions within the
policy.
SPECIALTY LINES SEGMENT
2004 2003 2002
---- ---- ----
Specialty Lines Segment
Loss ratio 42.7% 28.7% 39.0%
Loss adjustment expense ratio 4.8% 5.0% 11.0%
Underwriting expense ratio 49.7% 43.5% 44.1%
---- ---- ----
Combined ratio 97.2% 77.2% 94.1%
==== ==== ====
Specialty Lines combined ratio for 2004 increased 20.0 points. Given the volume
and nature of the coverage, the Specialty Lines combined ratio is subject to
more volatility than the other product lines. The 2004 combined ratio included
$9.3, or 6.2 points, of favorable development on prior year loss and LAE
reserves compared to $21.3, or 13.1 points, in 2003 and $2.2, or 1.4 points, in
2002.
The fidelity and surety product lines contributed to the favorable results for
this segment. The fidelity and surety combined ratio increased to 78.9% in 2004,
compared with 68.1% in 2003 and 81.7% in 2002. The 2004 fidelity and surety
combined ratio included $4.2 of favorable development on prior accident year
loss and LAE reserves compared to $5.5 in 2003 and $1.2 in 2002. The 2003
fidelity and surety combined ratio also benefited from lower overall losses (in
both frequency and severity) for this product line. In 2002, there was a return
of ceded premium of $5.3 million before tax for the fidelity and surety
business, which lowered the combined ratio by 10.8 points. This return of ceded
premium was due to the exercise of a contractual option on the bond reinsurance
treaty based on highly favorable bond combined ratios over the past fourteen
years.
The 2004 commercial umbrella combined ratio was 103.8% compared to 80.5% and
97.7% in 2003 and 2002, respectively. The 2004 combined ratio included 4.8
points of favorable development on prior year loss and LAE reserves compared to
12.7 points and 1.1 points in 2003 and 2002, respectively. The increase in the
commercial umbrella combined ratio over 2003 is also the result of a $6.1
reinstatement accrual, which increased the 2004 combined ratio by 6.2 points and
a reduction in net premiums written of 28.0%, putting upward pressure on the
combined and component ratios for this product line.
PERSONAL LINES SEGMENT
2004 2003 2002
---- ------ ------
Personal Lines Segment
Loss ratio 58.7% 67.5% 70.5%
Loss adjustment expense ratio 10.0% 11.0% 14.0%
Underwriting expense ratio 28.9% 27.1% 29.6%
---- ------ ------
Combined ratio 97.6% 105.6% 114.1%
==== ====== ======
30
ITEM 7. CONTINUED
The Personal Lines combined ratio for 2004 decreased 8.0 points. The 2004
improvement was partially driven by increased pricing and improved underwriting
such as increased deductibles on homeowner's policies. In addition, adverse
prior years reserve development was 0.5 points in 2004 compared to 3.0 points in
2003 and 2.2 points in 2002. Offsetting these improvements was the addition of
3.2 points of expense for the Proformance guarantee, as discussed previously. In
2004, the Group completed its withdrawal of Personal Lines business from
Florida, Georgia and Texas.
CRITICAL ACCOUNTING POLICIES
Management of the Corporation has identified the policies listed below as
significant accounting policies that are critical to the Corporation's business
operations and influence the consolidated results of operations and financial
performance. The policies listed below were selected as they require a higher
degree of complexity or use subjective judgements or assessments. Changes in
these judgements, assessments or estimates could have a material adverse impact
on the Corporation's consolidated financial statements. These policies follow
accounting principles generally accepted in the United States. A brief summary
of each critical accounting policy follows. Management discusses the development
and selection of these accounting policies with the Audit Committee of the Board
of Directors and the Audit Committee has reviewed the Corporation's MD&A. For a
complete discussion on the application of these and other accounting policies,
see Item 15, Notes to Consolidated Financial Statements, Footnote 1 on pages
54-56 of this Annual Report on Form 10-K.
RESERVES FOR LOSSES AND LOSS ADJUSTMENT EXPENSES
The Group establishes reserves for losses and LAE equal to the estimated amount
required to settle both reported and incurred but not yet reported (IBNR)
claims. For each reported claim, a case reserve is established within the
parameters of coverage provided in the specific insurance policy. For IBNR
claims, additional loss amounts needed for reported claims and LAE, reserves are
estimated using generally accepted actuarial methods. Estimates for loss and LAE
reserves are developed using the facts in each case, the Group's experience with
similar cases, the effects of current developments and anticipated trends. The
methods and assumptions used in making such estimates are continually reviewed
and updated when considered appropriate. Reserves established in prior years are
adjusted as loss experience develops and new information becomes available.
Adjustments to previously estimated reserves, both positive and negative, are
reflected in the consolidated financial statements in the periods in which they
are made and are referred to as prior period development. Because of the high
degree of uncertainty involved in estimating loss and LAE reserves, revisions to
estimated reserves could have a material impact on the results of operations of
the Group.
INVESTMENTS
All investment securities are classified upon acquisition as either
held-to-maturity or available-for-sale. Fixed maturity securities classified as
held-to-maturity are carried at amortized cost as management has the ability and
positive intent to hold the securities until maturity. Available-for-sale
securities are those securities that would be available to be sold in the future
in response to liquidity needs, changes in market interest rates and
asset-liability management strategies, among others. Available-for-sale
securities are reported at fair value, with unrealized gains and losses excluded
from earnings and reported as a component of other comprehensive income, net of
deferred tax. Transfers of fixed maturity securities into the held-to-maturity
category from the available-for-sale category are made at fair value at the date
of transfer. The unrealized holding gain or loss at the date of transfer is
retained in other comprehensive income and in the carrying value of the
held-to-maturity securities. Such amounts are amortized over the remaining life
of the security. Equity securities are carried at quoted market values and
include non-redeemable preferred stocks and common stocks. The difference
between cost and quoted market value, net of deferred taxes, is classified as
other comprehensive income. The Corporation and the Group closely monitor the
fixed maturity and equity portfolios for declines in value that are deemed to be
other than temporary. Investments are regularly evaluated based on current
economic conditions, credit loss experience and other specific developments. 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.
Mortgage-backed securities are amortized over a period based on estimated future
principal payments, including prepayments. Prepayment assumptions are reviewed
periodically and adjusted to reflect actual prepayments and changes in
expectations. Upon receipt of payments from such securities, the appropriate
amount of the
31
ITEM 7. CONTINUED
funds are allocated between a reduction of principal and interest income. In
making this allocation decision, investment personnel consider such factors as
the original estimated average life of the investment, the amount of funds
received to date and the timing of future cash flows. Variations from prepayment
assumptions will affect the life and yield of these securities. These securities
are evaluated for impairment by computing the net-present-value of expected
future cash flows and comparing this to the prior period estimate of expected
future cash flows from the security. When the timing and/or amount of cash
expected to be received from the security has changed materially and adversely
from the previous valuation, the security is considered to be other than
temporarily impaired and the amortized cost is written down to the estimated
fair value with a realized loss recorded in the current consolidated statement
of income.
DEFERRED POLICY ACQUISITION COSTS
The Group establishes a deferred asset for costs that vary with and are
primarily related to acquiring property and casualty insurance business. The
acquisition costs deferred consist principally of commissions, brokerage fees,
salaries and benefits and other underwriting expenses to include allocations for
inspections, taxes, rent and other expenses that vary directly with the
acquisition of insurance contracts. These costs are amortized over the life of
the underlying policies. Quarterly, an analysis of the asset is performed in
relation to the expected recognition of revenues including investment income to
determine if any deficiency exists. No deficiencies have been indicated for the
periods presented.
AGENT RELATIONSHIPS
The agent relationships asset is an identifiable intangible asset representing
the excess of cost over the fair value of net assets acquired in connection with
the 1998 GAI commercial lines acquisition. This purchase price was allocated to
specifically identifiable intangible assets based on their estimated values as
determined by appropriate valuation models. The agent relationships asset is
amortized on a straight-line basis over an estimated useful life of twenty-five
years. The estimated useful life was based on the Group's actual experience for
agency appointment terms for similar agents, which averaged approximately
twenty-five years in length. The estimated useful life is evaluated on an annual
basis or as events or circumstances arise that may impact the useful life of the
asset. The asset is evaluated quarterly as events or circumstances, such as
cancellation of agents, indicate a possible inability to recover the carrying
amount. Cancellation of certain agents for reasons such as lack of revenue
production or poor quality of business produced does not necessarily change the
estimated useful life of the remaining agents representing the agent
relationships intangible asset. Such evaluation is based on various analyses,
including cash flow and profitability projections that incorporate, as
applicable, the impact on existing company businesses. The analyses involve
significant management judgments to evaluate the capacity of an acquired
business to perform within projections. If future undiscounted cash flows are
insufficient to recover the carrying amount of the asset, an impairment loss is
recognized in income in the period in which the future cash flows are identified
to be insufficient in comparison to the carrying amount of the asset. Due to the
inherent uncertainties and judgements involved in developing assumptions for
each agent, further reductions in the valuation of the agent relationships asset
are likely to occur in the future.
INTERNALLY DEVELOPED SOFTWARE
In accordance with Statement of Position (SOP) 98-1, "Accounting for the Costs
of Computer Software Developed or Obtained for Internal Use" the Group
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
value of the asset exceeds the carrying value. Management evaluates the asset on
an annual basis for impairment. The costs associated with the software are
amortized on a straight-line basis over the estimated useful life of ten years
commencing when the software is substantially complete and ready for its
intended use.
PENSION AND POSTRETIREMENT BENEFIT PLAN ACTUARIAL ASSUMPTIONS
The Company's pension and postretirement benefit obligations, related costs and
contributions are calculated using actuarial methods in accordance with
Statement of Financial Accounting Standards (FASB) No. 87, "Employers'
Accounting for Pensions" and FASB 106, "Employers' Accounting for Postretirement
Benefits Other than Pension." These actuarial valuations involve key assumptions
including discount rates and expected return on plan assets, which are reviewed
by management on a annual basis, or more frequently as needed. Any
32
ITEM 7. CONTINUED
adjustments to these assumptions are based on considerations of current and
future market conditions, which can result in changes to the future related
benefit obligations, related costs and contributions incurred by the Company.
For additional discussion relative to pension and postretirement benefit plan
assumptions, see the section entitled "Pension and Other Postretirement
Benefits" of this MD&A on pages 37-39 and Item 15, Notes to Consolidated
Financial Statements, Footnote 5, pages 59-62 of this Annual Report on Form
10-K.
RECENTLY ISSUED ACCOUNTING STANDARDS
For disclosure related to recently issued accounting standards, refer to Item
15, Notes to Consolidated Financial Statements, Footnote 19 on page 71 of this
Annual Report on Form 10-K.
LIQUIDITY AND CAPITAL RESOURCES
CASH FLOW
Net cash generated from operations was $270.0 compared with $168.7 and $148.2 in
2003 and 2002, respectively. The increase in net cash for the years 2004 and
2003 compared to 2002 is due primarily to a reduction in paid losses and LAE of
$98.0 in 2004 and $57.2 in 2003, a result of the improved loss experience
discussed above. During 2003, the increase in cash was partially offset by an
increase in payments to reinsurers for premium cessions, contingent commission
bonus payments to agents and the final payments of the replacement carrier fee
for New Jersey private passenger auto business. The increase in the reinsurance
recoverable asset did not significantly impact cash flow in 2004 and 2003 since
there was a corresponding increase in liabilities for most of the increase in
this asset. The reinsurance recoverable asset at December 31 2004 and 2003,
increased $73.8 and $172.8 with $73.6 and $144.1 due to increases in loss and
LAE reserves for future loss payments expected to be paid by reinsurers along
with other components as shown in Item 15, Notes to Consolidated Financial
Statements, Footnote 7 on page 64 of this Annual Report on Form 10-K.
Investing activities used net cash of $274.4 in 2004, compared to $175.6 in 2003
and $173.7 in 2002. Cash used in investing activities increased $98.8 in 2004
due to the net proceeds received from the issuance of the Senior Notes in June
2004 and reinvestment of the cash generated from operations. Cash used in
investing activities remained relatively flat in 2003 compared to 2002 as fewer
fixed maturity securities were purchased as prepayments on mortgage backed
securities were reduced in 2003, leaving less cash inflow to reinvest. Cash
inflows from the sale of property and equipment increased over 2002 as the Group
sold a building located in Lexington, Kentucky including the related office
equipment and land for sales proceeds of $4.6.
Total cash generated from financing activities was $200.1 in 2004, compared to
$1.6 in 2003 and cash used of $4.6 in 2002. Cash provided by financing
activities in 2004 resulted from net proceeds of approximately $198.0 from the
issuance of 7.3% Senior Notes in June 2004, in addition to the exercise of stock
options, partially offset by the repurchase of $12.5 of the Corporation's
Convertible Notes and normal principal payments on the State of Ohio loan. Cash
provided by financing activities in 2003 resulted from the exercise of stock
options partially offset by principal payments on the State of Ohio loan. This
compares to cash used for financing activities in 2002, which included the
repayment of the Corporation's $205.0 credit facility and issuance of the
Convertible Notes with net proceeds of $194.0.
Overall, total cash generated in 2004 was $195.7, compared with net cash used in
2003 and 2002 of $5.3 and $30.1, respectively. The Corporation did not pay any
shareholder dividends for the years presented. On a regular basis management
analyzes the profitability and capital position of the Group and the liquidity
of the Corporation, including the Corporation's evaluation of whether to
reinstitute a dividend to shareholders of the Corporation or a share repurchase
program.
The Corporation is dependent on dividend payments from its insurance
subsidiaries in order to meet operating expenses and debt obligations. Insurance
regulatory authorities impose various restrictions and prior approval
requirements on the payment of dividends by insurance companies. As of December
31, 2004, approximately $138.3 of statutory surplus was not subject to prior
dividend approval requirements. Additional restrictions may result from the
minimum net worth and surplus requirements in the credit agreement as disclosed
in Item 15, Notes to Consolidated Financial Statements, Footnote 16 on pages 69
and 70 of this Annual Report on Form 10-K.
33
ITEM 7. CONTINUED
The Corporation has been examined by the Internal Revenue Service for the tax
years 1997 through 2001 and is currently in the process of finalizing a
settlement. The Corporation believes that the ultimate settlement of these years
will not have a material adverse impact on its financial position or results of
operations and has provided adequate book reserves for any matters that may not
be resolved as part of the settlement.
OFF-BALANCE SHEET ARRANGEMENTS AND CONTRACTUAL OBLIGATIONS
As of December 31, 2004 and 2003, the Corporation did not have any off-balance
sheet arrangements as defined by Financial Release - 67, "Disclosure in
Management's Discussion and Analysis about Off-Balance Sheet Arrangements and
Aggregate Contractual Obligations."
The following table presents the Corporation's obligations to make future
payments under contractual obligations as of December 31, 2004:
Payments Due by Period
------------------------------------------------------------------
Less than 1-3 3-5 More than 5
Contractual Obligations Total 1 year years years years
- -------------------------------------- --------- --------- ------ ------ -----------
Losses and benefits for policyholders* $ 2,756.4 $ 664.3 $884.8 $537.5 $ 669.8
Long-term debt** 342.3 15.3 30.7 30.6 265.7
Operating leases 20.0 5.4 8.8 4.8 1.0
Purchase obligations 31.6 18.2 11.3 2.1 -
Other long-term liabilities*** 117.6 90.8 18.5 8.3 -
--------- ------- ------ ------ --------
Total contractual cash
obligations $ 3,267.9 $ 794.0 $954.1 $583.3 $ 936.5
========= ======= ====== ====== ========
* The amounts presented are estimates of the dollar amounts and time periods in
which the Group expects to pay its gross loss and LAE reserves. These amounts
are based upon historical payment patterns and do not represent actual
contractual obligations. The actual payment amounts and the related timing of
those payments could differ significantly from these estimates. See Item 15,
Notes to Consolidated Financial Statements, Footnote 9 on page 66 of this Annual
Report on Form 10-K and discussed separately below.
**Excluded from long-term debt obligations are the Convertible Notes with
outstanding principal of $188.8 and semi-annual interest payments of $4.7. For
additional disclosure, see Item 15, Notes to Consolidated Financial Statements,
Footnote 16 on pages 69 and 70 of this Annual Report on Form 10-K and the Debt
section below.
***Excluded from other long-term liabilities are pension obligations which are
described in Item 15, Notes to Consolidated Financial Statements, Footnote 5 on
pages 59-62 of this Annual Report on Form 10-K and disclosed separately below.
In December 2003, the FASB issued a revised Interpretation No. 46 "Consolidation
of Variable Interest Entities" (FIN 46), an interpretation of Accounting
Research Bulletin No. 51. FIN 46 requires a variable interest entity (VIE) to be
consolidated by the primary beneficiary of the entity if certain criteria are
met. The Corporation currently holds an equity investment, representing a 49%
interest, in APM Spring Grove, Inc. (APM), which was deemed a variable interest
entity in accordance with FIN 46. As a result, the entity was consolidated into
the Corporation's financial statements during the first quarter of 2004, which
resulted in a $1.6 loss, net of tax, due to a cumulative effect of an accounting
change. The Corporation's maximum exposure to loss as a result of its
involvement with APM is $3.3. See Item 15, Notes to Consolidated Financial
Statements, Footnote 18 on page 71 of this Annual Report on Form 10-K for
further discussion.
DEBT
On June 29, 2004, the Corporation issued $200.0 of 7.3% Senior Notes due June
15, 2014 (Senior Notes). The net proceeds from the issuance after related fees
and discount were $198.0. In the fourth quarter 2004, the Corporation used part
of the net proceeds to repurchase $12.5 of the $201.3 aggregate principal amount
of its 5.00% Convertible Notes due March 19, 2022, (Convertible Notes) and
intends to use the remainder of the net proceeds to redeem the remainder of its
Convertible Notes. 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 from the Senior Notes 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.
34
ITEM 7. CONTINUED
The Convertible and Senior Notes are reported on the consolidated balance sheets
net of unamortized issuance-related costs and discount of $8.7 ($6.3 related to
the Convertible Notes and $2.4 related to the Senior Notes) and $6.9 (all
related to the Convertible Notes) at December 31, 2004 and 2003, respectively.
The Corporation uses the effective interest rate method to record interest
expense, amortization of issuance-related costs and amortization of the
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, as
defined in the indenture, 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.
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. At December 31, 2004, if all the outstanding
Convertible Notes were converted, total outstanding common shares would increase
by 8.3 million shares compared to 8.9 million shares at December 31, 2003.
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 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 February 22, 2005, the Corporation announced that it has commenced an
exchange offer under which the Corporation is offering to exchange up to $184.3
of new 5.00% Convertible Notes due 2022 for an equal principal amount of its
currently outstanding Convertible Notes. The exchange offer is being made
pursuant to Section 3(a)(9) of the Securities Act of 1933, as amended. The new
notes will have substantially similar terms to the old notes, except that the
new notes will include a net share settlement feature and a cash exchange fee
payable to the holder of the old notes in an amount equal to 0.35% of the
principal amount of the old notes exchanged. The net share settlement feature
will require the Corporation upon conversion to pay cash up to the principal
amount of the new notes and pay any conversion consideration in excess of the
principal amount in common shares. The exchange offer will expire at 12:00
midnight EST on March 21, 2005, unless extended or terminated by the
Corporation. The Corporation plans to redeem all or a portion of the new notes
and the old notes, to the extent any remain outstanding, shortly after the
completion of this exchange offer. The Corporation intends to use the proceeds
of the Senior Note offering discussed above to accomplish this redemption. In
2005, prior to the commencement of this exchange offer, the Corporation
repurchased $4.5 of the Convertible Notes in unsolicited negotiated
transactions.
The impact of the Convertible Notes on diluted earnings per share is based upon
the "if-converted" method. In accordance with EITF 04-8, all diluted earnings
per share amounts have been restated since the issuance of the Convertible Notes
in March 2002. See Item 15, Notes to Consolidated Financial Statements, Footnote
10 on pages 66 and 67 of this Annual Report on Form 10-K for further discussion.
On July 31, 2002, the Corporation entered into a revolving credit agreement
expiring on March 15, 2005. Under the terms of the revolving 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 revolving 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
35
ITEM 7. CONTINUED
to establishing the line of credit and amortizes the fees over the term of the
agreement with a remaining unamortized balance at December 31, 2004, of less
than $0.1 compared to $0.2 at December 31, 2003. In addition, the Corporation is
obligated to pay agency fees and facility fees of up to $0.2 annually. These
fees are expensed when incurred by the Corporation. The revolving credit
agreement requires the Corporation to maintain minimum net worth of $800.0. The
credit agreement also includes a minimum statutory surplus for the Company of
$650.0. Additionally, other financial covenants and other customary provisions,
as defined in the agreement, exist. At December 31, 2004, the Corporation was in
compliance with all financial covenants and other provisions of this agreement.
There were no amounts outstanding under this revolving credit agreement at
either December 31, 2004 or 2003. In February 2005, the revolving credit
agreement was renewed, under substantially the same terms and conditions, for
one year and will expire on March 15, 2006.
In addition to the debt described above, the Corporation has a $6.5 loan with
the State of Ohio that is secured by a mortgage on the Corporation's home office
property. As of December 31, 2004, the loan bears a fixed interest rate of 3%,
compared to an interest rate of 2% at December 31, 2003. The loan requires
annual principal payments of approximately $0.6 and expires in November 2009.
The remaining balance at December 31, 2004, was $3.2 compared to $3.9 at
December 31, 2003.
Interest expense incurred for the period ending December 31, 2004, 2003 and 2002
was $17.5, $10.1 and $9.5, respectively. The increase in interest expense
incurred during 2004 is related to the issuance of the Senior Notes.
RATING AGENCIES
Regularly the Group's financial strength is reviewed by independent rating
agencies. These agencies may upgrade, downgrade, or affirm their previous
ratings of the Group. These agencies may also place an outlook on the Group's
rating.
On September 6, 2002, A.M. Best Company (A.M. Best) affirmed the Group's
financial strength rating of "A-" and assigned a positive outlook. In addition,
A.M. Best assigned an initial rating of "bbb" to the Corporation's Convertible
Notes. On August 22, 2003, A.M. Best revised its debt rating criteria and
assigned a "bbb-" to the Corporation's Convertible Notes. On December 8, 2003,
A.M. Best affirmed the Group's "A-" financial strength rating and the
Corporation's "bbb-" senior unsecured debt rating and assigned stable outlooks
on the ratings. On June 23, 2004, A.M. Best assigned a "bbb-" rating and a
stable outlook to the Corporation's 7.3% Senior Notes.
On March 14, 2002, Fitch, Inc. (Fitch) assigned its "BBB-" rating to the
Corporation's Convertible Notes and placed a stable outlook on its rating. On
November 5, 2002, Fitch affirmed its "BBB-" rating and stable outlook on the
Corporation's Convertible Notes. On January 21, 2004, Fitch assigned a financial
strength rating of "A-" to the Group and also affirmed its "BBB-" senior debt
and long term issuer ratings. On June 24, 2004, Fitch assigned a "BBB-" rating
to the Corporation's 7.3% Senior Notes. On December 21, 2004, Fitch affirmed its
financial strength rating of "A-" and re-affirmed its "BBB-" senior debt and
long term issuer ratings. The rating outlook remains at stable.
On March 13, 2002, Moody's Investor Services (Moody's) assigned its "Baa2"
rating to the Corporation's Convertible Notes. On November 27, 2002, Moody's
downgraded the Group's "A2" financial strength rating to "A3" and placed a
stable outlook on the Group's rating. Moody's also announced that it placed a
"Baa3" rating on the Corporation's Convertible Notes. On June 16, 2003, Moody's
affirmed its "Baa3" rating on the Convertible Notes and affirmed the "A3"
insurance financial strength ratings on the Group's intercompany pool. Moody's
also placed a stable outlook on its ratings. In addition, Moody's also assigned
prospective ratings to the $500 universal shelf registration filed on May 8,
2003. The prospective ratings for senior unsecured debt, subordinated debt and
preferred stock were "Baa3", "Ba1" and "Ba2", respectively. On June 29, 2004,
Moody's assigned a "Baa3" rating to the Corporation's 7.3% Senior Notes.
36
ITEM 7. CONTINUED
On March 11, 2002, Standard & Poor's Rating Services (S&P) removed its negative
outlook and placed a stable outlook on the Group's "BBB" financial strength
rating. S&P also announced that it assigned its "BB" senior debt rating to the
Corporation's Convertible Notes. Following the Corporation's announcement of
third quarter 2002 results, S&P revised its outlook to negative from stable and
indicated that the Group's financial strength rating would be reviewed for
possible downgrade. On April 30, 2003, S&P affirmed its "BBB" financial strength
rating for the Group and maintained its negative outlook. On May 13, 2003, S&P
assigned prospective ratings to the Corporation's universal shelf. The
prospective ratings for senior unsecured debt, subordinated debt and preferred
stock were "BB", "B+" and "B", respectively. On February 13, 2004, S&P revised
its outlook to stable and affirmed its financial strength and debt ratings on
the Group and the Corporation. On June 28, 2004, S&P assigned a "BB" rating to
the Corporation's 7.3% Senior Notes. On December 29, 2004, S&P revised its
outlook to positive from stable, affirmed its "BBB" financial strength rating on
the Group's intercompany pool, and affirmed its "BB" senior unsecured debt
rating on the Corporation.
Following is a summary of the Corporation's current ratings and rating outlooks
as of December 31, 2004:
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 Positive
Generally, credit ratings affect the cost and availability of debt financing.
Often, borrowers with investment grade credit ratings can borrow at lower rates
than those available to similarly situated companies with ratings that are below
investment grade, and the availability of certain debt products may be greater
for borrowers with investment grade credit ratings. Currently, the Corporation
is a "split-rated" borrower, having investment grade ratings from A.M. Best,
Fitch and Moody's and below investment grade debt rating from S&P. While
influenced by conditions in the credit markets, it is reasonable to anticipate
that the Corporation's split rating will result in a higher cost of borrowing as
compared to borrowers with only investment grade credit ratings. The recent
improvement in the rating outlook by S&P is a positive development in the
Corporation's rating profile.
STATUTORY SURPLUS
Statutory surplus, a traditional insurance industry measure of financial
strength and underwriting capacity, was $972.0 at December 31, 2004, compared
with $867.6 at December 31, 2003. Statutory surplus increased 12.0% from 2003
resulting primarily from statutory net income.
The ratio of net premiums written to statutory surplus is one of the measures
used by insurance regulators to gauge the financial strength of an insurance
company and indicates the ability of the Group to grow by writing additional
business. At December 31, 2004, the Group's net premiums written to surplus
ratio was 1.5 to 1 compared to 1.7 to 1 in 2003.
The National Association of Insurance Commissioners (NAIC) has developed a
"Risk-Based Capital" formula for property and casualty and life insurers. The
formula is intended to measure the adequacy of an insurer's capital given the
asset and liability structure and product mix of the company. As of December 31,
2004 and 2003, all insurance companies in the Group exceeded the necessary
capital requirements.
PENSION AND OTHER POSTRETIREMENT BENEFITS
The Company sponsors a non-contributory defined benefit pension plan and a
contributory postretirement healthcare plan. Several statistical and other
factors, which attempt to anticipate future events, are used in calculating the
expense and liability related to the plans. Key factors include assumptions
about the expected rates of return on plan assets, discount rates, rate of
compensation increases and health care cost trend rates, as determined by the
Company, within certain guidelines. Management reviews the assumptions used in
the valuations on an annual basis, or more frequently as needed. The Company
considers market conditions, including changes in investment returns, interest
rates and inflation in making these assumptions.
37
ITEM 7. CONTINUED
The Company determines the expected long-term rate of return on plan assets
based on the geometric method, which represents the average compound return of
the plan assets. Plan assets are comprised primarily of investments in mutual
funds, common stocks, corporate bonds, U.S. government securities, real estate
investment trusts and other investments. The Company considers the current level
of expected returns on risk free investments, primarily government bonds, the
historical level of the risk premium associated with the other asset classes,
current and expected asset allocation and the expectations for future returns of
each asset class when developing the expected long-term rate of return on assets
assumption. The expected return for each asset class is weighted based on the
target asset allocation to develop the expected long-term rate of return on
assets assumption for the portfolio. This resulted in the selection of the 8.75%
assumption for 2004 and 2003. The expected rate of return on plan assets is a
long-term assumption and generally does not change annually. Holding all other
assumptions constant, a one-percentage-point increase or decrease in the assumed
rate of return on plan assets would decrease or increase, respectively, 2005 net
periodic pension expense by approximately $2.5.
In determining the discount rate assumption, the Company utilizes current market
information including analysis of the Moody's "Aa" Corporate Bond Index Rate,
analysis provided by plan actuaries and independent survey data on similarly
positioned companies. As regards to the analysis provided by plan actuaries, a
discounted cash flow model of the plan's benefit obligations was developed using
an interest rate yield curve to make judgments regarding the appropriate
discount rate for both its pension and postretirement medical benefit
obligations. The yield curve is comprised of bonds with at least an "Aa" rating
with maturities primarily between zero and thirty years. This resulted in the
selection of 5.95% for 2004 and 6.15% for 2003.
Unrecognized losses of approximately $49.7 are being recognized over
approximately a 13-year period, which represents the average future service
period of active participants. Unrecognized gains and losses arise from several
factors including experience and assumption changes in the obligations and from
the difference between expected and actual returns on plan assets. These
unrecognized losses will be systematically recognized as an increase in future
net periodic pension expense in accordance with FASB Statement No. 87,
"Employers' Accounting for Pensions."
The Company expects to contribute approximately $8.0 to fund the pension plan
during 2005. The source for the funding will be cash flow from operating
activities.
Key assumptions used in determining the amount of the obligation and expense
recorded for postretirement benefits other than pensions (OPEB), under FASB
Statement No. 106, "Employers' Accounting for Postretirement Benefits Other Than
Pensions," including the assumed discount rate and the assumed rate of increases
in future health care costs, are reviewed by management on an annual basis, or
more frequently as needed. In estimating the health care cost trend rate, the
Company considers its actual health care cost experience, future benefit
structures, industry trends and advice from its third-party actuaries. The
Company assumes that the relative increase in health care costs will generally
trend downward over the next several years, reflecting assumed increases in
efficiency in the health care system and industry-wide cost containment
initiatives. At December 31, 2004, the expected rate of increase in future
health care costs was 10% for 2005, declining to 5% in 2014 and thereafter.
Increasing the assumed health care cost trend by one percentage point in each
year would increase the accumulated postretirement benefit obligation as of
December 31, 2004, by approximately $5.1 and increase the postretirement benefit
cost for 2004 by $0.9. Likewise, decreasing the assumed health care cost trend
by one percentage point in each year would decrease the accumulated
postretirement benefit obligation as of December 31, 2004, by approximately $4.6
and decrease the postretirement benefit cost for 2004 by $0.7.
The actuarial assumptions used by the Company in determining its pension and
OPEB retirement benefits may differ materially from actual results due to
changing market and economic conditions, higher or lower turnover and retirement
rates or longer or shorter life spans of participants. While the Company
believes that the assumptions used are appropriate, differences in actual
experience or changes in assumptions may materially affect the Company's
financial position or results of operations.
38
ITEM 7. CONTINUED
In 2004, the Company announced changes to its defined benefit retirement plan
and defined postretirement health care plans. The Company's traditional defined
benefit retirement plan was amended to freeze accrued benefits effective June
30, 2004, and to incorporate a new benefit formula beginning July 2004. As a
result of this change in the defined benefit retirement plan, the Company
recognized a reduction in net periodic pension cost of $1.9 in 2004 attributable
to the amortization of unrecognized prior service cost and has a remaining
unrecognized prior service cost of $28.9 at December 31, 2004, which will be
ratably recognized over the next 13 years as a reduction of net periodic pension
cost. Also effective in July 2004, eligibility for subsidized retiree medical
and dental coverage was restricted to then current retirees and employees with
25 or more years of continuous service. Other employees are eligible for access
to unsubsidized retiree medical and dental coverage. As a result of this change
in the defined postretirement benefit plan, the Company recognized a reduction
in net periodic postretirement cost of $5.0 in 2004 attributable to the
amortization of unrecognized prior service cost and has a remaining unrecognized
prior service cost of $54.3 at December 31, 2004, which will be ratably
recognized over the next 9 years as a reduction of net periodic postretirement
cost.
For more information on the Company's pension and other postretirement benefit
plans, please refer to Item 15, Notes to Consolidated Financial Statements,
Footnote 5 on pages 59-62 of this Annual Report on Form 10-K.
LOSS AND LOSS ADJUSTMENT EXPENSES
The Group's largest liabilities are reserves for losses and LAE. Loss and LAE
reserves are established for all incurred claims without discounting for the
time value of money and before credit for reinsurance recoverable. Actual losses
and LAE are adjusted upward or downward as new information is received. These
reserves amounted to $2.8 billion and $2.6 billion at December 31, 2004 and
2003, respectively. As of December 31, 2004, the reserves by operating segment
were as follows: $1.7 billion Commercial Lines, $0.7 billion Specialty Lines and
$0.4 billion Personal Lines.
The Group's actuaries conduct a reserve study using generally accepted actuarial
methods each quarter from which point estimates of ultimate losses and LAE by
product line or coverage within product line are selected. In selecting the
point estimates, thousands of data points are reviewed and the judgment of the
actuaries is applied broadly. Each quarter management records its best estimate
of the liability for loss and LAE reserves by considering the actuaries' point
estimates. Management's best estimate recognizes that there is uncertainty
underlying the actuarial point estimates.
Estimating the ultimate cost of claims is a complex process. This estimation
process is based largely on the assumption that actuarial reserving methods,
using historical loss experience and applied by experienced reserving actuaries,
produces reasonable estimates of future losses on prior insured events. Reserve
estimates can change over time because of unexpected changes in the internal
and/or external environment. Assumptions internal to company operations include:
recording of premium and loss statistics in the appropriate detail is accurate
and consistent; claims handling, including the recording of claims, payment and
closure rates, and case reserving is consistent; the quality of business written
and the mix of business (e.g. states, limits, coverages and deductibles) have
been consistent; rate changes and changes in policy provisions have been
measured accurately; reinsurance coverage has been consistent and reinsured
losses are collectible. Assumptions related to the external environment include:
tort law and the legal environment have been and remain consistent; coverage
interpretation by the courts has been and remains consistent; regulations
regarding coverage provisions have been consistent; and loss inflation is
relatively stable. To the extent any of the above factors have changed over
time, attempts are made to adjust for the changes.
The following example is presented to illustrate the sensitivity of loss
estimates to a change in the stable loss inflation assumption. The impact of an
unexpected increase in loss inflation was determined by deriving expected
payment patterns for each major product line and applying these patterns to the
December 31, 2004, loss and LAE reserves to generate estimated annual payments
for each subsequent calendar year. Then, an explicit annual incremental
inflationary trend of one percent was applied to the annual payments, and
revised loss and LAE payments were calculated. The estimated cumulative impact
that this additional unexpected one percent increase in the inflationary trend
would have on our results over the lifetime of the underlying claims is shown
below.
39
ITEM 7. CONTINUED
Product Line Before-tax Income Reduction
- ------------------------------------ ---------------------------
Homeowners $ 2.4
Personal automobile 4.8
Commercial automobile 5.5
Workers' compensation 45.5
Commercial multi-peril 10.6
General liability including umbrella 27.8
This additional unexpected claims inflation trend could arise from a variety of
sources such as a general increase in economic inflation, an increase in tort
costs, the introduction of higher cost medical technologies and procedures,
changes in the utilization of medical procedures, or increased life expectancy.
Unexpected changes to other internal and external assumptions could also
generate changes to the expected loss and LAE payments.
The Group has three categories of loss and LAE reserves that it considers highly
uncertain, and therefore, could have a material impact on future financial
results: asbestos and environmental liability, construction defect and
commercial umbrella exposures. These categories are described below with
relevant historical data.
In recent years, asbestos and environmental liability claims have expanded
greatly in the insurance industry. Historically, the Group has written small
commercial accounts with a focus on contracting business. Within the
manufacturing category, the Group has concentrated on light manufacturers. Thus
the Group's exposure to asbestos is related to installers and distributors as
opposed to the large manufacturers. Consequently, the Group believes it does not
have exposure to the primary defendants involved in major asbestos litigation.
The Group's exposure to environmental liability is due to policies written prior
to the introduction of the absolute pollution endorsement in the mid-80's, and
to underground storage tanks mostly from New Jersey homeowners policies in
recent years. The Group has limited exposures to the national priority list, a
list of known or threatened releases of hazardous substances, pollutants, or
contaminants throughout the United States.
In 2004 and 2003, respectively, the Group increased loss and LAE reserves by
$12.3 and $12.0 for environmental claims. In 2002, the Group re-classified
approximately $5.0 of homeowners reserves related to underground storage tanks
as environmental reserves. For 2004 and 2003, respectively, the asbestos and
environmental reserves, prior to the impact of reinsurance, were $90.8 and
$78.0. Asbestos reserves were $38.0 and $37.6, and environmental reserves were
$52.8 and $40.4 for 2004 and 2003, respectively.
The Group defines construction defect exposure as liability for allegations of
defective work and completed operations losses from general liability,
commercial multiple peril liability and umbrella liability policies involving
multiple-units (condos/townhouses/apartments/tracts of single family homes),
multiple defendants (e.g. developers, sub-contractors), usually with multiple
defect issues, and often involving multiple insurance carriers. The Group
excludes from the definition, claims related to individual single family homes,
apartments/townhomes or other residential properties if the defect issues are
limited in scope and volume.
The number of construction defect claims reported in 2004, 2003 and 2002 were
332, 271 and 224, respectively. Paid losses, net of reinsurance, in 2004 were
$9.9, compared to $16.5 in 2003 and $11.4 in 2002. Paid claims legal related
LAE, net of reinsurance, for construction defect claims were $5.1 in 2004,
compared with $4.3 in 2003 and $4.1 in 2002. These totals exclude construction
defect losses from the state of California. Although the Group has construction
defect losses from California exposure, it excludes California from this data
because the Group stopped writing in the state in 1993 and the remaining claims
are minimal.
The Group writes commercial umbrella business with large policy limits that are
heavily reinsured. The period of time between the loss occurrence, the reporting
of the claim to the insurer, and the settlement of the claim can be substantial.
The large policy limits coupled with this lengthy time period increase the
uncertainty of loss estimates before the application of reinsurance. For 2004
and 2003 loss and LAE reserves prior to reinsurance were $637.1 and $496.0,
respectively. For losses occurring in 2004, reinsurance purchased by the Group
limits
40
ITEM 7. CONTINUED
its retention of losses to 100% of the first $1.0, 3.5% of $4.0 excess of $1.0
and 7% of $20 excess of $5.0. The reinsurance purchased in 2003 and 2002 was
comparable to that purchased in 2004. For 2004 and 2003 loss and LAE reserves
net of reinsurance were $236.1 and $198.5, respectively.
Results for the year 2004 were favorably impacted by losses and LAE incurred for
prior accident years totaling $21.8 before tax on an All Lines basis. This
amount and those stated below are net of reinsurance, including change in the
allowance for uncollectible reinsurance recoverables. Losses and LAE incurred
for prior accident years were recognized during the year 2004 due to new
information that caused a revision to prior estimates for loss and LAE reserves.
The following table provides the before-tax amount of prior accident year loss
and LAE reserve development by reportable segment:
(Favorable) Unfavorable 2004 2003 2002
- ------------------------------------------- ------ ------ -----
Commercial Lines $(15.0) $ 41.0 $73.9
Specialty Lines (9.4) (21.3) (2.2)
Personal Lines 2.6 14.4 12.7
------ ------ -----
Total Prior Accident Years' Development $(21.8) $ 34.1 $84.4
====== ====== =====
For the Commercial Lines operating segment, the favorable loss and LAE
development for prior accident years recorded during 2004 was concentrated in
the commercial automobile product line. In 2003, the adverse development was
concentrated in the general liability, commercial multi-peril and workers'
compensation product lines. In 2002, the adverse development was concentrated in
the general liability product line, and was heavily impacted by construction
defect losses. Commercial automobile and workers' compensation also contributed
to the 2002 adverse development.
For the Specialty Lines operating segment, the favorable loss and LAE
development for prior accident years recorded during 2004 was concentrated in
the commercial umbrella and bonds product lines. In 2003, the favorable
development was concentrated in the commercial umbrella product line.
For the Personal Lines operating segment, the adverse loss and LAE development
for prior accident years recorded during 2004, 2003 and 2002 was concentrated
in the personal automobile including personal umbrella product line.
The following table provides prior year development for loss and LAE by accident
year:
2004 2003 2002
------- ------ ------
Accident Year 2003 $ (36.9) $ - $ -
Accident Year 2002 (10.4) (39.0) -
Accident Year 2001 (0.9) 8.0 (15.8)
Accident Year 2000 0.4 29.8 10.2
Accident Year 1999 & prior 26.0 35.3 90.0
------- ------ ------
Total Prior Accident Years' Development $ (21.8) $ 34.1 $ 84.4
======= ====== ======
The amount of statutory loss and LAE reserves by accident year at the beginning
of 2004 was $602.8 for accident year 2003, $401.8 for accident year 2002 and
$1,124.3 for accident year 2001 and prior.
In the opinion of management, the reserves recorded at December 31, 2004,
represent the Group's best estimate of its ultimate liability for losses and
LAE. However, due to the inherent complexity of the estimation process and the
potential variability of the assumptions used, final claim settlements may vary
significantly from the amounts recorded. Furthermore, the timing, frequency and
extent of adjustments to the estimated liabilities cannot be predicted since
conditions and events which established historical loss and LAE reserve
development and which serve as the basis for estimating ultimate claim costs may
not occur in exactly the same manner, if at all.
41
ITEM 7. CONTINUED
REINSURANCE PROGRAMS
The Group maintains several programs that provide reinsurance coverage. The
programs in effect for 2004 and key changes in these programs for 2005 are
summarized below.
The Group's 2004 property per risk program covers property losses in excess of
$1.5 for a single insured, for a single event. This property per risk program
covers up to $13.5 in losses in excess of the $1.5 retention level for a single
event. The retention on the property per risk excess of loss treaty increased to
$2.0 in 2005. The Group's casualty per occurrence program covers liability
losses. For 2004, workers' compensation, umbrella and other casualty reinsurance
cover losses up to $58.8, $22.4 and $22.8, respectively, in excess of the $1.0
retention level for a single insured event. The 2004 casualty reinsurance treaty
includes a layer of coverage of $5.0 in excess of $1.0 that consists of a
reinsurance treaty fund managed by the Group, and the Group has title to the
assets held in this fund. Ceded premiums are paid by the Group into the
reinsurance treaty fund and reinsured losses are paid to the Group under the
terms of the reinsurance agreement with various reinsurers. The reinsurers bear
the risk of losses in excess of the assets held in the reinsurance treaty fund.
The Group's ability to manage the investments of the fund reduces credit risk
related to reinsurers. The balance of the reinsurance treaty fund as of December
31, 2004, was approximately $195.0. For 2005, the casualty $5.0 layer excess of
$1.0 retention was replaced by two treaties. For casualty other than commercial
umbrella, a $4.0 layer excess of $2.0 retention was purchased; the Group retains
15% of the $4.0 layer. For commercial umbrella, a $3.0 layer excess of $2.0
retention was purchased; the Group retains 25% and 50% of the $3.0 layer for
supported and unsupported policies, respectively.
The property catastrophe reinsurance program protects the Group against an
accumulation of losses arising from one defined catastrophic occurrence or
series of events. The 2004 program provided $80.0 of coverage in excess of the
Group's $25.0 retention level. The catastrophe excess of loss treaty changed to
$100.0 in excess of $25.0 for 2005. Over the last 20 years, only two events
triggered coverage under the catastrophe reinsurance program. Both of these
losses exceeded the prior retention amount of $13.0, resulting in significant
recoveries from reinsurers. Reinsurance limits are purchased to cover exposure
to catastrophic events having the probability of occurring approximately every
250 years.
GAI agreed to maintain reinsurance on the commercial lines business that the
Group acquired from GAI and its affiliates in 1998 for loss dates prior to
December 1, 1998. GAI is obligated to reimburse the Group if GAI's reinsurers
are unable to pay claims with respect to the acquired commercial lines business.
Reinsurance contracts do not relieve the Group of their obligations to
policyholders. The collectibility of reinsurance depends on the solvency of the
reinsurers at the time any claims are presented. The Group monitors each
reinsurer's financial health and claims settlement performance because
reinsurance protection is an important component of the Corporation's financial
plan. Each year, the Group reviews financial statements and calculates various
ratios used to identify reinsurers who no longer meet appropriate standards of
financial strength. Reinsurers who fail these tests are reviewed and those that
are determined by the Group to have insufficient financial strength are removed
from the program at renewal. Additionally, a large base of reinsurers is
utilized to mitigate concentration of risk. The Group also records an estimated
allowance for uncollectible reinsurance amounts as deemed necessary. During the
last three fiscal years, no reinsurer accounted for more than 15 percent of
total ceded premiums. As a result of these measures, amounts of uncollectible
reinsurance have not been significant. For more discussion on the reinsurance
recoverable asset, see Item 15, Notes to Consolidated Financial Statements,
Footnote 7 on page 64 of this Annual Report on Form 10-K.
42
ITEM 7. CONTINUED
INVESTMENT PORTFOLIO
The following table sets forth the distribution and other data of invested
assets for the years ended December 31, 2004 and December 31, 2003.
December 31, 2004 December 31, 2003
----------------- -----------------
Average Amortized Carrying % of Amortized Carrying % of
Rating Cost Value Total Cost Value Total
------- --------- -------- ----- --------- -------- -----
U.S. GOVERNMENT:
Available-for-sale AAA $ 31.9 $ 33.4 0.8 $ 40.9 $ 43.2 1.2
STATES, MUNICIPALITIES, AND POLITICAL
SUBDIVISIONS:
Investment grade:
Available-for-sale AA+ 1,018.4 1,034.6 24.4 76.8 79.1 2.1
CORPORATE SECURITIES:
Investment grade:
Available-for-sale A 1,562.8 1,686.4 39.7 1,863.6 2,001.4 53.4
Held-to-maturity A+ 164.7 164.7 3.9 167.7 167.7 4.5
Below Investment grade:
Available-for-sale BB- 51.6 58.4 1.4 77.5 84.0 2.2
--------- -------- ----- --------- -------- -----
Total corporate securities 1,779.1 1,909.5 45.0 2,108.8 2,253.1 60.1
--------- -------- ----- --------- -------- -----
MORTGAGE-BACKED SECURITIES:
Investment grade:
Available-for-sale AAA 505.2 524.7 12.4 778.3 799.8 21.3
Held-to-maturity AAA 136.7 136.7 3.2 188.4 188.4 5.0
Below Investment grade:
Available-for-sale CCC+ 6.9 8.6 0.2 14.1 14.7 0.4
--------- -------- ----- --------- -------- -----
Total mortgage-backed
securities 648.8 670.0 15.8 980.8 1,002.9 26.7
--------- -------- ----- --------- -------- -----
Total fixed maturities 3,478.2 3,647.5 86.0 3,207.3 3,378.3 90.1
Equity securities 98.9 357.4 8.4 77.9 329.0 8.8
Short-term investments 239.9 239.1 5.6 40.4 40.4 1.1
--------- -------- ----- --------- -------- -----
Total investment portfolio $ 3,817.0 $4,244.0 100.0 $ 3,325.6 $3,747.7 100.0
========= ======== ===== ========= ======== =====
The fixed maturity portfolio is allocated between investment grade and below
investment grade as follows:
December 31, 2004 December 31, 2003
----------------- -----------------
Amortized Carrying % of Amortized Carrying % of
Cost Value Fixed Cost Value Fixed
--------- -------- ----- --------- -------- -----
Total investment grade $ 3,419.7 $3,580.5 98.2 $ 3,115.7 $3,279.6 97.1
Total below investment grade 58.5 67.0 1.8 91.6 98.7 2.9
The fixed maturity portfolio is allocated between available-for-sale and
held-to-maturity as follows:
Total available-for-sale fixed
securities $ 3,176.8 $ 3,346.1 91.7 $ 2,851.2 $ 3,022.2 89.5
Total held-to-maturity fixed securities 301.4 301.4 8.3 356.1 356.1 10.5
The excess of market value over cost was $427.0 compared with $422.1 at year-end
2003. The increase in 2004 was attributable to the increase in the market value
of certain equity securities.
During 2004, the Corporation and Group, as a result of improved profitability,
changed its investment strategy to increase its investment into tax exempt
securities.
The consolidated fixed maturity portfolio, including short-term securities, has
an intermediate duration and a laddered maturity structure. The duration of the
fixed maturity portfolio was approximately 5.1 and 4.6 years as of December 31,
2004 and 2003, respectively. The Corporation and the Group remain fully invested
and do not time markets.
43
ITEM 7. CONTINUED
Fixed maturity securities are classified as investment grade or non-investment
grade based upon the higher of the ratings provided by S&P and 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 $31.5 and $24.0 at December 31, 2004 and 2003, respectively.
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 significantly 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 and subordinate to other debt. 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.
Following is a table displaying available-for-sale non-investment grade and
non-rated securities in an unrealized loss position at December 31, 2004 and
December 31, 2003:
Amortized Fair Unrealized
Cost Value Loss
--------- ----- ----------
2004 $ 1.5 $ 1.4 $ (0.1)
2003 23.5 22.6 (0.9)
The majority of mortgage-backed security holdings within the fixed maturity
portfolio are in sequential structures, planned amortization class and agency
pass-through securities. Of this portfolio, $0.2, and $6.2 were invested in more
volatile bond classes (e.g. interest-only securities which do not return
principal at maturity, super-floater securities which pay interest at a formula
rate that is a function of LIBOR and inverse-floater securities which pay
interest per a formula that adjusts inversely to changes in LIBOR rates) at
December 31, 2004 and 2003, respectively.
Equity securities are carried at fair market value on the consolidated balance
sheets. As a result, shareholders' equity and statutory surplus fluctuate with
changes in the value of the equity portfolio. As of December 31, 2004, the
equity portfolio consisted of stocks in a total of 50 separate entities in 38
different industries. Of this total, 31.2% was invested in five companies and
the largest single position was 7.3% 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.
In June 2004, the Corporation invested the proceeds of the June 2004 Senior Note
offering in short-term instruments. Short-term investments are carried at fair
market value on the consolidated balance sheets and produce a lower yield.
The investment portfolio also 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 December 31, 2004,
was $310.8 compared to $318.8 at December 31, 2003.
The Corporation and Group use assumptions and estimates when valuing certain
investments and related income. These assumptions include estimations of cash
flows and interest rates. Although the Corporation and Group believe the values
of its investments represent fair value, certain estimates could change and lead
to changes in fair values due to the inherent uncertainties and judgements
involved with accounting measurements.
44
ITEM 7. CONTINUED
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
MD&A that are not historical information, are forward-looking statements. The
Private Securities Litigation Reform Act of 1995 provides a safe harbor under
the Securities Act of 1933 and the Securities Exchange Act of 1934 for
forward-looking statements. 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 in this release. 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 appoint and/or retain agents;
ability to achieve targeted expense savings; ability to achieve premium targets
and profitability goals; and general economic and market conditions.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
MARKET RISK DISCLOSURES FOR FINANCIAL INSTRUMENTS
Market risk is the risk of loss resulting from adverse changes in interest
rates. In addition to market risk, the Corporation and the Group are exposed to
other risks such as equity price risk, credit, reinvestment and liquidity risk.
Credit risk refers to the financial risk that an obligation will not be paid and
a loss will result. Reinvestment risk is the risk that interest rates will fall
causing the reinvestment of interim cash flows to earn less than the original
investment. Liquidity risk describes the ease with which an investment can be
sold without substantially affecting the asset's price. The sensitivity analysis
below summarizes only the exposure to market risk and equity price risk.
The Corporation and the Group strive to produce competitive returns by investing
in a diversified portfolio of securities issued by high-quality companies.
Market Risk - The Corporation and the Group have exposure to losses resulting
from potential volatility in interest rates. The Corporation and the Group
attempt to mitigate the exposure to interest rate risk through active portfolio
management, periodic reviews of asset and liability positions and through
maintaining a laddered fixed maturity portfolio with an intermediate duration.
Estimates of cash flows and the impact of interest rate fluctuations relating to
the fixed maturity investment portfolio are modeled quarterly and reviewed
regularly.
Equity Price Risk - Equity price risk can be separated into two elements. The
first, systematic risk, is the portion of a portfolio or individual security's
price movement attributed to stock market movement as a whole. The second
element, nonsystematic risk, is the portion of price movement unique to the
individual portfolio or security. This risk can be further divided between
characteristics of the industry and of the individual issuer. The Corporation
and the Group attempt to manage nonsystematic risk by maintaining a portfolio
that is diversified across industries and companies.
The following tables illustrate the hypothetical effect of an increase in
interest rates of 100 basis points (1%) and a 10% decrease in equity values at
December 31, 2004, 2003 and 2002, respectively. The changes selected above
reflect management's view of shifts in rates and values that are quite possible
over a one-year period. These rates should not be considered a prediction of
future events.
Interest rates may, in fact, be much more volatile in the future. This analysis
is not intended to provide a precise forecast of the effect of changes in
interest rates and equity prices on income, cash flow or shareholders' equity.
In addition, the analysis does not take into account any actions that may be
taken to reduce the exposure in response to market fluctuations.
45
ITEM 7A. CONTINUED
Estimated Adjusted Market Value
Fair Value as indicated above
---------- ---------------------
December 31, 2004
Interest Rate Risk:
Fixed maturities $ 3,649.2 $ 3,463.1
Short-term investments 239.1 239.1
Equity Price Risk:
Equity securities 357.4 321.7
--------- ---------
Totals $ 4,245.7 $ 4,023.9
========= =========
December 31, 2003
Interest Rate Risk:
Fixed maturities $ 3,378.3 $ 3,222.9
Short-term investments 40.4 40.4
Equity Price Risk:
Equity securities 329.0 296.1
--------- ---------
Totals $ 3,747.7 $ 3,559.4
========= =========
December 31, 2002
Interest Rate Risk:
Fixed maturities $ 3,139.8 $ 2,997.5
Short-term investments 49.8 49.8
Equity Price Risk:
Equity securities 312.5 281.1
--------- ---------
Totals $ 3,502.1 $3 ,328.4
========= =========
Certain assumptions are inherent in the above analysis. An instantaneous and
parallel shift in interest rates and a simultaneous decline of 10% in equity
prices at December 31, 2004, 2003 and 2002, are assumed. Also, it is assumed
that the change in interest rates is reflected uniformly across all financial
instruments. The adjusted market values are estimated using discounted cash flow
analysis and duration modeling.
ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
See Item 15 for Index to Consolidated Financial Statements, including the Notes
to Consolidated Financial Statements and the Report of Independent Registered
Public Accounting Firm, and Schedules on page 49 of this Annual Report on Form
10-K.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
ITEM 9A. CONTROLS AND PROCEDURES
(a) Evaluation of Disclosure Controls and Procedures
The Corporation's Chief Executive Officer and Chief Financial Officer have
evaluated the Corporation's disclosure controls and procedures as of the
end of the period covered by this report and they have concluded that
these controls and procedures are effective.
46
ITEM 9A. CONTINUED
(b & c) Management's Annual Report on Internal Control over Financial
Reporting
The management of the Corporation is responsible for establishing and
maintaining adequate internal control over financial reporting. The
Corporation's internal control system was designed to provide reasonable
assurance to the Corporation's management and board of directors
regarding the preparation and fair presentation of published financial
statements.
All internal control systems, no matter how well designed, have inherent
limitations. Therefore, even those systems determined to be effective
can provide only reasonable assurance with respect to financial
statement preparation and presentation.
The Corporation's management assessed the effectiveness of the
Corporation's internal control over financial reporting as of December
31, 2004. In making this assessment, it used the criteria set forth by
the Committee of Sponsoring Organizations of the Treadway Commission
(COSO) in Internal Control-Integrated Framework. Based on our assessment
we believe that, as of December 31, 2004, the Corporation's internal
control over financial reporting is effective based on those criteria.
The Corporation's independent registered public accounting firm has
issued an audit report on our assessment of the Company's internal
control over financial reporting. This report appears on page 73 of this
Annual Report on Form 10-K.
(d) Changes in Internal Control over Financial Reporting
There have been no significant changes in internal control over
financial reporting that occurred during the fourth quarter of 2004,
that have materially affected, or are reasonably likely to materially
affect, the Corporation's internal control over financial reporting.
ITEM 9B. OTHER INFORMATION
None
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Incorporated by reference herein from those portions of the Corporation's Proxy
Statement for the Annual Meeting of Shareholders of the Corporation for 2005
under the headings "Election of Directors," "Other Matters," "Meetings of the
Board of Directors and Committees of the Board," "Shareholder Proposals and
Nominations" and "Section 16(a) Beneficial Ownership Reporting Compliance."
Additionally, incorporated by reference is the "Code of Ethics for Senior
Financial Officers" disclosed on the Corporation's website at www.ocas.com.
The following table provides information for executive officers of the
Corporation who are not separately reported in the Corporation's Proxy
Statement:
47
ITEM 10. CONTINUED
EXECUTIVE OFFICERS OF THE REGISTRANT
Position with Company and/or
Principal Occupation or Employment
Name Age During Last Five Years
- ---- --- ------------------------------------------------
Ralph G. Goode 59 Senior Vice President of the Corporation's
insurance subsidiaries since December 1998. Mr.
Goode served as Vice President of the
Corporation's insurance subsidiaries from October
1995 through November 1998.
John S. Kellington 43 Senior Vice President and Chief Technology
Officer of the Corporation's insurance
subsidiaries since December 2002. Chief
Technology Officer of the Corporation's insurance
subsidiaries since April 2001. Mr. Kellington
served as Chief Architect and Principal, National
Insurance Practice of IBM Global Services from
1996 to April 2001.
Thomas E. Schadler 54 Senior Vice President and Chief Actuary of the
Corporation's insurance subsidiaries since April
2001. Mr. Schadler served as Vice President and
Chief Actuary of Grange Insurance Company from
September 1997 to April 2001 and as Vice
President and Chief Actuary of
Shelby/Anthem/Vesta Companies from September 1988
to September 1997.
Howard L. Sloneker III 48 Senior Vice President of the Corporation's
insurance subsidiaries since December 1998. Mr.
Sloneker also served as Senior Vice President of
the Corporation from December 1998 to April 2002
and as Secretary of the Corporation and its
subsidiaries from April 1988 to April 2002.
ITEM 11. EXECUTIVE COMPENSATION
Incorporated by reference herein from those portions of the Corporation's Proxy
Statement for the Annual Meeting of Shareholders of the Corporation for 2005
under the headings "Executive Compensation," "Employment and Separation
Agreements," "Change in Control Agreements," "Pension Plans," "Report of the
Executive Compensation Committee," and "Report of the Audit Committee."
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Incorporated by reference herein from those portions of the Corporation's Proxy
Statement for the Annual Meeting of Shareholders of the Corporation for 2005
under the headings "Principal Shareholders," and "Shareholdings of Directors,
Executive Officers and Nominees for Election as Director," and "Equity
Compensation Plans."
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Incorporated by reference herein from these portions of the Corporation's Proxy
Statement from the Annual Meeting of Shareholders of the Corporation for 2005
under the heading "Certain Relationships and Related Transactions."
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES
Incorporated by reference herein from those portions of the Corporation's Proxy
Statement from the Annual Meeting of Shareholders of the Corporation for 2005
under the heading "Principal Accountant Fees" and "Policies and Procedures
Regarding Pre-Approval of Accountant Fees."
48
PART IV
ITEM 15. EXHIBITS, FINANCIAL STATEMENTS SCHEDULES
(a) FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES REQUIRED TO BE
FILED BY ITEM 8 OF THIS FORM AND REGULATION S-X
Page Number
in this Report
--------------
(1) The following statements are included herein:
Consolidated Balance Sheets at December 31, 2004 and 2003 50
Consolidated Statements of Income for the years ended
December 31, 2004, 2003 and 2002 51
Consolidated Statements of Shareholders' Equity for the years
ended December 31, 2004, 2003 and 2002 52
Consolidated Statements of Cash Flows for the years ended
December 31, 2004, 2003 and 2002 53
Notes to Consolidated Financial Statements 54-71
Reports of Independent Registered Public Accounting Firm 72-73
(2) The following financial statement schedules are included herein:
Schedule I - Consolidated Summary of Investments Other
than Investments in Related Parties at December 31, 2004 75
Schedule II - Condensed Financial Information of Registrant
for the years ended December 31, 2004, 2003 and 2002 76
Schedule III - Consolidated Supplementary Insurance
Information for the years ended December 31, 2004, 2003
and 2002 77-79
Schedule IV - Consolidated Reinsurance for the years ended
December 31, 2004, 2003 and 2002 80
Schedule V - Valuation and Qualifying Accounts for the years
ended December 31, 2004, 2003 and 2002 81
Schedule VI - Consolidated Supplemental Information
Concerning Property and Casualty Insurance Operations for
the years ended December 31, 2004, 2003 and 2002 82
(b) EXHIBITS.
See Index to Exhibits on pages 83 and 84 of this Annual Report on Form 10-K.
49
ITEM 15. CONTINUED
CONSOLIDATED BALANCE SHEETS
DECEMBER 31 (IN MILLIONS, EXCEPT SHARE DATA) 2004 2003
======================================================= ========= ========
ASSETS
Investments, at fair value:
Fixed maturities:
Available for sale, at fair value
(amortized cost: $3,176.8 and $2,851.2) $ 3,346.1 $ 3,022.2
Held-to-maturity, at amortized cost
(fair value: $303.1 and $354.2) 301.4 356.1
Equity securities, at fair value
(cost: $98.9 and $77.9) 357.4 329.0
Short-term investments, at fair value 239.1 40.4
--------- ---------
Total investments 4,244.0 3,747.7
Cash 13.5 16.5
Premiums and other receivables, net of allowance 350.8 347.9
Deferred policy acquisition costs 159.8 169.3
Property and equipment, net of accumulated depreciation 82.9 89.2
Reinsurance recoverable, net of allowance 666.5 592.7
Agent relationships, net of accumulated amortization 122.0 142.6
Interest and dividends due or accrued 49.9 47.5
Other assets 25.6 15.5
--------- ---------
Total assets $ 5,715.0 $ 5,168.9
========= =========
LIABILITIES
Insurance reserves:
Losses $ 2,269.6 $ 2,163.7
Loss adjustment expenses 486.8 464.1
Unearned premiums 715.5 703.0
Debt 383.3 198.0
Reinsurance treaty funds held 195.0 150.5
Deferred income taxes 21.9 12.8
Other liabilities 348.0 331.0
--------- ---------
Total liabilities 4,420.1 4,023.1
SHAREHOLDERS' EQUITY
Common stock, $.125 par value
Authorized shares: 150,000,000
Issued shares: 72,418,344 and 72,418,344 9.0 9.0
Accumulated other comprehensive income 259.1 254.7
Retained earnings 1,161.5 1,033.4
Treasury stock, at cost:
(Shares: 10,209,215 and 11,461,301) (134.7) (151.3)
--------- ---------
Total shareholders' equity 1,294.9 1,145.8
--------- ---------
Total liabilities and shareholders' equity $ 5,715.0 $ 5,168.9
========= =========
See notes to consolidated financial statements
50
ITEM 15. CONTINUED
CONSOLIDATED STATEMENTS OF INCOME
YEAR ENDED DECEMBER 31 (IN MILLIONS,
EXCEPT SHARE AND PER SHARE DATA) 2004 2003 2002
============================================================== ========== ========== ==========
Premiums and finance charges earned $ 1,446.8 $ 1,424.4 $ 1,450.5
Investment income, less expenses 201.2 208.7 207.1
Investment gains realized, net 23.0 35.9 45.2
---------- ---------- ----------
Total revenues 1,671.0 1,669.0 1,702.8
Losses and benefits for policyholders 777.6 852.5 902.7
Loss adjustment expenses 158.7 174.9 227.1
General operating expenses 504.9 488.7 499.4
Amortization of agent relationships 6.9 7.4 10.2
Write-down of agent relationships 13.7 11.3 69.5
Amortization of deferred policy acquisition costs 365.2 384.0 376.2
Deferral of policy acquisition costs (355.7) (372.0) (390.7)
Depreciation and amortization expense 13.2 14.6 15.1
---------- ---------- ----------
Total expenses 1,484.5 1,561.4 1,709.5
---------- ---------- ----------
Income (loss) before income taxes 186.5 107.6 (6.7)
Income tax expense (benefit):
Current 50.0 21.2 (13.9)
Deferred 6.5 10.6 8.1
---------- ---------- ----------
Total income tax expense (benefit) 56.5 31.8 (5.8)
---------- ---------- ----------
Income (loss) before cumulative effect of an accounting change 130.0 75.8 (0.9)
Cumulative effect of an accounting change, net of tax (1.6) - -
---------- ---------- ----------
Net income (loss) $ 128.4 $ 75.8 $ (0.9)
========== ========== ==========
Average shares outstanding - basic 61,509,128 60,848,718 60,494,104
========== ========== ==========
Earnings per share - basic
Net income (loss), per share $ 2.09 $ 1.25 $ (0.01)
========== ========== ==========
Average shares outstanding - diluted 71,508,519 70,224,196 60,494,104
========== ========== ==========
Earnings per share - diluted
Net income (loss), per share $ 1.89 $ 1.18 $ (0.01)
========== ========== ==========
See notes to consolidated financial statements
51
ITEM 15. CONTINUED
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
COMMON ACCUMULATED
ADDITIONAL STOCK OTHER TOTAL
(IN MILLIONS, EXCEPT COMMON PAID-IN PURCHASE COMPREHENSIVE RETAINED TREASURY SHAREHOLDERS'
SHARE DATA) STOCK CAPITAL WARRANTS INCOME EARNINGS STOCK EQUITY
==================================== ======= ========== ======== ============= ========= ======== ============
Balance,
January 1, 2002 $ 11.8 $ 4.2 $ 21.1 $ 274.4 $ 1,221.5 $ (453.0) $ 1,080.0
Net loss (0.9) (0.9)
Change in unrealized gain,
net of deferred income tax
benefit of $10.0 (18.6) (18.6)
Change in minimum pension
liability, net of deferred income
tax benefit of $5.2 (9.6) (9.6)
----------
Other comprehensive loss (29.1)
Net issuance of restricted stock
(6,000 shares) 0.1 0.1
Net issuance of treasury
stock (613,283 shares) (0.1) (0.3) 8.1 7.7
Retirement of treasury stock
(22,000,000 shares) (2.8) (4.1) (283.6) 290.5 -
------- ------- -------- -------- --------- -------- ----------
Balance,
December 31, 2002 $ 9.0 $ - $ 21.1 $ 246.2 $ 936.7 $ (154.3) $ 1,058.7
Net income 75.8 75.8
Change in unrealized gain,
net of deferred income tax
expense of $14.8 27.4 27.4
Change in minimum pension
liability, net of deferred income
tax benefit of $10.2 (18.9) (18.9)
----------
Other comprehensive income 84.3
Expiration of warrants (21.1) 21.1 -
Net issuance of restricted stock
(11,000 shares) 0.1 0.1
Net issuance of treasury
stock (220,675 shares) (0.2) 2.9 2.7
------- ------- -------- -------- --------- -------- ----------
Balance,
December 31, 2003 $ 9.0 $ - $ - $ 254.7 $ 1,033.4 $ (151.3) $ 1,145.8
Net income 128.4 128.4
Change in unrealized gain,
net of deferred income tax
expense of $2.0 2.9 2.9
Change in minimum pension
liability, net of deferred
income tax expense of $0.8 1.5 1.5
----------
Other comprehensive income 132.8
Net issuance of restricted stock
(55,284 shares) (0.5) 0.7 0.2
Net issuance of treasury
stock (1,196,802 shares) 0.2 15.9 16.1
------- ------- -------- -------- --------- -------- ----------
Balance,
December 31, 2004 $ 9.0 $ - $ - $ 259.1 $ 1,161.5 $ (134.7) $ 1,294.9
======= ======= ======== ======== ========= ======== ==========
See notes to consolidated financial statements
52
ITEM 15. CONTINUED
CONSOLIDATED STATEMENTS OF CASH FLOWS
YEAR ENDED DECEMBER 31 (IN MILLIONS) 2004 2003 2002
======================================================================== ======== ======== ========
CASH FLOWS FROM OPERATING ACTIVITIES:
OPERATING ACTIVITIES
Net income (loss) $ 128.4 $ 75.8 $ (0.9)
Adjustments to reconcile net income (loss) to cash from operations:
Changes in:
Insurance reserves 141.1 228.4 284.9
Reinsurance treaty funds held 44.5 21.1 22.3
Income taxes 12.0 11.5 2.9
Premiums and other receivables (2.9) (23.2) 17.2
Deferred policy acquisition costs 9.5 12.0 (14.5)
Reinsurance recoverable (73.8) (172.8) (182.2)
Other assets (13.5) 0.5 2.5
Other liabilities 13.9 18.0 (33.6)
Amortization and write-down of agent relationships 20.6 18.7 79.7
Depreciation and amortization 13.2 14.6 15.1
Investment gains realized, net (23.0) (35.9) (45.2)
-------- -------- --------
Net cash provided by operating activities 270.0 168.7 148.2
-------- -------- --------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of securities:
Fixed maturity, available-for-sale (1,702.3) (1,207.9) (1,249.2)
Fixed maturity, held-to-maturity (1.9) (7.7) -
Equity (43.3) (6.1) (19.5)
Proceeds from sales of securities:
Fixed maturity, available-for-sale 1,262.5 883.5 948.3
Equity 56.8 39.8 100.9
Proceeds from maturities and calls of securities:
Fixed maturity, available-for-sale 103.6 95.5 62.4
Fixed maturity, held-to-maturity 53.3 17.4 -
Equity 3.4 13.7 -
Property and equipment:
Purchases (8.3) (9.9) (17.0)
Sales 1.8 6.1 0.4
-------- -------- --------
Net cash used in investing activities (274.4) (175.6) (173.7)
-------- -------- --------
CASH FLOWS FROM FINANCING ACTIVITIES:
Debt:
Proceeds from the issuance of convertible notes - - 201.3
Proceeds from the issuance of senior notes 199.3 - -
Repayments (13.0) (0.6) (205.6)
Payment for deferred financing costs - - (0.4)
Payment of issuance costs (1.3) - (7.4)
Proceeds from exercise of stock options 15.1 2.2 7.5
-------- -------- --------
Net cash provided by (used in) financing activities 200.1 1.6 (4.6)
-------- -------- --------
Net increase (decrease) in cash and cash equivalents 195.7 (5.3) (30.1)
Cash and cash equivalents, beginning of year 56.9 62.2 92.3
-------- -------- --------
Cash and cash equivalents, end of year $ 252.6 $ 56.9 $ 62.2
======== ======== ========
Additional disclosures:
Interest and related fees paid $ 17.0 $ 10.3 $ 14.9
Income taxes paid (refunded) 44.5 4.4 (7.0)
See notes to consolidated financial statements
53
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(All dollars in millions, except share and per share data, unless otherwise
stated)
NOTE 1 -- SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
A. NATURE OF BUSINESS
Ohio Casualty Corporation (the Corporation) is the holding company of The Ohio
Casualty Insurance Company, which is one of six property-casualty companies that
make up Ohio Casualty Group (the Group), whose primary products consist of
insurance for personal auto, homeowners, commercial property, commercial auto,
workers' compensation and other miscellaneous lines. The Group operates through
the independent agency system in over 40 states, with 29.5% of its 2004 net
premiums written generated in the states of New Jersey (11.5%), Pennsylvania
(9.1%) and Ohio (8.9%).
B. PRINCIPLES OF CONSOLIDATION
The consolidated financial statements have been prepared on the basis of
accounting principles generally accepted in the United States and include the
accounts of Ohio Casualty Corporation and its subsidiaries (The Ohio Casualty
Insurance Company, West American Insurance Company, Ohio Security Insurance
Company, American Fire and Casualty Company, Avomark Insurance Company and Ohio
Casualty of New Jersey, Inc.). In accordance with the provisions of Statement of
Financial Accounting Standard (FASB) Interpretation 46 (FIN 46) a variable
interest entity has also been included in the consolidated financial statements
of the Corporation. See Note 18 for further details on the variable interest
entity. Certain reclassifications have been made to prior years to conform to
the current year's presentation. All significant inter-company transactions have
been eliminated.
C. INVESTMENTS
Investment securities are classified into either the held-to-maturity category
or available-for-sale category. Fixed maturity securities classified as
held-to-maturity are carried at amortized cost because management has the
ability and positive intent to hold the securities until maturity.
Available-for-sale securities are those securities that would be available to be
sold in the future in response to liquidity needs, changes in market interest
rates and asset-liability management strategies, among others.
Available-for-sale securities are reported at fair value, with unrealized gains
and losses excluded from earnings and reported as a component of other
comprehensive income, net of deferred tax. Mortgage-backed securities are
amortized over a period based on estimated future principal payments, including
prepayments. Prepayment assumptions are reviewed periodically and adjusted to
reflect actual prepayments and changes in expectations. Variations from
prepayment assumptions will affect the life and yield of these securities.
Transfers of fixed maturity securities into the held-to-maturity category from
the available-for-sale category are made at fair value at the date of transfer.
The unrealized holding gain or loss at the date of transfer is retained in other
comprehensive income and in the carrying value of the held-to-maturity
securities. Such amounts are amortized over the remaining life of the security.
Fair values of fixed maturities are determined on the basis of dealer or market
quotations or comparable securities on which quotations are available. Equity
securities are carried at quoted market values and include nonredeemable
preferred stocks and common stocks.
The Corporation regularly evaluates all investments based on current
economic conditions, credit loss experience and other specific developments. The
Corporation monitors the difference between the cost and estimated fair value of
investments to determine whether a decline in value is temporary or other than
temporary in nature. 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. If a decline in the net realizable value of a security is determined
to be other than temporary, it is treated as a realized loss and the cost basis
of the security is reduced to its estimated fair value.
Short-term investments include securities with maturities of 90 days or
less at the date of acquisition and are stated at fair value, which approximates
cost.
Realized gains or losses on disposition of investments are determined on
the basis of the cost or amortized cost of specific investments sold on the
trade date basis.
D. FAIR VALUE OF FINANCIAL INSTRUMENTS
The carrying amounts of the Corporation's financial instruments include cash and
short-term investments which approximate fair value at December 31, 2004 and
2003. The fair value of the convertible and senior notes is based on quoted
market prices. As of December 31, 2004, the fair value of the convertible and
senior notes was $201.3 and $215.2, respectively. The carrying value of the
convertible and senior notes as of December 31, 2004 was $182.5 and $197.6,
respectively. The fair value of the convertible notes as of December 31, 2003
was $210.3, compared to a carrying value of $194.3.
E. PREMIUMS
Property and casualty insurance premiums are earned principally on a monthly pro
rata basis over the term of the policy; the premiums applicable to the unexpired
terms of the policies are included in unearned premium reserve. Premiums
receivable represents amounts due on insurance policies. The premiums receivable
balance is presented net of bad debt allowances determined by management of $4.3
and $4.2 at December 31, 2004 and 2003, respectively.
F. DEFERRED POLICY ACQUISITION COSTS
Acquisition costs incurred at policy issuance net of applicable reinsurance
ceding commissions are deferred and amortized over the term of the policy in
order to facilitate a matching of revenues and expenses. Acquisition costs which
are deferred consist principally of commissions, brokerage fees, salaries and
benefits and other underwriting expenses to include allocations for inspections,
taxes, rent and other expenses which vary directly with the acquisition of
insurance contracts. Quarterly, an analysis of the
54
deferred policy acquisition costs is performed in relation to the expected
recognition of revenues including investment income to determine if deferred
costs can be recovered through future revenue streams. No recoverability issues
were indicated in the periods presented.
G. PROPERTY AND EQUIPMENT
Property and equipment are carried at cost less accumulated depreciation of
$167.4 and $152.9 at December 31, 2004 and 2003, respectively. Depreciation is
computed principally on the straight-line method over the estimated useful lives
of the assets. Buildings are depreciated over an estimated useful life of 32
years, furniture and equipment over a three to seven year useful life.
H. INTERNALLY DEVELOPED SOFTWARE
In accordance with Statement of Position (SOP) 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
value of the asset exceeds the carrying value. Management evaluates the asset on
an annual basis for impairment. 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 sheets were $55.2 and $11.4 at December 31, 2004, and $52.0
and $7.2 at December 31, 2003, respectively.
I. 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 asset represents the excess of cost over the fair value of net
assets acquired. Agent relationships are amortized on a straight-line basis over
a twenty-five year period. Agent relationships are evaluated quarterly in
accordance with FASB 144 "Accounting for the Impairment or Disposal of
Long-Lived Assets," as events or circumstances, such as cancellation of agents,
indicate a possible inability to recover their carrying amount. Such evaluation
is based on various analyses, including cash flow and profitability projections
that incorporate, as applicable, the impact on existing company businesses. The
analyses involves significant management judgments to evaluate the capacity of
an acquired agent relationship to perform within projections. If future
projected undiscounted cash flows are insufficient to recover the carrying
amount of the asset, an impairment loss is recognized (See Note 14).
J. LOSS RESERVES
The reserves for unpaid losses and loss adjustment expenses (LAE) are based on
estimates of ultimate claim costs, including claims incurred but not reported
(IBNR), salvage and subrogation and inflation without discounting. For reported
losses, a case reserve is established within the parameters of coverage provided
in the insurance policy. Reserves are reviewed quarterly using generally
accepted actuarial techniques and any resulting adjustments are reflected in
current earnings. The estimates are developed using the facts in each case,
experience with similar cases and the effects of current developments and
anticipated trends. Accordingly there can be no assurance that the ultimate
liability will not vary from such estimates.
K. REINSURANCE
In the normal course of business, the Group seeks to diversify risk and reduce
the loss that may arise from catastrophes or other events that cause unfavorable
underwriting results by reinsuring certain levels of risk in various areas of
exposure with other insurance enterprises or reinsurers. The Group records its
ceded reinsurance transactions on a gross basis and records an asset as
reinsurance recoverable for estimates of paid and unpaid losses, including
estimates for losses incurred but not reported. The Group evaluates the
financial condition of its reinsurers and monitors concentrations of credit risk
to minimize exposure to significant losses from reinsurer insolvencies. To the
extent that any reinsuring companies are unable to meet obligations under the
agreements covering the reinsurance ceded, the Group would remain liable.
Amounts recoverable from reinsurers are calculated in a manner consistent with
the reinsurance contract and are reported net of an allowance of $2.3 and $2.4
as of December 31, 2004 and 2003, respectively. The Group is also required to
maintain a reinsurance treaty fund as stipulated by the first layer casualty
treaty. The Group deposits premium into the fund and makes withdrawals to pay
claims that qualify for that contract of reinsurance. Interest from the
securities is shared with the reinsurers. The securities held by the fund are
recorded as assets with a corresponding liability on the Corporation's
consolidated balance sheets. The ceded reinsurance transactions are recorded in
the same manner as all other cessions.
L. INCOME TAXES
The Corporation files a consolidated federal income tax return. The Corporation
records deferred tax assets and liabilities based on temporary differences
between the financial statement and tax basis of assets and liabilities using
enacted tax rates in effect in the year in which the differences are expected to
reverse. The principal assets and liabilities giving rise to such differences
are net unrealized gains/losses on securities, loss reserves, unearned premium
reserves, deferred policy acquisition costs and accruals not currently
deductible. The Corporation reviews its deferred tax assets for recoverability.
At December 31, 2004 and 2003, the Corporation is able to
55
demonstrate that the benefit of its deferred tax assets is fully realizable.
M. STOCK OPTIONS
The Corporation accounts for stock options issued to employees 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. See Note 19 for the Corporation's disclosure
regarding the adoption of FASB 123(R). Had the Corporation adopted income
statement recognition requirements of FASB 123 "Accounting for Stock Based
Compensation," the Corporation's net income (loss) and earnings (loss) per share
would have been reduced to the pro forma amounts disclosed below:
2004 2003 2002
------- ------- --------
Net income (loss)
As reported: $ 128.4 $ 75.8 $ (0.9)
Add: Stock-based employee
compensation reported in
net income (loss), net of
related tax effect 0.3 0.1 0.1
Deduct: Total stock-based
employee compensation,
net of related tax effects 6.4 5.8 4.6
------- ------- --------
Pro Forma: $ 122.3 $ 70.1 $ (5.4)
======= ======= ========
Basic EPS
As reported: $ 2.09 $ 1.25 $ (0.01)
Pro Forma: $ 1.99 $ 1.15 $ (0.09)
Diluted EPS*
As reported: $ 1.89 $ 1.18 $ (0.01)
Pro Forma: $ 1.81 $ 1.09 $ (0.09)
======= ======= ========
*Diluted EPS has been adjusted for the effect of EITF Issue No. 04-8 in 2004,
2003 and 2002. Also see Note 10.
N. INSURANCE ASSESSMENTS
The Group accrues a liability for insurance related assessments in accordance
with SOP 97-3 "Accounting by Insurance and Other Enterprises for
Insurance-Related Assessments." As of December 31, 2004 and 2003, the
undiscounted liability for these assessments was $8.8 and $8.9, respectively. A
portion of these assessments are recoupable by the Group based upon premium tax
credits or policyholder surcharges. In accordance with SOP 97-3, the Corporation
has established an asset of $1.7 at December 31, 2004. There was no such asset
recorded at December 31, 2003. These amounts are expected to be realized in the
near future as premium tax credits are used on the tax returns for the
respective states and/or policyholder surcharges are collected.
O. EARNINGS PER SHARE
Earnings per share of common stock is presented using basic and diluted earnings
per share. Basic earnings per share is calculated using the weighted average
number of common stock shares outstanding during the period. Diluted earnings
per share includes the effect of the assumed exercise of dilutive common stock
options and the convertible debt impact based upon the "if-converted" method as
prescribed in EITF 04-8.
P. CASH AND CASH EQUIVALENTS
Short-term investments are comprised of highly liquid investments that are
readily convertible into known amounts of cash. Such investments have maturities
of 90 days or less from the date of purchase. Short-term investments are deemed
to be cash equivalents. As of December 31, 2004 and 2003, the Group had $8.6 and
$7.7, respectively, of cash held in escrow or otherwise subject to withdrawal
restrictions.
Q. USE OF ESTIMATES
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 and
disclosure of contingent assets and liabilities at the date of financial
statements, and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
The insurance industry is subject to regulation that differs by state. A
dramatic change in regulation in a given state may have a material adverse
impact on the Corporation.
NOTE 2 -- INVESTMENTS
Investment income is summarized as follows:
2004 2003 2002
------ ------ -------
Investment income from:
Fixed maturities $208.3 $210.9 $ 207.0
Equity securities 9.1 8.4 8.6
Short-term securities 2.4 0.5 0.8
------ ------ -------
Total investment income 219.8 219.8 216.4
Investment expenses 18.6 11.1 9.3
------ ------ -------
Investment income, less
expenses $201.2 $208.7 $ 207.1
====== ====== =======
The gross realized gains and losses from sales of securities were as
follows:
Gross Gross Net
Realized Realized Realized
December 31 Gains (Losses) Gains
- ------------------ -------- -------- --------
2004 $ 50.6 $ (27.6) $ 23.0
2003 57.3 (21.4) 35.9
2002 92.3 (47.1) 45.2
Included in realized losses were the write-down of securities for other
than temporary declines in market value of $8.7, $10.5 and $10.9, in 2004, 2003
and 2002, respectively.
In the first quarter of 2003, the Corporation transferred $368.8 of its
fixed maturity securities from the available-for-sale classification into the
held-to-maturity classification,
56
which resulted in a $20.9 unrealized holding gain. The remaining unamortized
unrealized holding gain of $12.7 and $17.7 as of December 31, 2004 and 2003,
respectively, is retained in other comprehensive income and in the carrying
value of the held-to-maturity securities. This transfer was made as the
Corporation has both the ability to hold investments to maturity and the
positive intent to do so. As of December 31, 2004 and 2003, the amortized cost
of the held-to-maturity portfolio was $301.4 and $356.1, respectively. The
reduction for the year was a result of scheduled payments and maturities on the
securities held in this classification.
Changes in unrealized gains (losses) on investments in securities are
summarized as follows:
2004 2003
------ -------
Unrealized gains (losses):
Fixed maturity
securities, $ (1.7) $ (1.2)
available-for-sale
Equity securities 7.4 31.1
Short-term investments (0.8) -
Transfer of securities to
held-to-maturity - 12.3
Deferred tax loss (2.0) (14.8)
------ -------
Net unrealized gains $ 2.9 $ 27.4
====== =======
The amortized cost and estimated fair values of investments in
available-for-sale fixed maturity and equity securities are as follows:
Gross Gross Estimated
Amortized Unrealized Unrealized Fair
2004 Cost Gains Losses Value
- ------------------------ ---------- ---------- ---------- ----------
Securities:
U.S. Government $ 31.9 $ 1.5 $ - $ 33.4
States, municipalities
and political 1,018.4 16.9 (0.7) 1,034.6
subdivisions
Corporate securities 1,614.4 131.8 (1.4) 1,744.8
Mortgage-backed
securities:
U.S Government Agency 7.2 0.4 - 7.6
Other 504.9 22.3 (1.5) 525.7
---------- -------- ------ ----------
Total fixed maturities 3,176.8 172.9 (3.6) 3,346.1
Equity securities 98.9 259.2 (0.7) 357.4
Short-term
investments 239.9 - (0.8) 239.1
---------- -------- ------ ----------
Total securities $ 3,515.6 $ 432.1 $ (5.1) $ 3,942.6
========== ======== ====== ==========
Gross Gross Estimated
Amortized Unrealized Unrealized Fair
2003 Cost Gains Losses Value
- ------------------------ ---------- ---------- ---------- ----------
Securities :
U.S. Government $ 40.9 $ 2.4 $ (0.1) $ 43.2
States, municipalities
and political 76.8 2.5 (0.2) 79.1
subdivisions
Corporate securities 1,941.1 152.7 (8.4) 2,085.4
Mortgage-backed
securities:
U.S. Government Agency 12.6 0.6 - 13.2
Other 779.8 29.5 (8.0) 801.3
---------- -------- ------ ----------
Total fixed maturities 2,851.2 187.7 (16.7) 3,022.2
Equity securities 77.9 251.1 - 329.0
Short-term
investments 40.4 - - 40.4
---------- -------- ------ ----------
Total securities $ 2,969.5 $ 438.8 $(16.7) $ 3,391.6
========== ======== ====== ==========
The amortized cost and estimated fair values of investments in
held-to-maturity securities are as follows:
Gross Gross Estimated
Amortized Unrealized Unrealized Fair
2004 Cost Gains Losses Value
- ------------------------ ---------- ---------- ---------- ----------
Securities:
Corporate securities $ 164.7 $ 2.9 $(1.0) $ 166.6
Mortgage-backed
securities:
Other 136.7 0.6 (0.8) 136.5
---------- -------- ------ ----------
Total held-to-maturity
securities $ 301.4 $ 3.5 $ (1.8) $ 303.1
========== ======== ====== ==========
Gross Gross Estimated
Amortized Unrealized Unrealized Fair
2003 Cost Gains Losses Value
- ------------------------ ---------- ---------- ---------- ----------
Securities:
Corporate securities $ 167.7 $ 2.1 $ (2.0) $ 167.8
Mortgage-backed
securities:
Other 188.4 0.5 (2.5) 186.4
---------- -------- ------ ----------
Total held-to-maturity
securities $ 356.1 $ 2.6 $ (4.5) $ 354.2
========== ======== ====== ==========
For securities in an unrealized loss position, the Corporation evaluates
the difference between the cost/amortized cost and estimated fair value of the
security to determine whether a decline in value is temporary or other than
temporary in nature. Securities that had a relatively high degree of decline in
value and/or securities that had been in unrealized loss positions for longer,
continuous periods of time are more closely reviewed. This assessment includes
many factors such as the issuing entity's financial position, financial
flexibility, future prospects, management competence, and industry fundamentals.
Based on this review, the Corporation makes a judgement as to whether the
decline in value is temporary or other than temporary.
57
The following table summarizes, for all securities in an unrealized loss
position, the gross unrealized loss by the length of time the securities have
continuously been in an unrealized loss position as of December 31:
2004
Available-for-sale:
Less than 12 months 12 months or longer Total
--------------------- --------------------- ----------------------
Fair Value Unrealized Fair Value Unrealized Fair Value Unrealized
Losses Losses Losses
--------------------- --------------------- ----------------------
Securities:
States, municipal-
ities and political $187.8 $ (0.7) $ - $ - $187.8 $ (0.7)
subdivisions
Corporate securities 97.7 (1.1) 9.8 (0.3) 107.5 (1.4)
Mortgage-backed
securities:
Other 88.4 (1.2) 16.5 (0.3) 104.9 (1.5)
------ ------ ------ ------ ------ ------
Total fixed maturities 373.9 (3.0) 26.3 (0.6) 400.2 (3.6)
Equity securities 9.6 (0.7) - - 9.6 (0.7)
Short-term 177.4 (0.8) - - 177.4 (0.8)
------ ------ ------ ------ ------ ------
Total temporarily
impaired securities $560.9 $ (4.5) $ 26.3 $ (0.6) $587.2 $ (5.1)
====== ====== ====== ====== ====== ======
-
Held-to-maturity:
Less than 12 months 12 months or longer Total
--------------------- --------------------- ---------------------
Fair Value Unrealized Fair Value Unrealized Fair Value Unrealized
Losses Losses Losses
--------------------- --------------------- ---------------------
Corporate securities $ 85.8 $ (1.0) $ - $ - $ 85.8 $ (1.0)
Mortgage-backed
securities:
Other 66.8 (0.7) 9.9 (0.1) 76.7 (0.8)
------ ------ ------ ------ ------ ------
Total temporarily
impaired securities $152.6 $ (1.7) $ 9.9 $ (0.1) $162.5 $ (1.8)
====== ====== ====== ====== ====== ======
2003
Available-for-sale:
Less than 12 months 12 months or longer Total
------------------- -------------------- ---------------------
Fair Value Unrealized Fair Value Unrealized Fair Value Unrealized
Losses Losses Losses
------------------- -------------------- ---------------------
Securities:
U.S. Government $ 14.8 $ (0.1) $ - $ - $ 14.8 $ (0.1)
States, municipal-
ities and political
subdivisions 9.0 (0.2) - - 9.0 (0.2)
Corporate securities 248.4 (6.5) 37.0 (1.9) 285.4 (8.4)
Mortgage-backed
securities:
Other 242.2 (6.8) 19.2 (1.2) 261.4 (8.0)
------ ------ ------ ------ ------ ------
Total fixed maturities 514.4 (13.6) 56.2 (3.1) 570.6 (16.7)
Equity securities 0.7 - 1.6 - 2.3 -
------ ------ ------ ------ ------ ------
Total temporarily
impaired securities $515.1 $(13.6) $ 57.8 $ (3.1) $572.9 $(16.7)
====== ====== ====== ====== ====== ======
Held-to-maturity:
Less than 12 months 12 months or longer Total
------------------- -------------------- ---------------------
Fair Value Unrealized Fair Value Unrealized Fair Value Unrealized
Losses Losses Losses
------------------- -------------------- ---------------------
Corporate securities $106.0 $ (1.8) $ 5.0 $ (0.2) $111.0 $ (2.0)
Mortgage-backed
securities:
Other 115.7 (1.9) 27.7 (0.6) 143.4 (2.5)
------ ------ ------ ------ ------ ------
Total temporarily
impaired securities $221.7 $ (3.7) $ 32.7 $ (0.8) $254.4 $ (4.5)
====== ====== ====== ====== ====== ======
Based on a review of each security at December 31 2004, the Corporation
believes that unrealized losses on these securities were temporary declines in
value. In the December 31, 2004 tables above, there are approximately 180
securities represented. Of this total, 7 securities have unrealized loss
positions greater than 5% of their market values at December 31, 2004 with none
exceeding 25%. This group represents $0.8, or 11.6% of the total unrealized loss
position of the Corporation. Of this group, 3 securities, representing
approximately $0.6 in unrealized losses, have been in an unrealized loss
position for less than twelve months. Of the remaining 4 securities in an
unrealized loss position for longer than twelve months totaling $0.2 million,
the Corporation 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 the Corporation has positive intent
and ability to hold the securities until they mature or recover in value.
Gross gains of $11.8, $19.7 and $15.7 and gross losses of $27.5, $18.2 and
$40.9 were realized on the sales of fixed maturity securities in 2004, 2003 and
2002, respectively.
The Group is required to hold investments on deposit with regulatory
authorities in various states. As of December 31, 2004 and 2003, these
investments had a fair value of $60.9 and $59.6, respectively.
The amortized cost and estimated fair value of fixed maturity securities
at December 31, 2004, by contractual maturity are shown below. Expected
maturities will differ from contractual maturities because borrowers may have
the right to call or prepay obligations with or without call or prepayment
penalties.
Estimated
Amortized Fair
Available-for-sale Cost Value
- -------------------------------- --------- ---------
Due in one year or less $ 73.0 $ 75.0
Due after one year through five
years 494.5 525.9
Due after five years through ten
years 1,262.3 1,334.9
Due after ten years 834.9 877.0
Mortgage-backed securities:
U.S. Government Agency 7.2 7.6
Other 504.9 525.7
--------- ---------
Total fixed maturities $ 3,176.8 $ 3,346.1
========= =========
Estimated
Amortized Fair
Held-to-maturity Cost Value
- -------------------------------- --------- ---------
Due in one year or less $ 2.1 $ 2.1
Due after one year through five
years 29.5 29.4
Due after five years through ten
years 96.2 95.8
Due after ten years 36.9 39.3
Mortgage-backed securities:
Other 136.7 136.5
--------- ---------
Total fixed maturities $ 301.4 $ 303.1
========= =========
58
NOTE 3 -- DEFERRED POLICY ACQUISITION COSTS
Changes in deferred policy acquisition costs are summarized as follows:
2004 2003
------ ------
Deferred, January 1 $169.3 $181.3
------ ------
Additions:
Commissions and brokerage 244.6 243.6
Salaries and employee benefits 51.8 56.2
Other 59.3 72.2
------ ------
Deferral of expense 355.7 372.0
------ ------
Amortization to expense 365.2 384.0
------ ------
Deferred, December 31 $159.8 $169.3
====== ======
NOTE 4 -- INCOME TAX
The effective income tax rate is less than the statutory corporate tax rate of
35% for 2004, 2003 and 2002 for the following reasons:
2004 2003 2002
----- ----- -----
Tax at statutory rate $65.3 $37.7 $(2.3)
Tax exempt interest (5.8) (1.3) (0.9)
Dividends received deduction
(DRD) (1.8) (2.1) (2.2)
Proration of DRD and tax
exempt interest 1.0 0.4 0.2
Other (2.2) (2.9) (0.6)
----- ----- -----
Actual tax expense
(benefit) $56.5 $31.8 $(5.8)
===== ===== =====
Income taxes payable were $9.8 and $4.4 at December 31, 2004 and 2003,
respectively.
The components of the net deferred tax liability were as follows:
2004 2003
-------- ---------
Unearned premium proration $ 45.5 $ 35.3
Accrued expenses 14.5 39.9
NOL and AMT carryforward - 1.8
Postretirement benefits 36.0 37.7
Discounted loss and loss expense reserves 92.1 83.9
-------- ---------
Total deferred tax assets 188.1 198.6
-------- ---------
Deferred policy acquisition costs (55.9) (59.3)
Unrealized gains on investments (154.1) (152.1)
-------- ---------
Total deferred tax liabilities (210.0) (211.4)
-------- ---------
Net deferred tax liability $ (21.9) $ (12.8)
======== =========
The Corporation is required to establish a valuation allowance for any
portion of the deferred tax asset that management believes will not be realized.
Management has determined that no such valuation allowance is necessary for
either period presented.
The Corporation has been examined by the Internal Revenue Service for the
tax years 1997 through 2001 and is currently in the process of finalizing a
settlement. The Corporation believes that the ultimate settlement of these years
will not have a material adverse impact on its financial position or results of
operations and has provided adequate book reserves for any matters that may not
be resolved as part of the settlement.
NOTE 5 -- EMPLOYEE BENEFIT PLANS
The Corporation has a non-contributory defined benefit retirement plan, a
contributory health care plan, life and disability insurance plans and a savings
plan covering substantially all employees. Benefit expenses for these plans are
as follows:
2004 2003 2002
------ ------ ------
Employee benefit costs:
Retirement plan $ 3.8 $ 4.2 $ 0.2
Postretirement plan 0.1 10.5 10.6
Health care insurance 14.9 14.4 18.2
Life and disability
insurance 2.0 1.9 1.7
Savings plan 2.9 3.0 2.8
------ ------ ------
Total $ 23.7 $ 34.0 $ 33.5
====== ====== ======
NON-CONTRIBUTORY DEFINED BENEFIT RETIREMENT PLAN
Retirement benefits accrued through June 30, 2004 under the Employees
Retirement Plan are generally payable to eligible employees upon retirement at
age 65 so long as they have completed five years of vesting service or in
reduced amounts upon retirement prior to age 65 so long as they have completed
ten years of vesting service. Retirement benefits accrued after June 30, 2004
are generally payable to eligible employees upon termination of employment so
long as they have completed five years of vesting service. A retiree's benefit
amount is based upon their June 30, 2004 benefit, if any, the years of credited
service after June 30, 2004 and before age 50, if any, the years of credited
service after June 30, 2004 and after attaining age 50, if any, and final
average compensation for the five consecutive calendar years of highest salary
during the last ten years of service immediately prior to age 65 or, if greater,
the average annual compensation paid during the 60 consecutive month period
immediately preceding retirement or other termination of employment.
In 2004, the Corporation announced changes to the defined benefit
retirement plan which froze accrued benefits under the plan's then current
formula and incorporated a new benefit accrual formula beginning July 2004. As a
result of these changes and staff reductions announced during the year, the
Corporation recognized a curtailment charge of $0.1 in accordance with FASB 88
"Employers' Accounting for Settlements and Curtailments of Defined Benefit
Pensions Plans and for Termination Benefits."
59
The net periodic pension cost is determined as follows:
2004 2003 2002
------ ------- -------
Service cost earned during the
year $ 7.7 $ 7.2 $ 6.7
Interest cost on projected
benefit obligation 16.8 18.4 17.9
Expected return on plan assets (21.6) (21.6) (22.9)
Amortization of unrecognized
net asset - - (1.7)
Amortization of accumulated
losses 2.7 - -
Amortization of unrecognized
prior service cost (1.9) 0.2 0.2
Curtailment 0.1 - -
------ ------- -------
Net periodic pension cost $ 3.8 $ 4.2 $ 0.2
====== ======= =======
The following data in the tables below are measured as of September 30,
2004 and 2003. Changes in the benefit obligation during the year:
2004 2003
------- -------
Benefit obligation at beginning of year $ 318.2 $ 270.9
------- -------
Service cost 7.7 7.2
Interest cost 16.8 18.4
Actuarial loss 19.4 39.1
Benefits paid (17.7) (17.4)
Amendment (32.7) -
Curtailment (12.2) -
------- -------
Benefit obligation at end of year $ 299.5 $ 318.2
======= =======
Changes in retirement plan assets during the year:
2004 2003
------- -------
Fair value of plan assets at
beginning of year $ 241.7 $ 235.1
------- -------
Actual return on plan assets 31.3 24.0
Benefits paid (17.7) (17.4)
Employer contributions as of
measurement date 7.5 -
------- -------
Fair value of plan assets at
end of year $ 262.8 $ 241.7
======= =======
A summary of the projected benefit obligation, accumulated benefit
obligation and fair value of plan assets as of the measurement date is as
follows:
2004 2003
------- -------
Projected benefit obligation $ 299.5 $ 318.2
Accumulated benefit obligation 299.0 284.8
Fair value of plan assets 262.8 241.7
The Corporation contributed approximately $7.5 to its retirement plan
prior to the measurement date and contributed an additional $1.9 during the
fourth quarter of 2004. The Corporation did not make any contributions to the
retirement plan in 2003. The Corporation expects to contribute approximately
$8.0 during the fiscal year 2005.
Retirement plan funding at December 31:
2004 2003
------- -------
Funded status $ (36.7) $ (76.5)
Unrecognized net gain (loss) 72.1 (77.3)
Unrecognized prior service cost (29.8) (1.3)
Employer contribution after
measurement date 1.9 -
------- -------
Accrued pension asset, net of
accrued liability $ 7.5 $ 2.1
======= =======
The net accrued pension asset at December 31, 2004 and 2003 consist of an
accrued prepaid asset of $8.6 and $3.0, respectively, for the retirement plan
and an accrued liability of $1.1 and $0.9, respectively for the Benefit
Equalization Plan, a non-qualified plan.
Total benefit payments expected to be paid to retirement plan
participants, which includes estimated future service, are as follows:
2005 $ 18.5
2006 18.5
2007 18.5
2008 18.5
2009 18.7
2010 - 2014 97.9
-------
Total 2005-2014 $ 190.6
=======
Management of the Corporation reviews the assumptions used in the
actuarial valuation on an annual basis, or more frequently as needed. Management
believes the assumptions listed below are reasonable and appropriate based upon
the current level of interest rates for high-quality debt securities, average
future rate of return on the plan's target asset allocation and underlying
compensation levels and merit increases.
2004 2003 2002
------- ------- -------
Measurement date 9/30/04 9/30/03 9/30/02
Expected long-term return
on plan assets 8.75% 8.75% 8.50%
Discount rate on plan
benefit obligations 5.95% 6.15% 7.00%
Expected future rate of
salary increases 4.00% 4.00% 4.00%
The Corporation considers the current level of expected returns on risk
free investments, primarily government bonds, the historical level of the risk
premium associated with the other asset classes and the expectations for future
returns of each asset class when developing the expected long-term rate of
return on assets assumption. The expected return for each asset class is
weighted based on the target asset allocation to develop the expected long-term
rate of return on assets assumption for the portfolio. This resulted in the
selection of the 8.75% assumption.
In determining the discount rate assumption, the Corporation utilized
current market information including analysis of the Moody's Aa Corporate Bond
Index Rate, analysis provided by plan actuaries and independent survey
60
data on similarly positioned companies. As regards to the analysis provided by
plan actuaries, a discounted cashflow model of the plan's benefit obligations
was developed using an interest rate yield curve to make judgments regarding the
appropriate discount rate for both its pension and post-retirement medical
benefit obligations. The yield curve is comprised of bonds with at least an Aa
rating with maturities primarily between zero and thirty years.
The Corporation considers future changes attributed to general price
levels, productivity, seniority, promotion, and other factors when developing
the salary increase assumption. In addition, the Corporation compares long-term
salary increase estimates to its actual history. Based on 2005 budgeted salary
and merit increases, as well as future estimated increases, the Corporation
maintained its expected future rate of salary increase at 4.0%.
The Corporation's targeted ranges of asset allocation for the retirement
plan at December 31 by asset category are as follows:
2004 2003
----- -----
Equity securities 55-79% 55-79%
Debt securities 22-30% 22-30%
Real estate 4-10% 4-10%
Other 0-5% 0-5%
The retirement plan's weighted-average asset allocation at September 30,
2004 and 2003, the measurement date, by asset category is as follows:
2004 2003
----- -----
Equity securities 59.8% 61.4%
Debt securities 28.7% 21.8%
Real estate 8.9% 9.3%
Other 2.6% 7.5%
----- -----
Total 100.0% 100.0%
===== =====
Investments are diversified among capitalization and style within the
equity portfolio. Up to 18% of the equity portfolio may be invested in financial
markets outside of the United States. In order to minimize equity risk,
limitations are placed on the overall amount that can be invested in a single
stock at both cost and market value. Equity investments are also diversified
across the various economic sectors. Approximately 9.0% of the portfolio is
allocated to real estate to further diversify risk.
Retirement plan assets at December 31, 2004 include $12.4 of the
Corporation's common stock at market value compared to $13.5 at December 31,
2003. The retirement plan held 534,464 and 771,964 shares of the Corporation's
common stock at December 31, 2004 and 2003, respectively. The retirement plan
purchased no additional shares and sold 237,500 shares of the Corporation's
common stock during 2004. The retirement plan purchased no additional shares and
sold 565,000 shares of the Corporation's common stock during 2003.
The fair value of the retirement plan assets was less than the accumulated
benefit obligation as of September 30, 2004 and 2003, resulting in the
recognition of a minimum pension liability of approximately $41.6 and $45.2, of
which $1.3 was recognized as an intangible asset in 2003. There was no such
intangible asset in 2004. The remaining before tax amounts of $41.6 and $43.9,
respectively, represent components of accumulated other comprehensive loss
reported in the December 31, 2004 and 2003 consolidated balance sheets.
CONTRIBUTORY POSTRETIREMENT HEALTH CARE PLAN
The Corporation's health care plan is a predominately managed care plan.
Prior to July 1, 2004, retired employees with four or more years of service with
the Corporation were eligible to continue to participate in the health care and
life insurance plans of the Corporation. In July 2004, the Corporation announced
changes related to its postretirement health care plan that limits eligibility
for subsidized retiree coverages to the then current retirees and employees with
25 or more years of service as of July 1, 2004 and subsequently then retire.
Other employees who retire from the organization are eligible for access to
unsubsidized retiree medical and dental coverage until age 65. As a result of
these changes and staff reductions announced during the year, the Corporation
recognized a curtailment charge of $0.1. Contributions to the health care plan
have been established as a flat dollar amount with periodic adjustments as
determined by the Corporation. The health care plan is unfunded. Benefit costs
are accrued based on actuarial projections of future payments. There are
approximately 2,200 active employees and 1,920 retired employees covered by
these plans.
The components of the Corporation's net periodic postretirement benefit
cost at December 31:
2004 2003 2002
----- ------ ------
Service cost $ 0.8 $ 2.9 $ 2.8
Interest cost 4.0 7.4 7.6
Amortization of unrecognized (5.0) 0.2 0.2
prior service costs
Amortization of net loss 0.2 - -
Curtailment 0.1 - -
----- ------ ------
Net periodic postretirement
benefit cost $ 0.1 $ 10.5 $ 10.6
===== ====== ======
Changes in the postretirement benefit obligation during the year:
2004 2003
------ ------
Benefit obligation at beginning of year $126.4 $108.2
------ ------
Service cost 0.8 2.9
Interest cost 4.0 7.4
Benefits paid net of plan
participants' contributions (4.9) (5.2)
Increase due to actuarial (gain)loss,
change in discount rate, or other
assumptions (9.4) 13.1
Amendment (61.5) -
Curtailment (0.9) -
------ ------
Benefit obligation at end of year $ 54.5 $126.4
====== ======
61
The accrued postretirement benefit liability at December 31:
2004 2003
------- -------
Accumulated postretirement
benefit obligation $ 54.5 $ 126.4
Unrecognized net loss (6.9) (17.6)
Unrecognized prior service
benefit (cost) 55.3 (1.2)
------- -------
Accrued postretirement
benefit liability $ 102.9 $ 107.6
======= =======
The postretirement benefit trend and discount rate assumptions are as
follows:
2004 2003 2002
------- ------- ---------
Measurement date 9/30/04 9/30/03 12/31/02
Medical trend rate 10.00% 10.00% 10.00%
Ultimate health care trend rate 5.00% 5.00% 5.00%
Year ultimate trend rate reached 2014 2013 2012
Dental trend rate 5.00% 5.00% 5.00%
Discount rate 5.75% 6.15% 7.00%
Management of the Corporation reviews the assumptions used in the
actuarial valuation on an annual basis, or more frequently as needed. Management
reviews external data and its own historical trends for health care costs to
determine the medical and dental trend rates. Management reviews market rates
for high quality corporate bonds and fixed income investments consistent with
the duration of its liabilities to determine the discount rate. Management
believes the assumptions are reasonable and appropriate.
Increasing the assumed health care cost trend by one percentage point in
each year would increase the accumulated postretirement benefit obligation as of
December 31, 2004 by approximately $5.1 and increase the postretirement benefit
cost for 2004 by $0.9. Likewise, decreasing the assumed health care cost trend
by one percentage point in each year would decrease the accumulated
postretirement benefit obligation as of December 31, 2004 by approximately $4.6
and decrease the postretirement benefit cost for 2004 by $0.7.
Total benefit payments expected to be paid to participants are as follows:
2005 $ 5.3
2006 4.7
2007 4.1
2008 4.1
2009 4.1
2010 - 2014 20.0
-----
Total 2005-2014 $42.3
=====
EMPLOYEE SAVINGS PLAN
Employees can contribute a percentage of their eligible compensation to
the Employee Savings Plan, a defined contribution plan. During 2004, 2003 and
2002, respectively, the Corporation matched 3% of the first 6% of a
participant's contribution to the plan. This match is invested according to the
investment direction chosen by the participant. The Corporation contributed
$2.9, $3.0 and $2.8 in 2004, 2003 and 2002, respectively for the participant
match. In 2004, the Employee Savings Plan added a profit sharing contribution
feature for all eligible employees based upon a profitability target established
by the Corporation. The profit sharing contribution for 2004 was approximately
$3.7, which was accrued at December 31, 2004 and will be contributed to the plan
in the first quarter of 2005. Effective January 1, 2005, the provisions of the
Corporation's matching contribution was changed to what is known as a 'safe
harbor' match. The Corporation's match is $1 for each $1 contributed for the
first 3% of a participant's salary contributed and $0.50 for each $1 contributed
for the next 2% of a participant's salary contributed. The maximum company match
is 4%.
NOTE 6 - STOCK BASED COMPENSATION
The Corporation has several stock based incentive programs that are utilized to
facilitate the Corporation's long-term financial success including the 1999 and
2002 Broad-based Employee Stock Option Plans and a 2002 Stock Incentive Plan.
The Corporation's stock based incentive programs are accounted for under APB 25
"Accounting for Stock Issued to Employees."
BROAD-BASED EMPLOYEE STOCK OPTION PLANS
The Corporation is authorized under provisions of the 1999 and 2002
Broad-based Employee Stock Option Plans to grant options to purchase 1,500,000
and 2,000,000 shares, respectively, of the Corporation's common stock to full
time employees and certain part time employees at a price not less than the fair
market value of the shares on dates the options are granted.
The options granted under the 1999 and 2002 Broad-based Employee Stock
Option Plans are nonqualified options. The options under both plans are
exercisable at any time after the vesting requirements are met. The options also
have accelerated vesting provisions for participant retirement, death, or
disability, subject to a holding period of twelve months for the 1999 program.
Option expiration dates are ten years from the grant date. As of December 31,
2004, there are 293,900 and 2,000,000 remaining options available to be granted
for the 1999 and 2002 Broad-based plans, respectively, compared to 259,850 and
2,000,000 remaining options available to be granted as of December 31, 2003,
respectively.
2002 STOCK INCENTIVE PLAN
The 2002 Stock Incentive Plan (the "2002 Plan") was established by the
Corporation and is available to employees of the Corporation. The 2002 Plan
reserved for issuance an aggregate of 3,000,000 shares. Pursuant to the
provisions of the 2002 Plan, 471,537 shares available for issuance under the
1993 plan as well as shares previously awarded and subsequently forfeited under
the 1993 plan were made available for issuance under the 2002 Plan. Options are
no longer available to grant under the 1993 plan.
62
The options granted under the 2002 Plan may be either incentive or
non-qualified options as defined by the Internal Revenue Code. The difference
affects treatment of the options for income tax purposes by the individual
employee and the Corporation. The options under the plan are exercisable at any
time after the vesting requirements are met. The plan provides for accelerated
vesting for participant retirement, death or disability. Option expiration dates
are ten years from the grant date. As of December 31, 2004, there were 1,431,535
remaining options available to be granted under the 2002 Plan compared to
2,362,273 remaining options available to be granted as of December 31, 2003.
In addition, the 2002 Plan also provides for the grant of Freestanding
and/or Tandem Stock Appreciation Rights (SAR) and Restricted Stock. The exercise
price of a Freestanding SAR is equal to the fair market value of a share of the
Corporation's stock on the grant date. Freestanding SARs provide the recipient
with the right to receive payment in cash, stock or a combination of both equal
to appreciation in value of a share of stock from the date of grant. At December
31, 2004 and 2003, there were no outstanding Freestanding SARs.
The exercise price of a Tandem SAR is equal to the exercise price of the
related stock option on the grant date. Tandem SARs provide the recipient with
the right to receive in cash, stock or a combination of both, equal to the
appreciation in value of the optioned stock from the date of grant in lieu of
exercise of the stock options held. At December 31, 2004 and 2003, there were no
outstanding Tandem SARs.
Grants of restricted stock provide the recipient with the right to receive
shares of the Corporation's stock, upon satisfying the restrictions imposed as a
condition to the award, during a specified restriction period. During the
restriction period, which is determined at the time of grant, the recipient may
exercise full voting rights and is entitled to receive dividends and other
distributions paid to shareholders. If dividends or other distributions are paid
in shares of stock, those shares are subject to the same restrictions as the
underlying restricted stock. Shares of restricted stock may not be sold,
transferred, pledged, assigned or otherwise alienated until the end of the
applicable restriction period. At the discretion of the Corporation's Executive
Compensation Committee, all shares of restricted stock may either be held by the
Corporation as escrow agent during the restriction period or issued to the
recipient in the form of certificates with a legend describing the restrictions
imposed on the shares. During the years ended December 31, 2004, 2003 and 2002,
there were 55,284, 11,000 and 6,000 restricted shares issued under either the
1993 plan or 2002 Plan. These grants were made at a weighted average grant date
fair value of $19.08, $12.26 and $17.70 in 2004, 2003 and 2002, respectively. At
December 31, 2004, there are 55,284 restricted shares which are under the
restriction period. Unearned stock compensation is recognized for the fair value
of the restricted shares when granted and is accounted for as a reduction of
shareholders' equity. The balance is amortized into compensation expense over
the restriction period. Unearned stock compensation of $0.8 was recorded as a
reduction of shareholders' equity as of December 31, 2004. There was no unearned
stock compensation at December 31, 2003. The Corporation has recognized
compensation expense on the grants of restricted shares of $0.3, $0.1 and $0.1
in 2004, 2003 and 2002, respectively.
STOCK OPTION PLANS FOR SENIOR EXECUTIVE OFFICERS
Pursuant to the employment agreements of the Chief Executive Officer and
the prior Chief Financial Officer, the Corporation established specific stock
option plans for each of these individuals. Under each of these specific plans,
the aggregate amount of options granted to purchase shares of the Corporation's
common stock was 400,000 in 2002. There were no options granted in 2004 and
2003. The options were granted as nonqualified options. Option expiration dates
are ten years from the grant date. The stock options granted vest at 33% per
year for three consecutive years. The total amount of stock options granted
under the two plans was 1,400,000. There are no additional remaining shares to
be granted under these plans.
EMPLOYEE STOCK PURCHASE PLAN
The Corporation introduced an employee stock purchase plan in 2003 that is
available to eligible employees as defined in the plan. Under the plan, shares
of the Corporation's common stock may be purchased at a discount of up to 85% of
the lesser of the closing price of the Corporation's common stock on the first
trading day or the last trading day of the offering period. The offering period
(currently six months) and the offering price are subject to change.
Participants may purchase no more than twenty-five thousand dollars of
Corporation stock in a calendar year. During 2004, 54,030 shares were purchased
under the plan compared to 43,618 shares purchased under the plan in 2003. At
December 31, 2004 and 2003, there were 1,902,352 and 1,956,382 shares available
for future issuance, respectively.
63
The following table summarizes information about the stock-based compensation
plans as of December 31, 2004, 2003 and 2002, respectively, and changes that
occurred during the respective years:
2004 2003 2002
---------------------- --------------------- ----------------------
Weighted- Weighted- Weighted-
Avg Avg Avg
Shares Exercise Shares Exercise Shares Exercise
(000) Price (000) Price (000) Price
------- --------- ------ --------- ------- ---------
Outstanding
Beginning of year 5,108 $ 13.26 4,491 $ 13.40 4,230 $ 12.87
Granted 895 18.58 936 12.44 1,088 15.85
Exercised (1,133) 13.24 (175) 12.08 (611) 12.42
Forfeited (97) 14.74 (144) 14.91 (216) 17.83
-------
Outstanding end of year 4,773 $ 14.23 5,108 $ 13.26 4,491 $ 13.40
======= ====== =======
Options exercisable at
year end 3,255 $ 13.34 3,174 $ 13.28 2,479 $ 13.41
Avg Remaining contractual
life 6.97 yrs 7.43 yrs 8.00 yrs
Weighted-Avg fair
value of options
granted during the year $ 7.36 $ 6.32 $ 8.36
The following table summarizes the status of stock options outstanding and
exercisable at December 31, 2004:
Stock Options Outstanding Stock Options Exercisable
----------------------------------------- -------------------------
Weighted-
Avg Weighted- Weighted-
Remaining Avg Avg
Range of Exercise Shares Contractual Exercise Shares Exercise
Prices Per Share (000) Life(Years) Price (000) Price
- ----------------- ------ ------------ --------- ------ ---------
$ 8.60 - $ 9.75 846 6.19 $ 9.36 846 $ 9.36
$11.20 - $11.46 110 6.69 11.22 110 11.22
$12.26 - $12.26 689 8.12 12.26 226 12.26
$12.38 - $12.38 620 5.16 12.38 620 12.38
$12.82 - $13.26 493 7.53 13.23 359 13.21
$13.45 - $17.50 487 6.40 14.69 486 14.70
$17.70 - $18.42 297 7.16 17.73 225 17.73
$18.51 - $18.51 766 9.36 18.51 5 18.51
$18.68 - $23.47 459 5.18 20.42 372 20.77
$23.63 - $23.63 6 3.41 23.63 6 23.63
------ -------- ------- ------ --------
$8.60 - $23.63 4,773 6.97 $ 14.23 3,255 $ 13.34
====== ======== ======= ====== ========
Under the provisions of FASB 123, as amended by FASB 148, and further
revised by FASB 123(R), which is effective July 1, 2005, the Corporation is
required to estimate on the date of grant the fair value of each option using an
option-pricing model. Accordingly, the Black-Scholes option pricing model is
used with the following weighted-average assumptions: dividend yield of 1.8%,
expected volatility ranging from 34.84% to 45.39% for 2004, 52.81% for 2003 and
54.98% for 2002, risk free interest rate ranging from 3.6% to 4.6% for 2004,
3.81% for 2003 and 4.74% for 2002, and expected life ranging from five to eight
years for 2004 and eight years for 2003 and 2002. During 2004 the Corporation,
on a quarterly basis, reviewed and revised the assumptions indicated above, thus
resulting in the assumption range in 2004. Had the Corporation adopted the
income statement recognition requirements of FASB 123, the additional amount of
before-tax compensation expense that would have been recognized in 2004, 2003
and 2002 was $8.0, $7.7 and $6.2, respectively.
NOTE 7 -- REINSURANCE
A reconciliation of direct to net premiums, on both a written and earned basis
and a reconciliation of incurred losses is as follows:
Direct Assumed Ceded Net
-------- ------- ------- --------
2004
Premiums written $1,581.3 $ 23.1 $(150.5) $1,453.9
Premiums earned 1,570.8 21.4 (145.4) 1,446.8
Losses incurred 873.1 51.4 (146.9) 777.6
2003
Premiums written $1,570.4 $ 20.0 $(148.8) $1,441.6
Premiums earned 1,539.7 16.4 (131.7) 1,424.4
Losses incurred 1,039.1 38.0 (224.6) 852.5
2002
Premiums written $1,536.1 $ 16.3 $(103.8) $1,448.6
Premiums earned 1,535.9 14.5 (99.9) 1,450.5
Losses incurred 1,081.2 28.3 (206.8) 902.7
During the last three fiscal years, no reinsurer accounted for more than 15% of
total ceded premiums.
The following components of the reinsurance recoverable asset at December
31, are:
2004 2003
------- -------
Reserve for unearned premiums $ 65.6 $ 60.6
Reserve for losses 529.9 473.3
Reserve for loss adjustment expenses 42.7 25.7
Allowance for reinsurance recoverable (2.3) (2.4)
Reinsurance recoveries on paid losses 30.6 35.5
------- -------
Reinsurance recoverable $ 666.5 $ 592.7
======= =======
NOTE 8 -- OTHER CONTINGENCIES AND COMMITMENTS
Annuities are purchased from other insurers to pay certain claim settlements.
These payments are made directly to the claimants; should such insurers be
unable to meet their obligations under the annuity contracts, the Group would be
liable to claimants for the remaining amount of annuities. The claim reserves
are presented net of the related annuities on the Corporation's consolidated
balance sheets. The total amount of unpaid annuities was $19.0 and $19.4 at
December 31, 2004 and 2003, respectively.
The Corporation leases certain equipment and many of its operating and
office facilities for various terms under long-term, cancelable and
non-cancelable operating lease agreements. The leases expire at various dates
through 2010 and provide for renewal options ranging from one month to five
years. The facility leases provide for increases in future minimum annual rental
payments based on such measures as increases in operating expenses and
pre-negotiated rates. Also, the facility agreements generally require the
Corporation to pay executory costs (utilities, real estate taxes, insurance and
repairs). The equipment leases generally require the Corporation to pay taxes as
determined by the local taxing authority. Lease expense and related
64
items totaled $5.7, $5.9 and $7.0 during 2004, 2003 and 2002, respectively.
The following is a schedule by year of future minimum rental payments
required under the operating lease agreements:
Year Ending
December 31 Amount
- --------------------- ------
2005 $ 5.4
2006 5.2
2007 3.7
2008 2.7
2009 and thereafter 3.0
------
Total rental payments $ 20.0
======
Total minimum lease payments do not include contingent rentals that may be
paid under certain leases. Contingent rental payments were not significant in
2004, 2003, or 2002.
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 contract stipulates that a premiums-to-surplus ratio of 2.5 to 1
must be maintained by Proformance on the transferred business during the periods
of March 2002 through December 2004. If this criteria is not met, OCNJ will have
to pay up to a maximum cumulative amount of $15.6 to Proformance to maintain
this premiums-to-surplus ratio. Based on data through December 31, 2003 as
provided by Proformance in the first quarter of 2004, the Group estimated and
accrued $9.0 (of which $6.8 was paid in July 2004) related to this obligation.
During the second half of 2004, the Group accrued an additional $6.6. At
December 31, 2004, the Group has $8.8 accrued in the consolidated financial
statements for any possible additional liability that may be incurred based upon
the final liability calculation using Proformance's 2004 results. This amount,
which is management's best estimate of the liability, reflects the maximum
additional amount that could be paid to Proformance. The Corporation expects to
resolve the final settlement to be paid to Proformance relative to the surplus
guarantee in the first half of 2005.
A proceeding entitled Carol Murray v. Ohio Casualty Corporation, The Ohio
Casualty Insurance Co., Avomark Insurance Co., Ohio Security Insurance Co., West
American Insurance Co. (West American), American Fire and Casualty Insurance
Co., and OCNJ was filed in the United States District Court for the District of
Columbia on February 5, 2004. A motion to change venue was granted on May 25,
2004 with the proceeding assigned to the U.S. District Court for the Southern
District of Ohio, Eastern Division, Columbus, Ohio. The plaintiff, a former
automobile physical damage claim adjuster, originally sought to certify a
nationwide collective action consisting of all current and former salaried
employees since February 5, 2001 who are/were employed to process claims by
policyholders and other persons for automobile property damage. The plaintiff
has filed motions to expand the definition to include claim specialists,
representative trainees, and representatives performing claims adjusting
services. The complaint seeks overtime compensation for the plaintiff and the
class of persons plaintiff seeks to represent. The defendants deny the
allegations made in the complaint and are vigorously defending themselves.
A proceeding entitled Carol Lazarus v. The Ohio Casualty Group was brought
against West American in the Court of Common Pleas Cuyahoga County, Ohio on
October 25, 1999. The Court ordered the case to proceed solely against West
American on July 10, 2003. The complaint alleges West American improperly
charged for uninsured motorists coverage following an October 1994 decision of
the Supreme Court of Ohio in Martin v. Midwestern Insurance Company. The Martin
decision was overruled legislatively in September 1997. West American filed a
motion for summary judgment on December 16, 2003. Plaintiff filed a motion for
class certification on February 23, 2004. West American has responded to the
motion for class certification stating the motion is untimely (filed more than
four years after the initial complaint) and that Carol Lazarus failed to provide
sufficient evidence to satisfy the requirements for class certification.
A proceeding entitled Douglas and Carla Scott v. The Ohio Casualty
Insurance Company, West American, American Fire and Casualty Company, and Ohio
Security Company was filed in the District Court of Tulsa County, State of
Oklahoma and served on January 3, 2005. The proceeding challenges the use of a
certain vendor in valuing total loss automobiles. Plaintiff alleges that use of
the database results in valuations to the detriment of the insureds. Plaintiff
is seeking class status and alleges breach of contract, fraud and bad faith. The
lawsuit is in its early stages and will be vigorously defended.
The proceedings described above and various other legal and regulatory
proceedings are currently pending that involve the Corporation and specific
aspects of the conduct of its business. The outcome of these proceedings is
currently unpredictable. However, at this time, based on their present status,
it is the opinion of management that the ultimate liability, if any, in one or
more of these proceedings in excess of amounts currently reserved is not
expected to have a material adverse effect on the financial condition, liquidity
or results of operation of the Corporation.
65
NOTE 9 -- LOSSES AND LOSS RESERVES
The following table presents a reconciliation of liabilities for losses and LAE
net of reinsurance:
2004 2003 2002
-------- -------- --------
Balance as of January 1,
net of reinsurance
recoverables of $496.5,
$354.4 and $168.7 $2,131.3 $2,079.3 $1,982.0
Incurred related to:
Current year 958.1 993.3 1,045.4
Prior years (21.8) 34.1 84.4
-------- -------- --------
Total incurred 936.3 1,027.4 1,129.8
-------- -------- --------
Paid related to:
Current year 354.1 388.6 423.6
Prior years 527.4 586.8 608.9
-------- -------- --------
Total paid 881.5 975.4 1,032.5
-------- -------- --------
Balance as of December 31,
net of reinsurance
recoverables of $570.3,
$496.5 and $354.4 $2,186.1 $2,131.3 $2,079.3
======== ======== ========
Each quarter management records its best estimate of the liability for
loss and LAE reserves. However, because of the uncertainty inherent in the
estimation process, the estimate can change over time as new information is
received.
The 2004 incurred loss and LAE for prior accident years was favorably
impacted by $21.8 which includes a $0.1 change in allowance for uncollectible
reinsurance. This favorable development was concentrated in the commercial
automobile product line in the Commercial Lines operating segment and commercial
umbrella and bond product lines in the Specialty Lines operating segment. The
2003 and 2002 incurred loss and LAE for prior accident years were negatively
impacted by $34.1 and $84.4. For the year 2003, this development was
concentrated in the general liability, workers' compensation and commercial
multiple peril product lines of the Commercial Lines operating segment and in
the personal auto product line of the Personal Lines operating segment. For the
year 2002, this was concentrated in the general liability and commercial auto
product lines of the Commercial Lines operating segment and in the personal auto
including personal umbrella product line of the Personal Lines operating
segment. Approximately $62.0 of loss and LAE, net of reinsurance, was recognized
in the third quarter of 2002 related primarily to construction defect claims.
The following table presents before-tax catastrophe losses incurred and
the respective impact on the statutory loss ratio:
2004 2003 2002
----- ----- -----
Incurred losses $43.5 $43.8 $20.8
Statutory loss
ratio effect 3.0% 3.1% 1.4%
In 2004, 2003 and 2002 there were 22, 21 and 25 catastrophes, respectively. The
largest catastrophe in each year was $8.0, $11.5 and $7.5, respectively, in
incurred losses. Additional catastrophes with over $1.0 in incurred losses
numbered ten, nine and six in 2004, 2003 and 2002, respectively.
The effect of catastrophes on the Corporation's results cannot be
accurately predicted. Consequently, severe weather events, acts of war or
terrorist activities could have a material adverse impact on the Corporation's
results.
The Group has three categories of loss and LAE reserves that it considers
highly uncertain, and which therefore could have a material impact on future
financial results. These are asbestos and environmental liability exposures,
construction defect exposures, and commercial umbrella exposures.
Loss and LAE reserves, net of reinsurance, for asbestos and environmental
exposure totaled $81.0 and $68.0 at December 31, 2004 and 2003, respectively.
Loss and allocated LAE reserves, net of reinsurance, for construction defect
exposure totaled $78.3 and $86.7 at December 31, 2004 and 2003, respectively.
Reserves, net of reinsurance, for loss and LAE related to commercial umbrella
totaled $236.1 and $198.5 at December 31, 2004 and 2003, respectively.
NOTE 10 -- EARNINGS PER SHARE
Basic and diluted earnings per share are summarized as follows:
2004 2003 2002
----------- ----------- -----------
Net income (loss) $ 128.4 $ 75.8 $ (0.9)
Average shares
outstanding - basic 61,509,128 60,848,718 60,494,104
Basic income (loss)
per average share $ 2.09 $ 1.25 $ (0.01)
=========== =========== ===========
Net income (loss) $ 128.4 $ 75.8 $ (0.9)
Effect of EITF 04-8 on
net income using
"if-converted" method 6.9 6.7 -
Adjusted net income
using "if-converted"
method $ 135.3 $ 82.5 $ (0.9)
Average shares
outstanding 61,509,128 60,848,718 60,494,104
Effect of dilutive
securities 1,152,349 477,974 -
Effect of EITF 04-8 8,847,042 8,897,504 -
----------- ----------- -----------
Average shares
outstanding - diluted 71,508,519 70,224,196 60,494,104
Diluted income (loss)
per average share $ 1.89 $ 1.18 $ (0.01)
=========== =========== ===========
At December 31, 2004 and 2003, 351,418 and 1,485,388 stock options were
not included in earnings per share calculations for 2004 and 2003, respectively,
as they were anti-dilutive. Stock options are considered anti-dilutive under the
"treasury stock method" when the average market price of the stock for the year
is less than the exercise price of the stock options. At December 31, 2002, the
Corporation reported a net loss per share and therefore all outstanding stock
options were considered anti-dilutive as any assumed
66
redemption of stock options using the "treasury stock method" would decrease the
reported net loss per share.
In September 2004, the FASB finalized Emerging Issues Task Force (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 guidance, 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 treated as outstanding using
the "if-converted" method. As a result of this EITF, the Corporation has
included approximately 8.9 million shares into its diluted earnings per share
calculation using the "if-converted" method. As required by the EITF, all prior
period earnings per share amounts have been restated for periods presented
subsequent to the March 2002 Convertible Notes issuance. The adoption of EITF
04-8 reduced previously reported diluted earnings per share by $0.06 for the
full year 2003. The adoption of EITF 04-8 did not impact the reported diluted
earnings per share for the full year 2002 due to the reported net loss as
discussed above.
NOTE 11 -- QUARTERLY FINANCIAL INFORMATION (UNAUDITED)
2004 First Second Third Fourth
- -------------------------- ------ ------ ------ ------
Premiums and
finance charges earned $361.1 $367.2 $356.8 $361.7
Net investment income 50.5 48.6 44.9 57.2
Investment gains
(losses) realized 3.7 3.2 (4.3) 20.4
Income before
cumulative effect of an
accounting change 20.8 32.7 19.6 56.9
Net income 19.2 32.7 19.6 56.9
Basic income per share
before cumulative
effect of an
accounting change 0.34 0.53 0.32 0.92
Basic net income
per share 0.31 0.53 0.32 0.92
Diluted net income
per share before
cumulative effect of
an accounting change 0.34 0.52 0.31 0.90
Diluted net income
per share - as
reported 0.31 0.52 0.31 0.90
Effect of EITF 04-8 (0.04) (0.01) (0.08)
Diluted net income
per share - as restated 0.31 0.48 0.30 0.82
2003 First Second Third Fourth
- -------------------------- ------ ------ ------ ------
Premiums and finance
charges earned $349.3 $351.2 $360.4 $363.5
Net investment income 53.2 51.4 51.0 53.1
Investment gains realized 19.3 6.8 5.9 3.9
Net income 19.9 11.0 17.2 27.7
Basic net income per
share 0.33 0.18 0.28 0.46
Diluted net income
per share - as
reported 0.33 0.18 0.28 0.45
Effect of EITF 04-8 (0.02) (0.01) (0.03)
Diluted net income
per share - as 0.31 0.18 0.27 0.42
restated
The quarterly diluted earnings per share amounts have been restated for
2004 and 2003 for the adoption of EITF 04-8 as disclosed in Note 10.
NOTE 12 -- COMPREHENSIVE INCOME
Comprehensive income consists of changes in unrealized gains (losses) on
securities and a minimum pension liability as detailed below:
2004 Gross Tax Net
- ------------------------- ------ ----- ------
Net income $184.9 $56.5 $128.4
------ ----- ------
Components of other
comprehensive income:
Unrealized gains
arising during the
period 38.7 13.8 24.9
Reclassification
adjustment for gains
included in net income (33.8) (11.8) (22.0)
Minimum pension
liability 2.3 0.8 1.5
------ ----- ------
Other comprehensive
income 7.2 2.8 4.4
------ ----- ------
Comprehensive income $192.1 $59.3 $132.8
====== ===== ======
2003 Gross Tax Net
- ------------------------- ------ ------ ------
Net income $107.6 $ 31.8 $ 75.8
------ ------ ------
Components of other
comprehensive income:
Unrealized gains
arising during the
period 76.5 26.8 49.7
Reclassification
adjustment for gains
included in net income (34.3) (12.0) (22.3)
Minimum pension
liability (29.1) (10.2) (18.9)
------ ------ ------
Other comprehensive
income 13.1 4.6 8.5
------ ------ ------
Comprehensive income $120.7 $ 36.4 $ 84.3
====== ====== ======
2002 Gross Tax Net
- ------------------------- ------ ------ ------
Net loss $ (6.7) $ (5.8) $ (0.9)
------ ------ ------
Components of other
comprehensive income:
Unrealized gains
arising during the
period 54.7 19.1 35.6
Reclassification
adjustment for gains
included in net income (83.4) (29.2) (54.2)
Minimum pension
liability (14.8) (5.2) (9.6)
------ ------ ------
Other comprehensive loss (43.5) (15.3) (28.2)
------ ------ ------
Comprehensive loss $(50.2) $(21.1) $(29.1)
====== ====== ======
NOTE 13 -- SEGMENT INFORMATION
The Corporation reviews and determines its reportable segments based upon its
method of internal reporting, which is organized by product line. The
Corporation aggregates similar insurance products into product lines by
accessing the nature of the product. The property and casualty
67
reportable segments are Commercial Lines, Specialty Lines and Personal Lines.
These segments generate revenues by selling a wide variety of commercial, surety
and personal insurance products. The Corporation also has an all other
reportable segment which derives its revenue from investment income.
Each segment of the Corporation is managed separately. The property and
casualty reportable segments are managed by assessing the performance and
profitability of the segments through analysis of industry financial
measurements including statutory loss and LAE 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.
Commercial Lines Segment 2004 2003 2002
- ------------------------------ ------ ------- -------
Net premiums written $828.2 $ 792.6 $ 762.2
% change 4.5% 4.0% 10.5%
Net premiums earned 807.9 777.4 725.6
% change 3.9% 7.1% 2.5%
Underwriting loss (before tax) (0.9) (101.4) (123.1)
Specialty Lines Segment 2004 2003 2002
- ------------------------------ ------ ------- -------
Net premiums written $135.5 $ 164.9 $ 179.9
% change (17.8)% (8.3)% 32.2%
Net premiums earned 150.3 162.7 158.5
% change (7.6)% 2.6% 21.4%
Underwriting gain (before tax) 11.5 36.1 -
Personal Lines Segment 2004 2003 2002
- ------------------------------ ------ ------- -------
Net premiums written $490.2 $ 484.1 $ 506.5
% change 1.3% (4.4)% (21.6)%
Net premiums earned 488.4 484.3 566.3
% change 0.8% (14.5)% (15.2)%
Underwriting gain/(loss)
(before tax) 11.0 (27.0) (62.0)
Total Property & Casualty 2004 2003 2002
- ------------------------------ -------- -------- --------
Net premiums written $1,453.9 $1,441.6 $1,448.6
% change 0.8% (0.5)% (1.6)%
Net premiums earned 1,446.6 1,424.4 1,450.4
% change 1.5% (1.8)% (3.7)%
Underwriting gain/(loss)
(before tax) 21.6 (92.3) (185.1)
All Other 2004 2003 2002
- ------------------------------ ------- ------- --------
Revenues $ 8.2 $ 4.8 $ 1.2
Write-down and amortization
of agent relationships (20.6) (18.7) (79.7)
Other expenses (22.8) (12.1) (10.5)
------- ------- --------
Net loss before income tax $ (35.2) $ (26.0) $ (89.0)
Reconciliation of Revenues 2004 2003 2002
- ------------------------------ -------- -------- --------
Net premiums earned for
reportable segments $1,446.6 $1,424.4 $1,450.4
Net investment income 185.2 204.9 205.8
Realized gains, net 14.0 31.9 53.0
-------- -------- --------
Total property and casualty
revenues (Statutory basis) 1,645.8 1,661.2 1,709.2
Property and casualty
statutory to GAAP
adjustment 17.0 3.0 (7.6)
-------- -------- --------
Total revenues property and
casualty (GAAP basis) 1,662.8 1,664.2 1,701.6
Other segment revenues 8.2 4.8 1.2
-------- -------- --------
Total revenues $1,671.0 $1,669.0 $1,702.8
======== ======== ========
Reconciliation of Underwriting
Gain/(Loss) (before tax) 2004 2003 2002
- ------------------------------ ------ ------- -------
Property and casualty under-
writing gain/(loss)
(before tax)
(Statutory basis) $ 21.6 $ (92.3) $(185.1)
Statutory to GAAP adjustment (15.9) (13.9) 16.3
Property and casualty under-
writing gain/(loss)
(before tax)(GAAP basis) 5.7 (106.2) (168.8)
Net investment income 201.2 208.7 207.1
Realized gains, net 23.0 35.9 45.2
Write-down and amortization
of agent relationships (20.6) (18.7) (79.7)
Other expenses (22.8) (12.1) (10.5)
------ ------- -------
Income (loss) before income
taxes and cumulative effect
of an accounting change $186.5 $ 107.6 $ (6.7)
====== ======= =======
NOTE 14 -- AGENT RELATIONSHIPS
The agent relationships asset is an identifiable intangible asset acquired in
connection with the 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 $13.7, $11.3 and $69.5 in
2004, 2003 and 2002, respectively, for agency cancellations and for 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 agent relationships asset balance was $122.0 and $142.6, net
of accumulated amortization of $41.4 and $39.1, at December 31, 2004 and 2003,
respectively. At December 31, 2004, the remaining portion of the agent
relationships asset will be amortized on a straight-line basis over the
remaining useful period of approximately 19 years.
68
Based on historical data the remaining agents have been profitable. Future
cancellation of agents included in the agent relationships 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 15 -- STATUTORY ACCOUNTING INFORMATION
The following information has been prepared on the basis of statutory accounting
principles which differ from generally accepted accounting principles. The
principal differences relate to deferred policy acquisition costs, reinsurance,
assets not admitted for statutory reporting, agent relationships and the
treatment of deferred income taxes.
2004 2003 2002
------ ------ ------
Statutory net income $163.7 $119.1 $ 75.1
Statutory policyholders'
surplus 972.0 867.6 725.7
The Ohio Casualty Insurance Company (the Company), domiciled in Ohio,
prepares its statutory financial statements in accordance with the accounting
practices prescribed or permitted by the Ohio Insurance Department. Prescribed
statutory accounting practices include a variety of publications of the National
Association of Insurance Commissioners (NAIC), as well as state laws,
regulations and general administrative rules. Permitted statutory accounting
practices encompass all accounting practices not so prescribed.
For statutory purposes, the agent relationships asset related to the GAI
acquisition was taken as a direct charge to surplus.
The NAIC has developed a "Risk-Based Capital" formula for property and
casualty insurers and life insurers. The formula is intended to measure the
adequacy of an insurer's capital given the asset and liability structure and
product mix of the company. As of December 31, 2004 and 2003, all insurance
companies in the Group exceeded the necessary capital requirements.
The Corporation is dependent on dividend payments from its insurance
subsidiaries in order to meet operating expenses, debt obligations and to pay
shareholder dividends. Insurance regulatory authorities impose various
restrictions and prior approval requirements on the payment of dividends by
insurance companies and holding companies. At December 31, 2004, approximately
$138.3 of the Company's statutory surplus is not subject to restriction or prior
dividend approval requirements compared to approximately $86.8 at December 31,
2003. Additional restrictions limiting the amount of dividends paid by the
Company to the Corporation may result from the minimum net worth and surplus
requirements in the credit agreement.
The Group paid dividends to policyholders of $1.4, $2.9 and $5.6 in 2004,
2003 and 2002, respectively.
NOTE 16 -- DEBT
The following table represents outstanding debt of the Corporation at December
31:
2004 2003
------ ------
Convertible Debt (net of
issuance costs of $6.3 and
$6.9, respectively) $182.5 $194.3
Senior Debt (net of discount
and issuance costs of $2.4) 197.6 -
Ohio Loan 3.2 3.9
Other - (0.2)
------ ------
Total Debt $383.3 $198.0
====== ======
On June 29, 2004, the Corporation issued $200.0 of 7.3% Senior Notes due
June 15, 2014 (Senior Notes). The net proceeds from the issuance after related
fees and discount were $198.0. In the fourth quarter 2004 the Corporation used
part of the net proceeds to repurchase $12.5 of the $201.3 aggregate principal
amount of its 5.00% Convertible Notes due March 19, 2022 (Convertible Notes) and
intends to use the remainder of the net proceeds to redeem the balance of its
Convertible Notes. 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 from the Senior Notes 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
sheets net of unamortized issuance-related costs and discount of $8.7 ($6.3
related to the Convertible Notes and $2.4 related to the Senior Notes) and $6.9
(all related to the Convertible Notes) at December 31, 2004 and 2003,
respectively. The Corporation uses the effective interest rate method to record
interest expense, amortization of issuance-related costs and amortization of the
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.
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
69
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. At December 31, 2004, if all the
outstanding Convertible Notes were converted, total outstanding common shares
would increase by 8.3 million shares compared to 8.9 million shares at December
31, 2003.
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 February 22, 2005, the Corporation announced that it has commenced an
exchange offer under which the Corporation is offering to exchange up to $184.3
of new 5.00% Convertible Notes due 2022 for an equal principal amount of its
currently outstanding Convertible Notes. The exchange offer is being made
pursuant to Section 3(a)(9) of the Securities Act of 1933, as amended. The new
notes will have substantially similar terms to the old notes, except that the
new notes will include a net share settlement feature and a cash exchange fee
payable to the holder of the old notes in an amount equal to 0.35% of the
principal amount of the old notes exchanged. The net share settlement feature
will require the Corporation upon conversion to pay cash up to the principal
amount of the new notes and pay any conversion consideration in excess of the
principal amount in common shares. The exchange offer will expire at 12:00
midnight EST on March 21, 2005, unless extended or terminated by the
Corporation. The Corporation plans to redeem all or a portion of the new notes
and the old notes, to the extent any remain outstanding, shortly after the
completion of this exchange offer. The Corporation intends to use the proceeds
of the Senior Note offering discussed above to accomplish this redemption. In
2005, prior to the commencement of this exchange offer, the Corporation
repurchased $4.5 of the Convertible Notes in unsolicited negotiated
transactions.
The impact of the Convertible Notes on diluted earnings per share is based
upon the "if-converted" method. In accordance with EITF 04-8, all diluted
earnings per share amounts have been restated since the issuance of the
Convertible Notes in March 2002. (See Note 10).
On July 31, 2002, the Corporation entered into a revolving credit
agreement expiring on March 15, 2005. 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 December 31, 2004 of less than $0.1 compared to
$0.2 at December 31, 2003. In addition, the Corporation is obligated to pay
agency fees 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 agreement also includes a
minimum statutory surplus for The Ohio Casualty Insurance Company of $650.0.
Additionally, other financial covenants and other customary provisions, as
defined in the agreement, exist. At December 31, 2004, the Corporation was in
compliance with all financial covenants and other provisions. There were no
borrowings outstanding under the revolving line of credit at December 31, 2004
and 2003, respectively. In February 2005 the revolving credit agreement was
renewed, under the same terms and conditions, for one year and will expire on
March 15, 2006.
In addition to the debt described above, the Corporation has a $6.5 loan
with the State of Ohio that is secured by a mortgage on the Corporation's home
office property. As of December 31, 2004, the loan bears a fixed interest rate
of 3%, compared to an interest rate of 2% at December 31, 2003. The loan
requires annual principal payments of approximately $0.6 and expires in November
2009. The remaining balance at December 31, 2004 was $3.2 compared to $3.9 at
December 31, 2003.
Interest expense incurred for the years ending December 31, 2004, 2003 and
2002 was $17.5, $10.1 and $9.5, respectively. The increase in interest expense
incurred during 2004 was related to the issuance of the Senior Notes in June
2004.
NOTE 17 -- SHAREHOLDERS RIGHTS PLAN
In February 1998, the Board of Directors adopted an amended and restated
Shareholders Rights Agreement (the Agreement). The Agreement is designed to
deter coercive or unfair takeover tactics and to prevent a person(s) from
gaining control of the Corporation without offering a fair price to all
shareholders.
Under the terms of the Agreement, each outstanding common share is
associated with one half of one common share purchase right, expiring in 2009.
Currently, each whole right, when exercisable, entitles the registered holder to
purchase one common share of the Corporation at a purchase price of $125 per
share.
The rights become exercisable for a 60 day period commencing eleven
business days after a public announcement that a person or group has acquired
shares representing 20 percent or more of the outstanding shares of common
stock, without the prior approval of the Board of Directors; or eleven business
days following commencement of a tender or exchange of 20 percent or more of
such outstanding shares of common stock.
70
If after the rights become exercisable, the Corporation is involved in a
merger, other business consolidation or 50 percent or more of the assets or
earning power of the Corporation is sold, the rights will then entitle the
rightholders, upon exercise of the rights, to receive shares of common stock of
the acquiring company with a market value equal to twice the exercise price of
each right.
The Corporation can redeem the rights for $0.01 per right at any time
prior to becoming exercisable.
NOTE 18 -- VARIABLE INTEREST ENTITY
The Corporation currently holds an equity investment in APM Spring Grove, Inc.
(APM), which was deemed a variable interest entity in accordance with FASB
Interpretation No. 46 - Consolidation of Variable Interest Entities (FIN 46). As
a result, APM was consolidated into the Corporation's financial statements
effective January 1, 2004, in accordance with the provisions of FIN 46, which
resulted in a $1.6 (net of tax) loss due to a cumulative effect of an accounting
change. The investment relates to an agreement in 1984, which created APM, whose
largest asset is an office building located in Cincinnati, Ohio. APM's only
source of revenue is derived from leasing the office building. The rental income
on the office building is used by APM to repay principal and interest on bonds
owned by the Corporation that were issued to purchase the building. The
Corporation's maximum exposure to loss as a result of its involvement with APM
is $3.3. As of December 31, 2004, APM had total assets and total liabilities of
$0.7 and $2.1, respectively.
NOTE 19 -- RECENTLY ISSUED ACCOUNTING STANDARDS
In December 2004, the FASB finalized Statement 123(R), "Share-Based Payment,"
effective for public companies for interim and annual periods beginning after
June 15, 2005. Statement 123(R) supersedes APB Opinion No. 25, "Accounting for
Stock Issued to Employees," and amends FASB Statement No. 95, "Statement of Cash
Flows." FASB 123R requires all share-based payments to employees, including
grants of employee stock options, to be recognized as compensation expense in
the income statement at fair value. Pro forma disclosure is no longer an
alternative. The Corporation will adopt the provisions of FASB 123(R) effective
July 1, 2005.
FASB 123(R) permits public companies to adopt its requirements using one
of two methods: (1) modified prospective or (2) modified retrospective. The
Corporation plans to adopt using the modified prospective method in which
compensation expense is recognized beginning July 1, 2005 (a) based on the
requirements of FASB 123(R) for all share-based payments granted after the July
1, 2005 and (b) based on the requirements of FASB 123 for all awards granted to
employees prior to July 1, 2005 that remain unvested on that date.
The adoption of FASB 123(R) fair value method is expected to increase the
Corporation's compensation expense by $3.0 to $4.0 in 2005. This impact could
change materially from the estimate based upon the Corporation's use of
share-based payments granted in the future. Had the Corporation adopted FASB
123(R) in prior periods, the impact of that standard would have approximated the
impact of FASB 123 as described in the disclosure of pro forma net income and
earnings per share in Note 6.
FASB 123(R) also requires the benefits of tax deductions in excess of
recognized compensation expense to be reported as a financing cash flow, rather
than as an operating cash flow as required under current accounting literature.
This requirement will reduce net operating cash flows and increase net financing
cash flows in periods after the adoption.
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 Corporation. 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 December
31, 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.
71
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
THE BOARD OF DIRECTORS AND SHAREHOLDERS, OHIO CASUALTY CORPORATION
We have audited the accompanying consolidated balance sheets of Ohio
Casualty Corporation and subsidiaries as of December 31, 2004 and 2003, and the
related consolidated statements of income, shareholders' equity, and cash flows
for each of the three years in the period ended December 31, 2004. Our audits
also included the financial statement schedules listed in the Index at Item
15(a). These financial statements and schedules are the responsibility of the
Company's management. Our responsibility is to express an opinion on these
financial statements and schedules based on our audits.
We conducted our audits in accordance with the standards of the
Public Company Accounting Oversight Board (United States). Those standards
require that we plan and perform the audit to obtain reasonable assurance about
whether the financial statements are free of material misstatement. An audit
includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements. An audit also includes assessing the
accounting principles used and significant estimates made by management, as well
as evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present
fairly, in all material respects, the consolidated financial position of Ohio
Casualty Corporation and subsidiaries at December 31, 2004 and 2003, and the
consolidated results of their operations and their cash flows for each of the
three years in the period ended December 31, 2004, in conformity with U.S.
generally accepted accounting principles. Also, in our opinion, the related
financial statement schedules, when considered in relation to the basic
financial statements taken as a whole, present fairly in all material respects
the information set forth therein.
We also have audited, in accordance with the standards of the Public
Company Accounting Oversight Board (United States), the effectiveness of Ohio
Casualty Corporation's internal control over financial reporting as of December
31, 2004, based on criteria established in Internal Control-Integrated Framework
issued by the Committee of Sponsoring Organizations of the Treadway Commission
and our report dated March 1, 2005, expressed an unqualified opinion thereon.
/s/ Ernst & Young LLP
Ernst & Young LLP
Cincinnati, Ohio
March 1, 2005
72
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
THE BOARD OF DIRECTORS AND SHAREHOLDERS, OHIO CASUALTY CORPORATION
We have audited management's assessment, included in the
accompanying Management's Report on Internal Control over Financial Reporting,
that Ohio Casualty Corporation maintained effective internal control over
financial reporting as of December 31, 2004, based on criteria established in
Internal Control -- Integrated Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission (the COSO criteria). Ohio Casualty
Corporation's management is responsible for maintaining effective internal
control over financial reporting and for its assessment of the effectiveness of
internal control over financial reporting. Our responsibility is to express an
opinion on management's assessment and an opinion on the effectiveness of the
company's internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the
Public Company Accounting Oversight Board (United States). Those standards
require that we plan and perform the audit to obtain reasonable assurance about
whether effective internal control over financial reporting was maintained in
all material respects. Our audit included obtaining an understanding of internal
control over financial reporting, evaluating management's assessment, testing
and evaluating the design and operating effectiveness of internal control, and
performing such other procedures as we considered necessary in the
circumstances. We believe that our audit provides a reasonable basis for our
opinion.
A company's internal control over financial reporting is a process
designed to provide reasonable assurance regarding the reliability of financial
reporting and the preparation of financial statements for external purposes in
accordance with generally accepted accounting principles. A company's internal
control over financial reporting includes those policies and procedures that (1)
pertain to the maintenance of records that, in reasonable detail, accurately and
fairly reflect the transactions and dispositions of the assets of the company;
(2) provide reasonable assurance that transactions are recorded as necessary to
permit preparation of financial statements in accordance with generally accepted
accounting principles, and that receipts and expenditures of the company are
being made only in accordance with authorizations of management and directors of
the company; and (3) provide reasonable assurance regarding prevention or timely
detection of unauthorized acquisition, use, or disposition of the company's
assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial
reporting may not prevent or detect misstatements. Also, projections of any
evaluation of effectiveness to future periods are subject to the risk that
controls may become inadequate because of changes in conditions, or that the
degree of compliance with the policies or procedures may deteriorate.
In our opinion, management's assessment that Ohio Casualty
Corporation maintained effective internal control over financial reporting as of
December 31, 2004, is fairly stated, in all material respects, based on the COSO
criteria. Also, in our opinion, Ohio Casualty Corporation maintained, in all
material respects, effective internal control over financial reporting as of
December 31, 2004, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public
Company Accounting Oversight Board (United States), the consolidated balance
sheets of Ohio Casualty Corporation and subsidiaries as of December 31, 2004 and
2003, and the related consolidated statements of income, shareholders' equity,
and cash flows for each of the three years in the period ended December 31, 2004
and our report dated March 1, 2005, expressed an unqualified opinion thereon.
/s/ Ernst & Young LLP
Ernst & Young LLP
Cincinnati, Ohio
March 1, 2005
73
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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)
March 11, 2005 By: /s/ Dan R. Carmichael
------------------------------------
Dan R. Carmichael
Chief Executive Officer and Director
Pursuant to the requirements of the Securities Exchange Act of 1934, this report
has been signed below by the following persons on behalf of the registrant and
in the capacities and on the dates indicated.
March 11, 2005 /s/ Stanley N. Pontius
----------------------------------------------------------
Stanley N. Pontius, Lead Director
March 11, 2005 /s/ Dan R. Carmichael
----------------------------------------------------------
Dan R. Carmichael, Chief Executive Officer and Director
March 11, 2005 /s/ Terrence J. Baehr
----------------------------------------------------------
Terrence J. Baehr, Director
March 11, 2005
----------------------------------------------------------
William P. Boardman, Director
March 11, 2005 /s/ Jack E. Brown
----------------------------------------------------------
Jack E. Brown, Director
March 11, 2005 /s/ Catherine E. Dolan
----------------------------------------------------------
Catherine E. Dolan, Director
March 11, 2005 /s/ Philip G. Heasley
----------------------------------------------------------
Philip G. Heasley, Director
March 11, 2005 /s/ Ralph S. Michael III
----------------------------------------------------------
Ralph S. Michael III, Director
March 11, 2005 /s/ Robert A. Oakley
----------------------------------------------------------
Robert A. Oakley, Director
March 11, 2005 /s/ Jan H. Suwinski
----------------------------------------------------------
Jan H. Suwinski, Director
March 11, 2005 /s/ Michael L. Wright
----------------------------------------------------------
Michael L. Wright, Director
March 11, 2005 /s/ Michael A. Winner
----------------------------------------------------------
Michael A. Winner, Executive Vice President and Chief
Financial Officer
74
Schedule I
Ohio Casualty Corporation and Subsidiaries
Consolidated Summary of Investments
Other than Investments in Related Parties
(In millions)
December 31, 2004
Amount shown
Type of investment Cost Value in balance sheet
- ------------------------------------ ---------- ---------- ----------------
Fixed maturities: Available-for-sale
Bonds:
U.S. Government $ 31.9 $ 33.4 $ 33.4
States, municipalities and
political subdivisions 1,018.4 1,034.6 1,034.6
Corporate securities 1,614.4 1,744.8 1,744.8
Mortgage-backed securities:
U.S. government guaranteed 7.2 7.6 7.6
Other 504.9 525.7 525.7
---------- ---------- ----------
Total fixed maturities
Available-for-sale 3,176.8 3,346.1 3,346.1
Fixed maturities: Held-to-maturity
Corporate securities 164.7 166.6 164.7
Mortgage-backed securities:
Other 136.7 136.5 136.7
---------- ---------- ----------
Total fixed maturities
Held-to-maturity 301.4 303.1 301.4
Equity securities:
Common stocks:
Banks, trust and insurance
companies 21.8 110.6 110.6
Industrial, miscellaneous and
all other 77.1 246.8 246.8
---------- ---------- ----------
Total equity securities 98.9 357.4 357.4
Short-term investments 239.9 239.1 239.1
---------- ---------- ----------
Total investments $ 3,817.0 $ 4,245.7 $ 4,244.0
========== ========== ==========
75
Schedule II
Ohio Casualty Corporation
Condensed Financial Information of Registrant
(In millions)
2004 2003 2002
---------- ---------- ----------
CONDENSED BALANCE SHEET:
Investment in wholly-owned
subsidiaries, at equity $ 1,342.2 $ 1,285.0 $ 1,197.8
Investment in fixed maturities and equity
securities, at fair value 133.2 44.2 40.7
Cash and other assets 209.6 18.8 21.0
---------- ---------- ----------
Total assets 1,685.0 1,348.0 1,259.5
Notes payable 383.3 198.0 198.3
Other liabilities 6.8 4.2 2.5
---------- ---------- ----------
Total liabilities 390.1 202.2 200.8
---------- ---------- ----------
Shareholders' equity $ 1,294.9 $ 1,145.8 $ 1,058.7
========== ========== ==========
CONDENSED STATEMENT OF INCOME:
Dividends from subsidiaries $ 86.7 $ - $ 25.0
Undistributed earnings of subsidiaries 52.0 79.8 (19.3)
Operating expenses (10.3) (4.0) (6.6)
---------- ---------- ----------
Net income (loss) $ 128.4 $ 75.8 $ (0.9)
========== ========== ==========
CONDENSED STATEMENT OF CASH FLOWS:
Operating activities
Net distributed income (loss) $ 76.4 $ (4.0) $ 18.4
Other 2.7 5.4 1.6
---------- ---------- ----------
Net cash provided by operating activities 79.1 1.4 20.0
Investing activities
Purchase of fixed maturity and equity securities (134.2) (29.1) (55.5)
Sales of fixed maturities and equity securities 45.5 26.1 30.5
---------- ---------- ----------
Net cash used in investing activities (88.7) (3.0) (25.0)
Financing activities
Debt:
Proceeds 199.3 - 201.3
Repayments (13.0) (0.6) (205.6)
Payment for deferred financing costs - - (0.4)
Payment for issuance costs (1.3) - (7.4)
Proceeds from exercise of stock options 15.1 2.2 7.5
---------- ---------- ----------
Net cash provided by (used in) financing
activities 200.1 1.6 (4.6)
Net change in cash 190.5 - (9.6)
---------- ---------- ----------
Cash and cash equivalents, beginning of year 0.4 0.4 10.0
---------- ---------- ----------
Cash and cash equivalents, end of year $ 190.9 $ 0.4 $ 0.4
========== ========== ==========
76
Schedule III
Ohio Casualty Corporation and Subsidiaries
Consolidated Supplementary Insurance Information
(In millions)
December 31, 2004
Deferred Reserves for
policy unpaid
acquisition losses and Unearned Earned
costs loss expenses premiums premiums
----------- ------------- ---------- ----------
Segment
Property and
casualty insurance:
Underwriting
Commercial Lines $ 98.9 $ 1,671.0 $ 404.6 $ 807.9
Specialty Lines 24.4 656.6 127.4 150.3
Personal Lines 36.5 428.8 183.5 488.4
Miscellaneous income - - - 0.2
Allowance for reinsurance recoverable - - - -
Investment - - - -
----------- ------------- ---------- ----------
Total property and
casualty insurance 159.8 2,756.4 715.5 1,446.8
Corporation - - - -
----------- ------------- ---------- ----------
Total $ 159.8 $ 2,756.4 $ 715.5 $ 1,446.8
=========== ============= ========== ==========
Amortization
Losses of deferred
Net and loss policy General
investment expenses acquisition operating Premiums
income incurred costs expenses written
---------- -------- ------------ --------- ---------
Segment
Property and
casualty insurance:
Underwriting
Commercial Lines $ - $ 527.1 $ 206.7 $ 80.5 $ 828.2
Specialty Lines - 71.4 57.0 16.3 135.5
Personal Lines - 337.9 101.5 42.8 490.2
Miscellaneous income - - - - -
Allowance for reinsurance recoverable - (0.1) - - -
Investment 196.9 - - - -
---------- -------- ------------ --------- ---------
Total property and
casualty insurance 196.9 936.3 365.2 139.6 1,453.9
Corporation 4.3 - - 43.4 -
---------- -------- ------------ --------- ---------
Total $ 201.2 $ 936.3 $ 365.2 $ 183.0 $ 1,453.9
========== ======== ============ ========= =========
1. Net investment income has been allocated to principal business segments on
the basis of separately identifiable assets.
2. The principal portion of general operating expenses has been directly
attributed to business segment classifications incurring such expenses
with the remainder allocated based on premium revenue. Amortization and
impairment write-downs of the agent relationships asset are classified as
corporate expenses as management believes these costs do not reflect
current underwriting profitability.
77
Schedule III
Ohio Casualty Corporation and Subsidiaries
Consolidated Supplementary Insurance Information
(In millions)
December 31, 2003
Deferred Reserves for
policy unpaid
acquisition losses and Unearned Earned
costs loss expenses premiums premiums
----------- ------------- --------- -----------
Segment
Property and
casualty insurance:
Underwriting
Commercial Lines $ 100.7 $ 1,661.2 $ 385.3 $ 777.4
Specialty Lines 30.2 512.5 135.8 162.7
Personal Lines 38.4 454.1 181.9 484.3
Allowance for reinsurance recoverable - - - -
Investment - - - -
----------- ------------- --------- -----------
Total property and
casualty insurance 169.3 2,627.8 703.0 1,424.4
Corporation - - - -
----------- ------------- --------- -----------
Total $ 169.3 $ 2,627.8 $ 703.0 $ 1,424.4
=========== ============= ========= ===========
Amortization
Losses of deferred
Net and loss policy General
investment expenses acquisition operating Premiums
income incurred costs expenses written
----------- ----------- ------------ ---------- ------------
Segment
Property and
casualty insurance:
Underwriting
Commercial Lines $ - $ 590.3 $ 212.6 $ 80.2 $ 792.6
Specialty Lines - 54.8 62.8 11.9 164.9
Personal Lines - 380.4 108.6 27.1 484.1
Allowance for reinsurance recoverable - 1.9 - - -
Investment 204.9 - - - -
----------- ----------- ------------ ---------- ------------
Total property and
casualty insurance 204.9 1,027.4 384.0 119.2 1,441.6
Corporation 3.8 - - 30.8 -
----------- ----------- ------------ ---------- ------------
Total $ 208.7 $ 1,027.4 $ 384.0 $ 150.0 $ 1,441.6
=========== =========== ============ ========== ============
1. Net investment income has been allocated to principal business segments on
the basis of separately identifiable assets.
2. The principal portion of general operating expenses has been directly
attributed to business segment classifications incurring such expenses
with the remainder allocated based on premium revenue. Amortization and
impairment write-downs of the agent relationships asset are classified as
corporate expenses as management believes these costs do not reflect
current underwriting profitability.
78
Schedule III
Ohio Casualty Corporation and Subsidiaries
Consolidated Supplementary Insurance Information
(In millions)
December 31, 2002
Deferred Reserves for
policy unpaid
acquisition losses and Unearned Earned
costs loss expenses premiums premiums
----------- ------------- ---------- -----------
Segment
Property and
casualty insurance:
Underwriting
Commercial Lines $ 92.8 $ 1,564.7 $ 370.0 $ 725.6
Specialty Lines 33.2 378.0 116.4 158.5
Personal Lines 55.3 491.0 182.3 566.3
Miscellaneous income - - - 0.1
Allowance for reinsurance recoverable - - - -
Investment - - - -
----------- ------------- ---------- -----------
Total property and
casualty insurance 181.3 2,433.7 668.7 1,450.5
Corporation - - - -
----------- ------------- ---------- -----------
Total $ 181.3 $ 2,433.7 $ 668.7 $ 1,450.5
=========== ============= ========== ===========
Amortization
Losses of deferred
Net and loss policy General
investment expenses acquisition operating Premiums
income incurred costs expenses written
---------- ---------- ------------ ---------- ----------
Segment
Property and
casualty insurance:
Underwriting
Commercial Lines $ - $ 571.9 $ 187.7 $ 80.6 $ 762.2
Specialty Lines - 79.2 52.1 15.2 179.9
Personal Lines - 478.2 136.4 17.5 506.5
Miscellaneous income - - - - -
Allowance for reinsurance recoverable - 0.5 - - -
Investment 205.8 - - - -
---------- ---------- ------------ ---------- ----------
Total property and
casualty insurance 205.8 1,129.8 376.2 113.3 1,448.6
Corporation 1.3 - - 90.2 -
---------- ---------- ------------ ---------- ----------
Total $ 207.1 $ 1,129.8 $ 376.2 $ 203.5 $ 1,448.6
========== ========== ============ ========== ==========
1. Net investment income has been allocated to principal business segments on
the basis of separately identifiable assets.
2. The principal portion of general operating expenses has been directly
attributed to business segment classifications incurring such expenses
with the remainder allocated based on premium revenue. Amortization and
impairment write-downs of the agent relationships asset are classified as
corporate expenses as management believes these costs do not reflect
current underwriting profitability.
79
Schedule IV
Ohio Casualty Corporation and Subsidiaries
Consolidated Reinsurance
(In millions)
December, 2004, 2003 and 2002
Percent of
amount
Ceded to Assumed assumed
Gross other from other Net to net
amount companies companies amount amount
---------- ---------- ---------- ---------- ----------
Year Ended December 31, 2004
Premiums written
----------------
Property and casualty insurance $ 1,581.2 $ 150.4 $ 23.1 $ 1,453.9 1.6%
Accident and health insurance 0.1 0.1 - - -
---------- ---------- ---------- ----------
Total premiums written 1,581.3 150.5 23.1 1,453.9 1.6%
Change in unearned premiums and finance charges (7.3)
----------
Total premiums and finance charges earned 1,446.6
Miscellaneous income 0.2
----------
Total premiums and finance charges earned $ 1,446.8
==========
Year Ended December 31, 2003
Premiums written
----------------
Property and casualty insurance $ 1,570.3 $ 148.7 $ 20.0 $ 1,441.6 1.4%
Accident and health insurance 0.1 0.1 - - -
---------- ---------- ---------- ----------
Total premiums written 1,570.4 148.8 20.0 1,441.6 1.4%
Change in unearned premiums and finance charges (17.2)
----------
Total premiums and finance charges earned $ 1,424.4
==========
Year Ended December 31, 2002
Premiums written
----------------
Property and casualty insurance $ 1,536.0 $ 103.7 $ 16.3 $ 1,448.6 1.1%
Accident and health insurance 0.1 0.1 - - -
---------- ---------- ---------- ----------
Total premiums written 1,536.1 103.8 16.3 1,448.6 1.1%
Change in unearned premiums and finance charges 1.7
----------
Total premiums and finance charges earned 1,450.3
Miscellaneous income 0.2
----------
Total premiums and finance charges earned $ 1,450.5
==========
80
Schedule V
Ohio Casualty Corporation and Subsidiaries
Valuation and Qualifying Accounts
(in millions)
Balance at Balance at
beginning Charged to end of
of period expenses period
---------- ---------- ----------
Year ended December 31, 2004
Reserve for bad debt $4.2 $0.1 $4.3
Reserve for uncollectible
reinsurance recoverable 2.4 (0.1) 2.3
Year ended December 31, 2003
Reserve for bad debt $4.3 ($0.1) $4.2
Reserve for uncollectible
reinsurance recoverable 0.5 1.9 2.4
Year ended December 31, 2002
Reserve for bad debt $8.4 ($4.1) $4.3
Reserve for uncollectible
reinsurance recoverable - 0.5 0.5
81
Schedule VI
Ohio Casualty Corporation and Subsidiaries
Consolidated Supplemental Information Concerning Property
and Casualty Insurance Operations
(In millions)
Reserves for
Deferred unpaid claims
policy and claim Net
Affiliation with acquisition adjustment Unearned Earned investment
registrant costs expenses premiums premiums income
----------- ------------- -------- --------- ----------
Property and casualty
subsidiaries
Year ended December 31,
2004 $ 159.8 $ 2,756.4 $ 715.5 $ 1,446.8 $ 196.9
=========== ============= ======== ========= ==========
Year ended December 31,
2003 $ 169.3 $ 2,627.8 $ 703.0 $ 1,424.4 $ 204.9
=========== ============= ======== ========= ==========
Year ended December 31,
2002 $ 181.3 $ 2,433.7 $ 668.7 $ 1,450.5 $ 205.8
=========== ============= ======== ========= ==========
Claims and claim
adjustment expenses Amortization Paid
incurred related to of deferred claims
-------------------- policy and claim
Affiliation with Current Prior acquisition adjustment Premiums
registrant year years costs expenses written
- ----------------------- ----------- -------- ------------ ----------- --------
Property and casualty
subsidiaries
Year ended December 31,
2004 $ 958.1 $ (21.8) $ 365.2 $ 881.5 $ 1,453.9
======== ======= ======== ========= =========
Year ended December 31,
2003 $ 993.3 $ 34.1 $ 384.0 $ 975.4 $ 1,441.6
======== ======= ======== ========= =========
Year ended December 31,
2002 $1,045.4 $ 84.4 $ 376.2 $ 1,032.5 $ 1,448.6
======== ======= ======== ========= =========
82
FORM 10-K
OHIO CASUALTY CORPORATION
INDEX TO EXHIBITS
Exhibit 4a Certificate of Adjustment by the Registrant dated as of July
1, 1999
Exhibit 10.1 Form of Change in Control Agreement entered into between the
Registrant and Mike E. Sullivan
Exhibit 10.2 Amended and Restated Ohio Casualty Corporation Directors
Deferred Compensation Plan
Exhibit 10.3 Form of Stock Option Agreement entered into between the
Registrant and Dan R. Carmichael for stock options granted on
December 12, 2002, 2001 and 2000, respectively
Exhibit 21 Subsidiaries of the Registrant
Exhibit 23 Consent of Independent Registered Public Accounting Firm to
incorporation of their opinion by reference in Registration
Statements on Forms S-3 (Nos. 333-29483, 333-88532, and
333-105092) and Form S-8 (Nos. 333-42944, 333-73738,
333-73740, 333-88398 and 333-91906)
Exhibit 31.1 Certification of Chief Executive Officer of Ohio Casualty
Corporation in accordance with SEC Rule 13(a)-14(a)/15(d)-14(a)
Exhibit 31.2 Certification of Chief Financial Officer of Ohio Casualty
Corporation in accordance with SEC Rule
13(a)-14(a)/15(d)-14(a)
Exhibit 32.1 Certification of Chief Executive Officer of Ohio Casualty
Corporation in accordance with Section 1350 of the
Sarbanes-Oxley Act of 2002
Exhibit 32.2 Certification of Chief Financial Officer of Ohio Casualty
Corporation in accordance with Section 1350 of the
Sarbanes-Oxley Act of 2002
Exhibits incorporated by reference:
Exhibit 3(i) Articles of Incorporation, as amended, filed as Exhibit 3 to
the Registrant's SEC Form 10-K on March 27, 2003
Exhibit 3(ii) Code of Regulations, as amended, filed as Exhibit 3.1 to the
Registrant's SEC Form 10-Q on May 13, 2003
Exhibit 4b First amendment to the Amended and Restated Rights Agreement
dated as of February 19, 1998, signed November 8, 2001, filed
as Exhibit 4b to the Registrant's SEC Form 10-K on March 5,
2002
Exhibit 4c Ohio Casualty Corporation's Registration Statement for
Convertible Notes due 2022 filed on Form S-3 (333-88532) on
May 17, 2002
Exhibit 4d First Amendment to the Ohio Casualty Corporation's
Registration Statement for Convertible Notes due 2022 filed on
Form S-3A (333-88532) on June 4, 2002
Exhibit 4e Ohio Casualty Corporation's Registration Statement for
Universal Shelf filed on Form S-3 (333-105092) on May 8, 2003
Exhibit 4f First Supplemental Indenture dated as of June 29, 2004,
between Ohio Casualty Corporation and Citibank, N.A. as
trustee, relating to the Senior Notes, filed as Exhibit 4.1 to
the Registrant's SEC Form 8-K on June 30, 2004
83
FORM 10-K
OHIO CASUALTY CORPORATION
INDEX TO EXHIBITS, CONTINUED
Exhibit 10a Employment Agreement with Dan R. Carmichael dated December 12,
2000, filed as Exhibit 10 to the Registrant's SEC Form 10-K on
March 30, 2001
Exhibit 10b Separation Agreement with Donald F. McKee dated May 10, 2004,
filed as Exhibit 10.1 to the Registrant's SEC Form 8-K on May
10, 2004
Exhibit 10c Stock Option Agreement for Directors' year 2000 grant, filed
as Exhibit 10.1 to the Registrant's SEC Form 10-Q on May 15,
2000
Exhibit 10d Stock Option Agreement for Executive Vice President and
Chief Financial Officer dated September 19, 2001, filed as
Exhibit 10.6 to the Registrant's SEC Form 10-K on March 27,
2003
Exhibit 10e Replacement carrier agreement between Ohio Casualty of New
Jersey, Inc. and Proformance Insurance Company and its parent,
National Atlantic Holdings Corporation, filed as Exhibit 10k
to the Registrant's SEC Form 10-K on March 5, 2002
Exhibit 10f Ohio Casualty Corporation 2002 Stock Incentive Program,
filed as Exhibit 10.2 to the Registrant's SEC Form 10-Q on May
14, 2002
Exhibit 10g Ohio Casualty Corporation 2002 Employee Stock Purchase
Plan, filed as Exhibit 10.3 to the Registrant's SEC Form 10-Q
on May 14, 2002
Exhibit 10h Credit Agreement dated as of July 31, 2002 between Ohio
Casualty Corporation and LaSalle Bank National Association and
certain other lenders, filed as Exhibit 10 to the Registrant's
SEC Form 10-Q on August 14, 2002
Exhibit 10i Amended and Restated Ohio Casualty Corporation Director's
Deferred Compensation Plan filed as Exhibit 10.1 to the
Registrant's SEC Form 10-K on March 27, 2003
Exhibit 10j The Ohio Casualty Insurance Company Supplemental Executive
Savings Plan, amended effective June 1, 2002 filed as Exhibit
10.2 to the Registrant's SEC Form 10-K on March 27, 2003
Exhibit 10k The Ohio Casualty Insurance Company 2002 Officer Annual
Incentive Program filed as Exhibit 10.3 to the Registrant's
SEC Form 10-K on March 27, 2003
Exhibit 10l The Ohio Casualty Insurance Company 2003 Executive Management
Team Annual Incentive Program filed as Exhibit 10 to the
Registrant's SEC Form 10-Q on August 3, 2004
Exhibit 10m The Ohio Casualty Insurance Company Benefit Equalization Plan
filed as Exhibit 10.4 to the Registrant's SEC Form 10-K on
March 27, 2003
Exhibit 10n The Ohio Casualty Insurance Company Deferred Compensation Plan
(Dan R. Carmichael) filed as Exhibit 10.5 to the Registrant's
SEC Form 10-K on March 27, 2003
Exhibit 10o Form of Amended Change in Control Agreement entered into
between the Registrant and each of the following executive
officers: John S. Busby, Debra K. Crane, Ralph G. Goode, John
S. Kellington, Elizabeth M. Riczko, Thomas E. Schadler,
Michael A. Winner, Derrick D. Shannon and Howard L. Sloneker
III filed as Exhibit 1e to the Registrant's SEC Form 10-K on
March 12, 2004
Exhibit 10p Ohio Casualty Corporation Agent Share Plan on Form S-3
(333-29483) filed as Exhibit 4.1 to the Registrant's SEC Form
10-K on March 12, 2004
84