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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
x | Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 |
for the Quarterly Period Ended June 30, 2008
¨ | 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: 1-6563
Safeco Corporation
State of Incorporation: Washington
I.R.S. Employer I.D. No.: 91-0742146
Address of Principal Executive Offices: Safeco Plaza, 1001 4th Avenue, Seattle, Washington 98154
Telephone: 206-545-5000
Securities Registered Pursuant to Section 12(b) of the Act:
Title of Each Class | Name of Each Exchange on Which Registered | |
Common Stock, no par value | New York Stock Exchange |
Securities Registered Pursuant to Section 12(g) of the Act: None
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
YES x NO ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer x Accelerated filer ¨ Non-accelerated filer ¨ Smaller reporting company ¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act):
YES ¨ NO x
89,944,301 shares of common stock were outstanding at July 18, 2008.
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CONTENTS
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Safeco Corporation
Consolidated Statements of Income
(In millions, except per share amounts)
THREE MONTHS ENDED JUNE 30, | SIX MONTHS ENDED JUNE 30, | |||||||||||
2008 | 2007 | 2008 | 2007 | |||||||||
(Unaudited) | (Unaudited) | |||||||||||
REVENUES | ||||||||||||
Net Earned Premiums | $ | 1,375.7 | $ | 1,394.0 | $ | 2,758.2 | $ | 2,761.0 | ||||
Net Investment Income | 112.2 | 128.2 | 223.8 | 255.4 | ||||||||
Net Realized Investment Gains | 16.5 | 17.4 | 10.0 | 29.8 | ||||||||
Service Fees and Other Revenues | 13.6 | 15.2 | 27.6 | 29.8 | ||||||||
Total Revenues | 1,518.0 | 1,554.8 | 3,019.6 | 3,076.0 | ||||||||
EXPENSES | ||||||||||||
Losses and Loss Adjustment Expenses | 899.1 | 858.0 | 1,795.4 | 1,706.2 | ||||||||
Amortization of Deferred Policy Acquisition Costs | 241.2 | 231.3 | 483.4 | 467.5 | ||||||||
Other Underwriting and Operating Expenses | 175.8 | 183.0 | 336.9 | 341.7 | ||||||||
Interest Expense | 6.7 | 22.0 | 13.8 | 46.2 | ||||||||
Restructuring and Asset Impairment Charges | 3.2 | 1.5 | 7.8 | 1.8 | ||||||||
Total Expenses | 1,326.0 | 1,295.8 | 2,637.3 | 2,563.4 | ||||||||
Income before Income Taxes | 192.0 | 259.0 | 382.3 | 512.6 | ||||||||
Provision for Income Taxes | 42.5 | 72.6 | 91.0 | 143.7 | ||||||||
Net Income | $ | 149.5 | $ | 186.4 | $ | 291.3 | $ | 368.9 | ||||
NET INCOME PER SHARE OF COMMON STOCK | ||||||||||||
Net Income Per Share of Common Stock – Diluted | $ | 1.65 | $ | 1.75 | $ | 3.23 | $ | 3.46 | ||||
Net Income Per Share of Common Stock – Basic | $ | 1.66 | $ | 1.76 | $ | 3.24 | $ | 3.49 | ||||
Dividends Declared Per Share | $ | 0.40 | $ | 0.40 | $ | 0.80 | $ | 0.70 | ||||
See Condensed Notes to Consolidated Financial Statements.
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Safeco Corporation
(In millions)
JUNE 30, 2008 | DECEMBER 31, 2007 | |||||
(Unaudited) | ||||||
ASSETS | ||||||
Investments | ||||||
Available-for-Sale Securities: | ||||||
Fixed Maturities, at Fair Value (Cost or amortized cost: $7,446.4; $7,615.2) | $ | 7,407.5 | $ | 7,763.9 | ||
Marketable Equity Securities, at Fair Value (Cost: $1,108.1; $993.2) | 1,345.9 | 1,402.6 | ||||
Other Invested Assets | 53.2 | 48.6 | ||||
Short-Term Investments | 12.5 | — | ||||
Total Investments | 8,819.1 | 9,215.1 | ||||
Cash and Cash Equivalents | 544.3 | 532.0 | ||||
Accrued Investment Income | 108.3 | 108.4 | ||||
Premiums and Service Fees Receivable | 1,099.3 | 1,074.7 | ||||
Deferred Policy Acquisition Costs | 428.8 | 415.7 | ||||
Reinsurance Recoverables | 452.3 | 461.9 | ||||
Property and Equipment for Company Use (At cost less accumulated depreciation: $212.1; $204.6) | 210.5 | 214.8 | ||||
Current Income Taxes Recoverable | 9.2 | 32.3 | ||||
Net Deferred Income Tax Assets | 296.7 | 157.9 | ||||
Other Assets | 96.1 | 96.6 | ||||
Securities Lending Collateral | 284.2 | 331.0 | ||||
Total Assets | $ | 12,348.8 | $ | 12,640.4 | ||
LIABILITIES AND SHAREHOLDERS’ EQUITY | ||||||
Loss and Loss Adjustment Expense Reserves | $ | 5,166.1 | $ | 5,185.0 | ||
Unearned Premiums | 2,271.7 | 2,240.9 | ||||
Debt | 504.0 | 704.0 | ||||
Other Liabilities | 712.1 | 765.4 | ||||
Securities Lending Payable | 284.2 | 331.0 | ||||
Total Liabilities | 8,938.1 | 9,226.3 | ||||
Commitments and Contingencies | — | — | ||||
Restricted Stock Rights | 25.8 | 21.5 | ||||
Preferred Stock, No Par Value | ||||||
Shares Authorized: 10 | ||||||
Shares Issued and Outstanding: None | — | — | ||||
Common Stock, No Par Value | ||||||
Shares Authorized: 300 | ||||||
Shares Reserved for Stock Awards: 4.1; 4.3 | ||||||
Shares Issued and Outstanding: 89.9; 89.7 | 11.5 | — | ||||
Retained Earnings | 3,242.6 | 3,025.3 | ||||
Accumulated Other Comprehensive Income, Net of Taxes | 130.8 | 367.3 | ||||
Total Shareholders’ Equity | 3,384.9 | 3,392.6 | ||||
Total Liabilities and Shareholders’ Equity | $ | 12,348.8 | $ | 12,640.4 | ||
See Condensed Notes to Consolidated Financial Statements.
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Safeco Corporation
Consolidated Statements of Cash Flows
(In millions)
SIX MONTHS ENDED JUNE 30, | 2008 | 2007 | ||||||
(Unaudited) | ||||||||
OPERATING ACTIVITIES | ||||||||
Insurance Premiums Received | $ | 2,770.4 | $ | 2,792.1 | ||||
Dividends and Interest Received | 232.4 | 269.1 | ||||||
Losses and Loss Adjustment Expenses Paid | (1,807.7 | ) | (1,708.1 | ) | ||||
Underwriting, Acquisition and Other Operating Costs Paid | (862.3 | ) | (973.1 | ) | ||||
Interest Paid | (17.2 | ) | (43.3 | ) | ||||
Income Taxes Paid | (77.3 | ) | (70.3 | ) | ||||
Net Cash Provided by Operating Activities | 238.3 | 266.4 | ||||||
INVESTING ACTIVITIES | ||||||||
Purchases of: | ||||||||
Fixed Maturities Available-for-Sale | (383.7 | ) | (805.3 | ) | ||||
Marketable Equity Securities Available-for-Sale | (496.0 | ) | (133.8 | ) | ||||
Property and Equipment for Company Use | (19.8 | ) | (68.8 | ) | ||||
Sales of: | ||||||||
Fixed Maturities Available-for-Sale | 133.8 | 854.9 | ||||||
Marketable Equity Securities Available-for-Sale | 402.7 | 122.2 | ||||||
Real Estate | — | 2.1 | ||||||
Maturities and Calls of Fixed Maturities Available-for-Sale | 417.9 | 377.6 | ||||||
Net Change in Short-Term Investments | (12.4 | ) | — | |||||
Securities Lending Collateral Returned | 46.9 | 215.9 | ||||||
Sale of Subsidiary, Net of Cash Sold | — | 5.0 | ||||||
Other, Net | (0.8 | ) | (0.5 | ) | ||||
Net Cash Provided By Investing Activities | 88.6 | 569.3 | ||||||
FINANCING ACTIVITIES | ||||||||
Repayment of Debt | (200.0 | ) | — | |||||
Dividends Paid to Shareholders | (72.4 | ) | (63.8 | ) | ||||
Stock Options Exercised | 4.7 | 9.7 | ||||||
Securities Lending Collateral Received | (46.9 | ) | (215.9 | ) | ||||
Common Shares Reacquired | — | (157.8 | ) | |||||
Net Cash Used in Financing Activities | (314.6 | ) | (427.8 | ) | ||||
Net Increase in Cash and Cash Equivalents | 12.3 | 407.9 | ||||||
Cash and Cash Equivalents at Beginning of Period | 532.0 | 287.6 | ||||||
Cash and Cash Equivalents at End of Period | $ | 544.3 | $ | 695.5 | ||||
See Condensed Notes to Consolidated Financial Statements.
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Safeco Corporation
Consolidated Statements of Cash Flows –
Reconciliation of Net Income to Net Cash Provided by Operating Activities
(In millions)
SIX MONTHS ENDED JUNE 30, | 2008 | 2007 | ||||||
(Unaudited) | ||||||||
Net Income | $ | 291.3 | $ | 368.9 | ||||
ADJUSTMENTS TO RECONCILE NET INCOME TO NET CASH PROVIDED BY OPERATING ACTIVITIES: | ||||||||
Net Realized Investment Gains | (10.0 | ) | (29.8 | ) | ||||
Amortization of Discount and Accretion of Premium on Fixed Maturities | 7.6 | 13.4 | ||||||
Amortization, Depreciation and Impairments | 24.2 | 27.7 | ||||||
Deferred Income Tax Provision (Benefit) | (11.5 | ) | 49.6 | |||||
Other, Net | 8.2 | 0.2 | ||||||
Changes in: | ||||||||
Accrued Investment Income | 0.1 | 0.7 | ||||||
Premiums and Service Fees Receivable | (24.6 | ) | (50.9 | ) | ||||
Current Income Taxes | 23.1 | 21.5 | ||||||
Deferred Policy Acquisition Costs | (13.1 | ) | (29.0 | ) | ||||
Loss and Loss Adjustment Expense Reserves | (18.9 | ) | (62.5 | ) | ||||
Unearned Premiums | 30.8 | 95.0 | ||||||
Other Assets and Liabilities | (68.9 | ) | (138.4 | ) | ||||
Total Adjustments | (53.0 | ) | (102.5 | ) | ||||
Net Cash Provided by Operating Activities | $ | 238.3 | $ | 266.4 | ||||
We issued 866,685 shares to settle our accelerated share repurchase program in the six months ended June 30, 2007. There were no other significant non-cash financing or investing activities in the six months ended June 30, 2008 or June 30, 2007.
See Condensed Notes to Consolidated Financial Statements.
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Safeco Corporation
Consolidated Statements of Shareholders’ Equity
(In millions, except share amounts)
SIX MONTHS ENDED JUNE 30, | 2008 | 2007 | ||||||
(Unaudited) | ||||||||
COMMON STOCK | ||||||||
Balance at Beginning of Period | $ | — | $ | 3.2 | ||||
Shares Issued for Options and Restricted Stock Rights (RSRs) (Includes Taxes of $0.5; $2.6) | 4.8 | 12.3 | ||||||
Share-based Compensation and Vesting of RSRs | 6.7 | 6.8 | ||||||
Shares Reacquired | — | (22.3 | ) | |||||
Balance at End of Period | 11.5 | — | ||||||
RETAINED EARNINGS | ||||||||
Balance at Beginning of Period | 3,025.3 | 3,440.5 | ||||||
Net Income | 291.3 | 368.9 | ||||||
Dividends Declared | (70.9 | ) | (74.8 | ) | ||||
Shares Reacquired | — | (135.5 | ) | |||||
Cumulative Effect of Adoption of EITF 06-10 | (3.1 | ) | — | |||||
Cumulative Effect of Adoption of FIN 48 | — | (0.7 | ) | |||||
Balance at End of Period | 3,242.6 | 3,598.4 | ||||||
ACCUMULATED OTHER COMPREHENSIVE INCOME, NET OF TAXES | ||||||||
Balance at Beginning of Period | 367.3 | 484.2 | ||||||
Other Comprehensive Loss | (236.5 | ) | (67.3 | ) | ||||
Balance at End of Period | 130.8 | 416.9 | ||||||
SHAREHOLDERS’ EQUITY | $ | 3,384.9 | $ | 4,015.3 | ||||
SIX MONTHS ENDED JUNE 30, | 2008 | 2007 | ||||||
(Unaudited) | ||||||||
COMMON SHARES OUTSTANDING | ||||||||
Number of Shares Outstanding at Beginning of Period | 89,731,146 | 105,341,791 | ||||||
Shares Issued for Options and Rights | 201,819 | 371,060 | ||||||
Shares Issued for Accelerated Stock Repurchase Settlement | — | 866,685 | ||||||
Shares Reacquired | — | (2,521,982 | ) | |||||
Number of Shares Outstanding at End of Period | 89,932,965 | 104,057,554 | ||||||
See Condensed Notes to Consolidated Financial Statements.
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Safeco Corporation
Consolidated Statements of Comprehensive Income
(In millions)
THREE MONTHS ENDED JUNE 30, | SIX MONTHS ENDED JUNE 30, | |||||||||||||||
2008 | 2007 | 2008 | 2007 | |||||||||||||
(Unaudited) | (Unaudited) | |||||||||||||||
Net Income | $ | 149.5 | $ | 186.4 | $ | 291.3 | $ | 368.9 | ||||||||
Other Comprehensive Loss, Net of Taxes: | ||||||||||||||||
Change in Unrealized (Losses) on Available-for-Sale Securities | (55.1 | ) | (43.8 | ) | (228.8 | ) | (44.4 | ) | ||||||||
Reclassification Adjustment for Net Realized Investment (Gains) Included in Net Income | (10.7 | ) | (11.4 | ) | (4.6 | ) | (19.3 | ) | ||||||||
Amortization of Pension and Other Postretirement Benefit Amounts | (1.5 | ) | (1.8 | ) | (3.1 | ) | (3.6 | ) | ||||||||
Derivative Qualifying as Cash Flow Hedge | 0.6 | (1.0 | ) | — | — | |||||||||||
Other Comprehensive Loss | (66.7 | ) | (58.0 | ) | (236.5 | ) | (67.3 | ) | ||||||||
Comprehensive Income | $ | 82.8 | $ | 128.4 | $ | 54.8 | $ | 301.6 | ||||||||
See Condensed Notes to Consolidated Financial Statements.
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Safeco Corporation
CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
(Dollar amounts in millions except for ratios and per share data, unless noted otherwise)
NOTE 1: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
NATURE OF OPERATIONS
Safeco Corporation is a Washington corporation operating across the United States. We sell property and casualty insurance to drivers, homeowners and small and mid-sized businesses. We also sell Surety bonds to contractors and businesses. We generate virtually all of our premiums from these activities.
Throughout our Consolidated Financial Statements, we refer to Safeco Corporation and its subsidiaries as “Safeco,” “we” and “our”. We refer to the property and casualty businesses as “Property & Casualty” and “P&C.” We refer to all other activities, primarily the financing of our business activities, as “Corporate.”
BASIS OF PRESENTATION
Our Consolidated Financial Statements and Condensed Notes to the Consolidated Financial Statements should be read in conjunction with the Consolidated Financial Statements and Notes to Consolidated Financial Statements included in our 2007 Annual Report on Form 10-K filed with the Securities and Exchange Commission (SEC).
We have prepared our Consolidated Financial Statements in conformity with U.S. generally accepted accounting principles (GAAP). Preparing financial statements in conformity with GAAP requires us to make estimates and assumptions that may affect the amounts reported in our Consolidated Financial Statements and Condensed Notes to the Consolidated Financial Statements. Actual results could differ from those estimates.
Our Consolidated Financial Statements include Safeco Corporation and its subsidiaries. We have eliminated all intercompany transactions and balances in our Consolidated Financial Statements.
We made certain reclassifications to prior-year amounts for consistency with our current-year presentation. We reclassified $15.2 from Other Underwriting and Operating Expenses to Service Fees and Other Revenues for the three months ended June 30, 2007 and $29.8 for the six months ended June 30, 2007. These reclassifications did not affect assets, shareholders’ equity, net income or net cash flows from operations.
EARNINGS PER SHARE
For the three months ended June 30, 2008, we excluded 449,000 stock options and Restricted Stock Rights (RSRs), and for the six months ended June 30, 2008, we excluded 504,000 stock options and RSRs from the dilutive earnings per share calculation because their inclusion would have been antidilutive. For the three months ended June 30, 2007, we excluded 428,000 stock options and RSRs from the dilutive earnings per share calculation and for the six months ended June 30, 2007, we excluded 536,000 stock options and RSRs.
Diluted and Basic Average Shares Outstanding and Net Income Per Share were:
THREE MONTHS ENDED JUNE 30, | SIX MONTHS ENDED JUNE 30, | |||||||||||
2008 | 2007 | 2008 | 2007 | |||||||||
COMPUTATION OF NET INCOME PER SHARE | ||||||||||||
Net Income | $ | 149.5 | $ | 186.4 | $ | 291.3 | $ | 368.9 | ||||
Diluted: | ||||||||||||
Average Number of Common Shares Outstanding | 89.9 | 105.8 | 89.8 | 105.7 | ||||||||
Additional Common Shares Assumed Issued | 0.6 | 0.5 | 0.5 | 0.8 | ||||||||
Average Shares Outstanding – Diluted | 90.5 | 106.3 | 90.3 | 106.5 | ||||||||
Net Income Per Share – Diluted | $ | 1.65 | $ | 1.75 | $ | 3.23 | $ | 3.46 | ||||
Basic: | ||||||||||||
Average Number of Common Shares Outstanding | 89.9 | 105.8 | 89.8 | 105.7 | ||||||||
Income Per Share – Basic | $ | 1.66 | $ | 1.76 | $ | 3.24 | $ | 3.49 | ||||
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SECURITIES LENDING
We had a market value of $161.2 of fixed maturities and $117.0 of marketable equity securities loaned at June 30, 2008. We had a market value of $233.3 of fixed maturities and $90.8 of marketable equity securities loaned at December 31, 2007.
SHARE REPURCHASES
In December 2007, we received authorization from our Board of Directors (the Board) to repurchase up to $500.0 of our outstanding common stock in open market purchases. As of June 30, 2008, we purchased no shares under this authorization.
NEW ACCOUNTING STANDARDS
New accounting pronouncements that we have adopted or will adopt in the near future are as follows:
Statement of Financial Accounting Standard (SFAS) 157, “Fair Value Measurements” – In September 2006, the Financial Accounting Standards Board (FASB) issued SFAS 157, which establishes a framework for measuring fair value and requires expanded disclosure about the information used to measure fair value. The statement applies whenever other statements require, or permit, assets or liabilities to be measured at fair value. The statement does not expand the use of fair value in any new circumstances. We adopted this statement as of January 1, 2008, and there was no material impact on our financial condition or results of operations. See Note 3 for the disclosures required by SFAS 157.
SFAS 159, “Fair Value Option for Financial Assets and Financial Liabilities” – In February 2007, the FASB issued SFAS 159, which permits entities to voluntarily choose to measure eligible items at fair value at specified election dates. The election is made on an instrument-by-instrument basis and is irrevocable. If the fair value option is elected for an instrument, the statement specifies that entities report unrealized gains and losses at each subsequent reporting date in earnings. We adopted SFAS 159 on January 1, 2008. The adoption of the statement did not impact our financial condition or results of operations as we did not elect the fair value option for any of our instruments.
Emerging Issues Task Force (EITF) Issue No. 06-10, “Accounting for Collateral Assignment Split Dollar Life Insurance Arrangements” provides guidance on the recognition and measurement of assets and liabilities related to collateral assignment split dollar life insurance arrangements, and requires that such policies be accounted for as post retirement benefits or a deferred compensation plan. We adopted Issue No. 06-10 on January 1, 2008 and the effect of the adoption was a decrease to retained earnings of $3.1.
EITF Issue No. 06-11, “Accounting for Income Tax Benefits of Dividends on Share-Based Payment Awards” – In June 2007, the EITF reached consensus on Issue No. 06-11, which requires that the tax benefit related to dividends paid on RSRs be recorded as an increase to equity, rather than a reduction in income tax expense. We adopted Issue No. 06-11 as of January 1, 2008 and the effect of the adoption was not material to our financial condition or results of operations.
SFAS 161, “Disclosures about Derivative Instruments and Hedging Activities-an amendment of FASB Statement No. 133” – In March 2008, FASB issued SFAS 161, which applies to all derivative instruments and non-derivative instruments that are designated and qualify as hedging instruments. The statement requires additional disclosures of the nature, accounting and effect on the financial position, results of operations and cash flow. The statement is effective for fiscal years beginning after November 15, 2008. We do not expect the guidance to have an impact on our financial condition or results of operations.
FSP EITF 03-6-1, “Determining Whether Instruments Granted in Share-Based Payment Transactions Are Participating Securities” – In June 2008, the FASB issued FASB Staff Position EITF 03-6-1, which addresses whether instruments granted in share-based payment transactions are participating securities prior to vesting and, therefore, need to be included in earnings allocation in computing earnings per share under the two-class method. The statement is effective for financial statements issued for fiscal years beginning after December 15, 2008. We are currently assessing the impact of the guidance on our financial condition or results of operations.
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NOTE 2: MERGER TRANSACTION
On April 23, 2008, we entered into an Agreement and Plan of Merger (the “Merger Agreement”) with Liberty Mutual Insurance Company, a Massachusetts stock insurance company (“Liberty Mutual”), and Big Apple Merger Corporation, a Washington corporation and a wholly owned subsidiary of Liberty Mutual (“Merger Sub”).
Subject to the terms and conditions of the Merger Agreement, Merger Sub will merge with and into us and we will continue as the surviving corporation and a wholly owned subsidiary of Liberty Mutual (the “Merger”). At the effective time of the Merger, each outstanding share of our common stock, other than shares owned by us or Liberty Mutual and any dissenting shares in the Merger, will be automatically converted into the right to receive $68.25 in cash, without interest, subject to any applicable withholding tax.
The Merger Agreement has been approved by Safeco’s and Liberty Mutual’s respective Boards of Directors. The consummation of the Merger is subject to a number of customary closing conditions, including, but not limited to, (i) approval of the Merger Agreement by our shareholders, (ii) expiration of termination of the applicable Hart-Scott Rodino Act (“HSR Act”) waiting period, (iii) receipt of specified regulatory consents and approvals, including state insurance department approvals in Washington, Missouri, Illinois, Texas, Indiana, Oregon and California, (iv) the absence of any law, order or injunction prohibiting the consummation of the Merger and (v) the absence of any material governmental litigation seeking to challenge, restrain, or prohibit consummation of the Merger. As of June 3, 2008, the 30-day statutory waiting period under the HSR Act expired.
The Merger Agreement contains certain termination rights for both Safeco and Liberty Mutual, and further provides that, upon termination of the Merger Agreement under specified circumstances, Safeco may be required to pay Liberty Mutual a termination fee of $182.5.
Following the announcement that we had entered into a merger agreement with Liberty Mutual and Merger Sub, the outlook for our credit ratings was updated by A.M. Best, Standard and Poor’s, Moody’s Investors and Fitch Rating, which left us on a negative rating watch. All agencies have indicated that their ratings outlook would be revised upon the closing of the transaction in the third quarter of 2008.
The transaction is not subject to financing contingencies and is expected to close by the end of the third quarter of 2008. The Merger Agreement does not restrict our ability to declare or pay dividends. The Merger is contingent upon approval by a two-thirds vote of our shares outstanding at our annual meeting scheduled to be held July 29, 2008.
NOTE 3: INVESTMENTS
FIXED MATURITIES AND MARKETABLE EQUITY SECURITIES
The following tables summarize our fixed maturities and marketable equity securities:
JUNE 30, 2008 | COST OR AMORTIZED COST | GROSS UNREALIZED GAINS | GROSS UNREALIZED LOSSES | NET UNREALIZED GAINS (LOSSES) | FAIR VALUE | ||||||||||||
Fixed Maturities: | |||||||||||||||||
U.S. Government and Agencies | $ | 251.4 | $ | 17.8 | $ | (0.6 | ) | $ | 17.2 | $ | 268.6 | ||||||
States and Political Subdivisions | 4,882.9 | 85.4 | (141.6 | ) | (56.2 | ) | 4,826.7 | ||||||||||
Foreign Governments | 18.9 | 5.2 | — | 5.2 | 24.1 | ||||||||||||
Corporate Securities: | |||||||||||||||||
Banks | 137.2 | 3.6 | (0.5 | ) | 3.1 | 140.3 | |||||||||||
Utilities | 100.2 | 1.3 | (0.8 | ) | 0.5 | 100.7 | |||||||||||
Diversified Financial Services | 397.6 | 4.8 | (6.6 | ) | (1.8 | ) | 395.8 | ||||||||||
Other | 769.9 | 16.7 | (8.7 | ) | 8.0 | 777.9 | |||||||||||
Total Corporate Securities | 1,404.9 | 26.4 | (16.6 | ) | 9.8 | 1,414.7 | |||||||||||
Mortgage-Backed Securities | 888.3 | 8.6 | (23.5 | ) | (14.9 | ) | 873.4 | ||||||||||
Total Fixed Maturities | 7,446.4 | 143.4 | (182.3 | ) | (38.9 | ) | 7,407.5 | ||||||||||
Marketable Equity Securities | 1,108.1 | 264.4 | (26.6 | ) | 237.8 | 1,345.9 | |||||||||||
Total | $ | 8,554.5 | $ | 407.8 | $ | (208.9 | ) | $ | 198.9 | $ | 8,753.4 | ||||||
DECEMBER 31, 2007 | COST OR AMORTIZED COST | GROSS UNREALIZED GAINS | GROSS UNREALIZED LOSSES | NET UNREALIZED GAINS | FAIR VALUE | ||||||||||||
Fixed Maturities: | |||||||||||||||||
U.S. Government and Agencies | $ | 290.2 | $ | 20.3 | $ | (0.2 | ) | $ | 20.1 | $ | 310.3 | ||||||
States and Political Subdivisions | 4,770.3 | 135.3 | (52.2 | ) | 83.1 | 4,853.4 | |||||||||||
Foreign Governments | 23.9 | 6.3 | — | 6.3 | 30.2 | ||||||||||||
Corporate Securities: | |||||||||||||||||
Banks | 150.4 | 4.9 | (0.2 | ) | 4.7 | 155.1 | |||||||||||
Utilities | 236.7 | 6.3 | (0.6 | ) | 5.7 | 242.4 | |||||||||||
Diversified Financial Services | 379.0 | 6.9 | (2.2 | ) | 4.7 | 383.7 | |||||||||||
Other | 762.6 | 18.4 | (4.2 | ) | 14.2 | 776.8 | |||||||||||
Total Corporate Securities | 1,528.7 | 36.5 | (7.2 | ) | 29.3 | 1,558.0 | |||||||||||
Mortgage-Backed Securities | 1,002.1 | 16.7 | (6.8 | ) | 9.9 | 1,012.0 | |||||||||||
Total Fixed Maturities | 7,615.2 | 215.1 | (66.4 | ) | 148.7 | 7,763.9 | |||||||||||
Marketable Equity Securities | 993.2 | 423.5 | (14.1 | ) | 409.4 | 1,402.6 | |||||||||||
Total | $ | 8,608.4 | $ | 638.6 | $ | (80.5 | ) | $ | 558.1 | $ | 9,166.5 | ||||||
The following tables illustrate the gross unrealized losses and fair values for our investments, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position at June 30, 2008 and December 31, 2007:
JUNE 30, 2008 | LESS THAN 12 MONTHS | 12 MONTHS OR MORE | TOTAL | ||||||||||||||||||
DESCRIPTION OF SECURITIES | FAIR VALUE | UNREALIZED LOSSES | FAIR VALUE | UNREALIZED LOSSES | FAIR VALUE | UNREALIZED LOSSES | |||||||||||||||
Fixed Maturities: | |||||||||||||||||||||
U.S. Government and Agencies | $ | 19.2 | $ | (0.6 | ) | $ | — | $ | — | $ | 19.2 | $ | (0.6 | ) | |||||||
States and Political Subdivisions | 1,701.1 | (56.2 | ) | 1,106.4 | (85.4 | ) | 2,807.5 | (141.6 | ) | ||||||||||||
Foreign Governments | 0.6 | — | — | — | 0.6 | — | |||||||||||||||
Corporate Securities | 566.0 | (13.5 | ) | 61.9 | (3.1 | ) | 627.9 | (16.6 | ) | ||||||||||||
Mortgage-Backed Securities | 421.4 | (18.9 | ) | 81.3 | (4.6 | ) | 502.7 | (23.5 | ) | ||||||||||||
Total Fixed Maturities | 2,708.3 | (89.2 | ) | 1,249.6 | (93.1 | ) | 3,957.9 | (182.3 | ) | ||||||||||||
Marketable Equity Securities | 425.4 | (26.6 | ) | — | — | 425.4 | (26.6 | ) | |||||||||||||
Total | $ | 3,133.7 | $ | (115.8 | ) | $ | 1,249.6 | $ | (93.1 | ) | $ | 4,383.3 | $ | (208.9 | ) | ||||||
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DECEMBER 31, 2007 | LESS THAN 12 MONTHS | 12 MONTHS OR MORE | TOTAL | ||||||||||||||||||
DESCRIPTION OF SECURITIES | FAIR VALUE | UNREALIZED LOSSES | FAIR VALUE | UNREALIZED LOSSES | FAIR VALUE | UNREALIZED LOSSES | |||||||||||||||
Fixed Maturities: | |||||||||||||||||||||
U.S. Government and Agencies | $ | 13.4 | $ | (0.1 | ) | $ | 2.2 | $ | (0.1 | ) | $ | 15.6 | $ | (0.2 | ) | ||||||
States and Political Subdivisions | 1,768.5 | (50.7 | ) | 62.6 | (1.5 | ) | 1,831.1 | (52.2 | ) | ||||||||||||
Foreign Governments | — | — | 1.3 | — | 1.3 | — | |||||||||||||||
Corporate Securities | 304.0 | (5.0 | ) | 153.0 | (2.2 | ) | 457.0 | (7.2 | ) | ||||||||||||
Mortgage-Backed Securities | 176.3 | (4.5 | ) | 265.7 | (2.3 | ) | 442.0 | (6.8 | ) | ||||||||||||
Total Fixed Maturities | 2,262.2 | (60.3 | ) | 484.8 | (6.1 | ) | 2,747.0 | (66.4 | ) | ||||||||||||
Marketable Equity Securities | 194.1 | (14.1 | ) | — | — | 194.1 | (14.1 | ) | |||||||||||||
Total | $ | 2,456.3 | $ | (74.4 | ) | $ | 484.8 | $ | (6.1 | ) | $ | 2,941.1 | $ | (80.5 | ) | ||||||
We reviewed all of our investments with unrealized losses as of December 31, 2007 and June 30, 2008. For all investments other than those for which we recognized an impairment charge, our evaluation determined that their declines in fair value were temporary and we have the intent and ability to hold these securities until they recover in value. In our review, we considered:
• | How long and by how much the fair value of the security has been below its cost or amortized cost |
• | The current financial condition and future prospects of the issuer of the security, including any specific events that may affect its operations or earnings potential |
• | Our intent and ability to keep the security long enough for us to recover its value |
• | Any downgrades of the security by a rating agency |
• | Any reduction or elimination of dividends or non-payment of scheduled interest payments |
NET INVESTMENT INCOME
The following table summarizes our net investment income:
THREE MONTHS ENDED JUNE 30, | SIX MONTHS ENDED JUNE 30, | |||||||||||||||
2008 | 2007 | 2008 | 2007 | |||||||||||||
Interest on Fixed Maturities: | ||||||||||||||||
Taxable | $ | 42.6 | $ | 60.4 | $ | 87.2 | $ | 124.7 | ||||||||
Non-Taxable | 55.6 | 53.8 | 111.8 | 106.9 | ||||||||||||
Dividends: | ||||||||||||||||
Marketable Equity Securities | 11.5 | 7.8 | 21.5 | 15.3 | ||||||||||||
Redeemable Preferred Stock | 0.2 | 1.5 | 1.5 | 2.9 | ||||||||||||
Other | 4.3 | 6.5 | 6.4 | 9.2 | ||||||||||||
Total Investment Income | 114.2 | 130.0 | 228.4 | 259.0 | ||||||||||||
Investment Expenses | (2.0 | ) | (1.8 | ) | (4.6 | ) | (3.6 | ) | ||||||||
Net Investment Income | $ | 112.2 | $ | 128.2 | $ | 223.8 | $ | 255.4 | ||||||||
The decrease in net investment income in the three and six months ended June 30, 2008 compared with the same periods in 2007 was a result of an overall lower invested asset base due primarily to the sale of securities to fund our debt maturity and redemption, share repurchases and the special dividend paid by our insurance subsidiaries to Safeco Corporation in 2007 that has not been reinvested.
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NET REALIZED INVESTMENT GAINS
The following table summarizes our net realized investment gains:
THREE MONTHS ENDED JUNE 30, | SIX MONTHS ENDED JUNE 30, | ||||||||||||
2008 | 2007 | 2008 | 2007 | ||||||||||
Net Realized Investment Gains (Losses) from: | |||||||||||||
Fixed Maturities | $ | 1.6 | $ | 0.8 | $ | (14.8 | ) | $ | 2.9 | ||||
Marketable Equity Securities | 11.2 | 6.4 | 21.6 | 10.9 | |||||||||
Other | 3.7 | 10.2 | 3.2 | 16.0 | |||||||||
Net Realized Investment Gains | $ | 16.5 | $ | 17.4 | $ | 10.0 | $ | 29.8 | |||||
The decrease in net realized investment gains is primarily due to realized losses on impaired securities partially offset by net realized gains on the sale of marketable equity securities. We recognized net realized losses on impaired securities of $40.4 during the three months ended June 30, 2008 and $83.2 during the six months ended June 30, 2008 due to credit-related events in connection with recent volatility in the credit markets. The impairment losses included $21.7 related to securities that became impaired during the three months ended June 30, 2008 and $45.6 during the six months ended June 30, 2008. The impairment losses also included $18.7 for the three months ended June 30, 2008 and $37.6 for the six months ended June 30, 2008 related to additional impairments of securities initially impaired in prior periods. We recognized net realized gains $44.6 on sales of marketable equity securities during the three months ended June 30, 2008 and $80.6 during the six months ended June 30, 2008 primarily due to sales of securities to restructure and reduce exposure in the marketable equity portfolio and increase our investment in international securities.
The following tables summarize the proceeds from sales of our investments and components of the related gains before taxes:
THREE MONTHS ENDED JUNE 30, 2008 | FIXED MATURITIES AVAILABLE FOR-SALE | MARKETABLE EQUITY SECURITIES | OTHER | TOTAL | |||||||||||
Proceeds from Sales | $ | 62.2 | $ | 160.3 | $ | 2.3 | $ | 224.8 | |||||||
Gross Realized Investment Gains | 1.8 | 50.2 | — | 52.0 | |||||||||||
Gross Realized Investment Losses | (0.6 | ) | (5.6 | ) | — | (6.2 | ) | ||||||||
Net Realized Investment Gains from Sales | 1.2 | 44.6 | — | 45.8 | |||||||||||
Impairments | (7.0 | ) | (33.4 | ) | — | (40.4 | ) | ||||||||
Other, Including Gains on Calls and Redemptions | 7.4 | — | 3.7 | 11.1 | |||||||||||
Net Realized Investment Gains | $ | 1.6 | $ | 11.2 | $ | 3.7 | $ | 16.5 | |||||||
THREE MONTHS ENDED JUNE 30, 2007 | FIXED MATURITIES AVAILABLE FOR-SALE | MARKETABLE EQUITY SECURITIES | OTHER | TOTAL | |||||||||||
Proceeds from Sales | $ | 399.1 | $ | 55.2 | $ | 11.6 | $ | 465.9 | |||||||
Gross Realized Investment Gains | 2.0 | 6.4 | — | 8.4 | |||||||||||
Gross Realized Investment Losses | (1.4 | ) | — | — | (1.4 | ) | |||||||||
Net Realized Investment Gains from Sales | 0.6 | 6.4 | — | 7.0 | |||||||||||
Impairments | (2.9 | ) | — | — | (2.9 | ) | |||||||||
Other, Including Gains on Calls and Redemptions | 3.1 | — | 10.2 | 13.3 | |||||||||||
Net Realized Investment Gains | $ | 0.8 | $ | 6.4 | $ | 10.2 | $ | 17.4 | |||||||
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SIX MONTHS ENDED JUNE 30, 2008 | FIXED MATURITIES AVAILABLE FOR-SALE | MARKETABLE EQUITY SECURITIES | OTHER | TOTAL | |||||||||||
Proceeds from Sales | $ | 133.8 | $ | 402.7 | $ | 29.3 | $ | 565.8 | |||||||
Gross Realized Investment Gains | 3.4 | 92.5 | — | 95.9 | |||||||||||
Gross Realized Investment Losses | (2.4 | ) | (11.9 | ) | — | (14.3 | ) | ||||||||
Net Realized Investment Gains from Sales | 1.0 | 80.6 | — | 81.6 | |||||||||||
Impairments | (24.2 | ) | (59.0 | ) | — | (83.2 | ) | ||||||||
Other, Including Gains on Calls and Redemptions | 8.4 | — | 3.2 | 11.6 | |||||||||||
Net Realized Investment Gains (Losses) | $ | (14.8 | ) | $ | 21.6 | $ | 3.2 | $ | 10.0 | ||||||
SIX MONTHS ENDED JUNE 30, 2007 | FIXED MATURITIES AVAILABLE FOR-SALE | MARKETABLE EQUITY SECURITIES | OTHER | TOTAL | |||||||||||
Proceeds from Sales | $ | 854.9 | $ | 122.2 | $ | 21.0 | $ | 998.1 | |||||||
Gross Realized Investment Gains | 4.1 | 15.0 | — | 19.1 | |||||||||||
Gross Realized Investment Losses | (1.9 | ) | (2.3 | ) | — | (4.2 | ) | ||||||||
Net Realized Investment Gains from Sales | 2.2 | 12.7 | — | 14.9 | |||||||||||
Impairments | (3.5 | ) | (1.8 | ) | — | (5.3 | ) | ||||||||
Other, Including Gains on Calls and Redemptions | 4.2 | — | 16.0 | 20.2 | |||||||||||
Net Realized Investment Gains | $ | 2.9 | $ | 10.9 | $ | 16.0 | $ | 29.8 | |||||||
NOTE 4: FAIR VALUE OF FINANCIAL INSTRUMENTS
Fair value, as defined by SFAS 157, is the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. SFAS 157 also establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standard describes three levels of inputs that may be used to measure fair value:
• | Level 1 –Quoted prices in active markets for identical assets or liabilities. Level 1 assets and liabilities include debt and equity securities that are traded in an active exchange market. |
• | Level 2 –Observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities. Level 2 assets and liabilities include debt and equity securities with quoted prices that are traded less frequently than exchange-traded instruments, or whose prices are based on comparable securities with quoted market prices, and derivative contracts whose value is determined using a pricing model with inputs that are observable in the market or can be derived principally from or corroborated by observable market data. This category generally includes U.S. Government securities, mortgage and asset-backed securities, corporate debt and equity securities, municipal bonds and derivative contracts. |
• | Level 3 –Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. We classify financial instruments in Level 3 of the fair value hierarchy when there is reliance on at least one significant unobservable input to the valuation model. Level 3 assets and liabilities include financial instruments whose value is determined using pricing models, discounted cash flow methodologies, or similar valuation techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation. This category primarily includes private equity investments, and privately placed or infrequently traded debt securities. |
Valuations of derivative assets and liabilities reflect the value of the instrument including the values associated with counterparty risk. The issuance of SFAS 157 clarified that these values must also take into account our own credit standing, thus including in the valuation of the derivative instrument the value of the net credit differential between the counterparties to the derivative contract. Effective January 1, 2008, we updated our methodology to calculate the impact of both the counterparty’s and our own credit standing. The net impact was not material to our financial condition or results of operations.
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Determining the Fair Value of Our Investments – For the majority of our investments, we use quoted market prices or available public market price information to determine the fair value. When such information is not available, as is the case for securities that are not publicly traded, we use other valuation techniques. These techniques include:
• | Using independent pricing sources, including brokers |
• | Evaluating discounted cash flows |
• | Identifying comparable securities with quoted market prices based on industry sector, credit quality and maturity |
• | Using internally prepared valuations based on certain modeling and pricing methods |
The following table presents the assets measured at fair value on a recurring basis for each of the fair value hierarchy levels:
FAIR VALUE MEASUREMENT INPUTS | ASSETS AT FAIR VALUE | |||||||||||
JUNE 30, 2008 | LEVEL 1 | LEVEL 2 | LEVEL 3 | |||||||||
Assets | ||||||||||||
Available-for-Sale Fixed Maturities | $ | 30.6 | $ | 7,273.3 | $ | 103.6 | $ | 7,407.5 | ||||
Available-for-Sale Marketable Equity Securities | 871.8 | 392.9 | 81.2 | 1,345.9 | ||||||||
Other Invested Assets(1) | — | 10.5 | — | 10.5 | ||||||||
Short Term Investments | — | 12.5 | — | 12.5 | ||||||||
Derivative Assets(2) | — | 4.0 | — | 4.0 | ||||||||
Total Assets | $ | 902.4 | $ | 7,693.2 | $ | 184.8 | $ | 8,780.4 | ||||
(1) | Excludes investments in limited partnerships which are not carried at fair value on a recurring basis. |
(2) | The fair value of the interest rate swap is reported as an offset to Debt on the Consolidated Balance Sheets. |
The table below reconciles all assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the three months ended June 30, 2008:
JUNE 30, 2008 | BALANCE AT MARCH 31, 2008 | TOTAL REALIZED/ UNREALIZED GAINS OR LOSSES | PURCHASES, ISSUANCES AND SETTLEMENTS | NET TRANSFERS IN AND/OR OUT OF LEVEL 3 | BALANCE AT JUNE 30, 2008 | CHANGE IN UNREALIZED GAINS/ (LOSSES) RELATED TO ASSETS HELD AT JUNE 30, 2008 (2) | |||||||||||||||||
INCLUDED IN EARNINGS (1) | INCLUDED IN ACCUMULATED OTHER COMPREHENSIVE INCOME(1) | ||||||||||||||||||||||
Available-For-Sale Fixed Maturities | $ | 88.3 | $ | (0.1 | ) | $ | (2.1 | ) | $ | 0.3 | $ | 17.2 | $ | 103.6 | $ | 2.8 | |||||||
Available-For-Sale Marketable Equity Securities | 79.8 | — | 0.2 | 1.2 | — | 81.2 | 0.2 | ||||||||||||||||
Total | $ | 168.1 | $ | (0.1 | ) | $ | (1.9 | ) | $ | 1.5 | $ | 17.2 | $ | 184.8 | $ | 3.0 | |||||||
(1) | We included $0.1 in Net Realized Investment Gains in our Consolidated Statement of Income for the three months ended June 30, 2008, which includes $0.1 of net realized losses for securities that became impaired during the period. |
(2) | Of the total $3.0 change in unrealized gains/(losses) for Level 3 assets held at June 30, 2008, there were no amounts included in earnings for the three months ended June 30, 2008 and no amounts were reported in Net Realized Investment Gains in the Consolidated Statements of Income. |
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The table below reconciles all assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the six months ended June 30, 2008:
JUNE 30, 2008 | BALANCE AT JANUARY 1, 2008 | TOTAL REALIZED/ UNREALIZED GAINS OR LOSSES | PURCHASES, ISSUANCES AND SETTLEMENTS | NET TRANSFERS IN AND/OR OUT OF LEVEL 3 | BALANCE AT JUNE 30, 2008 | CHANGE IN UNREALIZED GAINS/ (LOSSES) RELATED TO ASSETS HELD AT JUNE 30, 2008 (2) | ||||||||||||||||||
INCLUDED IN EARNINGS (1) | INCLUDED IN ACCUMULATED OTHER COMPREHENSIVE INCOME(1) | |||||||||||||||||||||||
Available-For-Sale Fixed Maturities | $ | 107.8 | $ | (7.6 | ) | $ | 4.1 | $ | 7.4 | $ | (8.1 | ) | $ | 103.6 | $ | (3.5 | ) | |||||||
Available-For-Sale Marketable Equity Securities | 78.5 | — | 1.5 | 1.2 | — | 81.2 | 1.5 | |||||||||||||||||
Total | $ | 186.3 | $ | (7.6 | ) | $ | 5.6 | $ | 8.6 | $ | (8.1 | ) | $ | 184.8 | $ | (2.0 | ) | |||||||
(1) | We included $7.6 in Net Realized Investment Gains in our Consolidated Statement of Income for the six months ended June 30, 2008, which includes $7.5 of net realized losses for securities that became impaired during the period and were transferred out of Level 3 to Level 2 during the period. |
(2) | Of the total $(2.0) change in unrealized gains/(losses) for Level 3 assets held at June 30, 2008, $(0.1) was included in earnings for the six months ended June 30, 2008 and reported in Net Realized Investment Gains in the Consolidated Statements of Income. |
NOTE 5: LOSS AND LAE RESERVES
The following table analyzes the changes in our loss and loss adjustment expense (LAE) reserves for the six months ended June 30, 2008 and 2007. We report changes in estimated reserves in the Consolidated Statements of Income in the period we make the change:
SIX MONTHS ENDED JUNE 30, | 2008 | 2007 | ||||||
Loss and LAE Reserves at Beginning of Period | $ | 5,185.0 | $ | 5,171.4 | ||||
Less Reinsurance Recoverables on Unpaid Losses, Net of Allowance | 413.1 | 415.0 | ||||||
Net Balance at Beginning of Period | 4,771.9 | 4,756.4 | ||||||
Incurred Loss and LAE for Claims Occurring During: | ||||||||
Current Year | 1,859.6 | 1,754.2 | ||||||
Prior Years | (64.2 | ) | (48.0 | ) | ||||
Total Incurred Loss and LAE | 1,795.4 | 1,706.2 | ||||||
Loss and LAE Payments for Claims Occurring During: | ||||||||
Current Year | 825.3 | 763.9 | ||||||
Prior Years | 945.3 | 1,007.8 | ||||||
Total Loss and LAE Payments | 1,770.6 | 1,771.7 | ||||||
Net Balance at End of Period | 4,796.7 | 4,690.9 | ||||||
Plus Reinsurance Recoverables on Unpaid Losses, Net of Allowance | 369.4 | 418.0 | ||||||
Loss and LAE Reserves at End of Period | $ | 5,166.1 | $ | 5,108.9 | ||||
In the first six months of 2008, we reduced our estimates for prior years’ loss and LAE by $64.2. This total decrease included:
• | $36.7 reduction in surety reserves due to a fewer-than-expected number of claims |
• | $24.4 increase in commercial auto reserves related to greater-than-expected severity |
• | $13.6 increase in asbestos primarily due to unfavorable settlement activity on large claims |
• | $13.2 reduction in construction defect claims due to fewer-than-expected number of claims |
• | $11.6 reduction in commercial umbrella reserves due to fewer-than-expected number of claims |
• | $9.9 reduction in personal auto reserves due to lower-than-expected severity |
• | $9.1 reduction in small business multiple peril reserves primarily due to lower-than-expected severity |
• | $9.1 reduction in commercial property reserves related to lower-than-expected severity |
• | $12.6 reduction in a number of lines due to emerging claim trends and related loss data, including unallocated LAE |
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In the first six months of 2007, we reduced our estimates for prior years’ loss and LAE by $48.0. This total decrease included:
• | $22.8 reduction in surety reserves due to a fewer-than-expected number of claims |
• | $12.9 reduction in catastrophe related reserves, primarily in property reserves, reflecting decreases in severity estimates principally related to hurricanes that occurred in 2005 |
• | $11.5 increase in asbestos reserves related to our participation in reinsurance pools |
• | $10.2 reduction in workers’ compensation reserves due to lower-than expected severity |
• | $13.6 reduction in a number of lines due to emerging claim trends and related loss data, including unallocated LAE |
NOTE 6: DEBT
The following table shows the total principal amount, current and long-term portions, interest rates and maturities of our debt:
JUNE 30, 2008 | DECEMBER 31, 2007 | |||||||||||||||||
TOTAL | CURRENT | LONG-TERM | TOTAL | CURRENT | LONG-TERM | |||||||||||||
4.200% Notes due 2008 | $ | — | $ | — | $ | — | $ | 200.0 | $ | 200.0 | $ | — | ||||||
4.875% Notes due 2010 | 300.0 | — | 300.0 | 300.0 | — | 300.0 | ||||||||||||
7.250% Notes due 2012 | 204.0 | — | 204.0 | 204.0 | — | 204.0 | ||||||||||||
Total Debt | $ | 504.0 | $ | — | $ | 504.0 | $ | 704.0 | $ | 200.0 | $ | 504.0 | ||||||
We repaid $200.0 in principal amount of 4.200% senior notes that matured on February 1, 2008.
We maintain a bank credit facility of $300.0 available, which expires March 2010. The terms of the bank credit facility require us to pay a fee to have these funds available, maintain a minimum level of $2,700.0 shareholders’ equity plus 50% of accumulated net income, and keep our debt-to-capitalization ratio below a maximum of 37.5%. This facility does not require us to maintain any deposits as compensating balances. As of June 30, 2008, we had no borrowings under the bank credit facility and we were in compliance with all its covenants.
NOTE 7: COMMITMENTS AND CONTINGENCIES
LEGAL PROCEEDINGS
In common with the insurance and financial service industries in general, we are subject to legal actions filed or threatened, including punitive damages, in the ordinary course of our operations. Generally, our involvement in legal actions involves defending third-party claims brought against our insureds (in our role as liability insurer) or principals of surety bonds and defending policy coverage claims brought against us.
Litigation arising from claims settlement activities is generally considered in the establishment of our reserve for Loss and Loss Adjustment Expenses (LAE). However, in certain circumstances, we may deem it necessary to provide disclosure due to the size or nature of the potential liability to us.
Based on information currently known to us, we believe that the ultimate outcomes of any pending matters are not likely to have a material adverse effect on our financial position or results from operations.
On May 9, 2008, a purported class action complaint,Loren v. Brown, et al, Action No. CV80733 RSM, was filed against Safeco and its directors, allegedly on behalf of Safeco shareholders, in the United States District Court for the Western District of Washington. The complaint alleges, among other matters, that the terms on which the Safeco board of directors agreed for Safeco to be acquired by Liberty Mutual constitute a breach of the directors’ fiduciary and other duties due to the inadequacy of the consideration to be received by the class and the defendants’ alleged failure to explore other alternatives. The complaint seeks injunctive and other relief against consummation of the merger and unspecified monetary damages.
On June 2, 2008 a purported class action complaint on behalf of Safeco’s shareholders,Gotham Investors v. Reynolds, et al., was filed against Safeco, Safeco’s directors and Liberty Mutual in King County, Washington Superior Court. That action was subsequently removed by defendants to the U.S. District Court for the Western District of Washington where it bears No. 2:08-cv-980. The complaint alleges that the merger agreement advances the interests of Safeco’s directors and Liberty Mutual at the expense of Safeco shareholders, principally because of an alleged failure to explore other possible transactions, and that the preliminary proxy statement filed by Safeco on or about May 23, 2008, was deficient in failing to disclose the amount of the compensation received by Morgan Stanley for its prior work on behalf of Liberty Mutual and its expectation of future work, as well as certain details of the methodologies used in assessing the consideration to be received pursuant to the merger agreement.
The plaintiffs, Safeco and Liberty Mutual entered into a memorandum of understanding reflecting a settlement in principle of the complaints in theLoren v. Brown, et al. andGotham Investors v. Reynolds, et al.actions on June 24, 2008. In connection with the settlement, (1) Safeco has included certain additional disclosures in its proxy statement and (2) Liberty Mutual has agreed that for the six month period beginning on the date of closing of the Merger, Liberty Mutual will not, and will use its reasonable best efforts to cause its affiliates not to, consummate any transaction in which it sells 90% or more of Safeco’s assets (as existing on the date of consummation of the Merger) to an unaffiliated third party, whether by merger, consolidation, or otherwise, for an amount in excess of 120% of the amount that Liberty Mutual paid in connection with the Merger (including transaction costs incurred by Liberty Mutual and Safeco and any debt assumed or issued in connection with the Merger), which is referred to as a flip transaction, unless Liberty Mutual pays or causes to be paid to the members of the shareholder class an amount equal to 10% of any amount in excess of 120% of the amount that Liberty Mutual paid in connection with the merger (including transaction costs incurred by Liberty Mutual and Safeco and any debt assumed or issued in connection with the merger), up to a maximum payment of $15.0.
The settlement will not affect the amount or form of the merger consideration that Safeco shareholders are entitled to receive in the proposed merger or otherwise modify the terms of the transaction, other than in connection with the consummation of a flip transaction as described above. Under the terms of the settlement, the parties have agreed to enter into a stipulation of settlement that will dismiss the claims in the two complaints with prejudice and release the defendants, Liberty Mutual, Safeco, and the current and former directors of Safeco, and their current and former affiliates, representatives and advisors from all of the claims that were or could have been brought in the settled litigation, including all claims relating to the merger, the merger agreement and any disclosure made in connection therewith. Liberty Mutual has agreed to pay on behalf of all of the defendants without contribution from them the sum of $850,000 to plaintiffs’ counsel for attorneys’ fees and expenses within five business days after final dismissal of the two actions. The settlement will be contingent upon, among other things, confirmatory due diligence, consummation of the merger and final court approval.
NOTE 8: RESTRUCTURING AND ASSET IMPAIRMENT CHARGES
In 2008, we began implementation of a restructuring initiative that includes activities related to corporate reorganization, real estate consolidation and business process outsourcing. As a result of this plan, approximately 350 positions will be eliminated. We anticipate that this plan will be completed by the middle of 2009.
Charges have been recognized and accrued as restructuring and asset impairment charges and allocated to our reportable segments in accordance with SFAS 146, “Accounting for Costs Associated with Exit or Disposal Activities,” and SFAS 144, “Accounting for the Impairment or Disposal of Long-Lived Assets”. Other costs that do not meet the criteria for accrual are being expensed as restructuring charges when we incur them.
For the remainder of 2008, we will incur lease termination and employee relocation costs in connection with our real estate consolidation efforts. Costs associated with lease termination and employee relocation are measured at fair value and reported as a liability on our Consolidated Balance Sheets.
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Total estimated costs we expect to incur in connection with the restructuring, including costs incurred in the three and six months ended June 30, 2008 are as follows:
TOTAL EXPECTED COSTS | COSTS INCURRED | ||||||||
THREE MONTHS ENDED JUNE 30, 2008 | SIX MONTHS ENDED JUNE 30, 2008 | ||||||||
Employee Termination Benefits | $ | 10.7 | $ | 3.0 | $ | 7.6 | |||
Asset Impairment | 1.9 | — | — | ||||||
Lease Termination and Other Costs | 9.7 | 0.2 | 0.2 | ||||||
Total | $ | 22.3 | $ | 3.2 | $ | 7.8 | |||
These costs are allocated to reportable segments as follows:
TOTAL EXPECTED COSTS | COSTS INCURRED | ||||||||
THREE MONTHS ENDED JUNE 30, 2008 | SIX MONTHS ENDED JUNE 30, 2008 | ||||||||
Safeco Personal Insurance (SPI) | |||||||||
Auto | $ | 10.0 | $ | 1.4 | $ | 3.5 | |||
Property | 4.0 | 0.6 | 1.4 | ||||||
Specialty | 0.5 | 0.1 | 0.2 | ||||||
Total SPI | 14.5 | 2.1 | 5.1 | ||||||
Safeco Business Insurance (SBI) | |||||||||
SBI Regular | 5.2 | 0.8 | 1.8 | ||||||
SBI Special Accounts Facility | 1.0 | 0.1 | 0.3 | ||||||
Total SBI | 6.2 | 0.9 | 2.1 | ||||||
Surety | 1.6 | 0.2 | 0.6 | ||||||
Other | — | — | — | ||||||
Total | $ | 22.3 | $ | 3.2 | $ | 7.8 | |||
Activity related to restructuring charges for the six months ended June 30, 2008 was as follows:
ACCRUAL AT DECEMBER 31, 2007 | COSTS INCURRED | AMOUNTS PAID | ACCRUAL AT JUNE 30, 2008 | |||||||||
Employee Termination Benefits | $ | — | $ | 7.6 | $ | 5.8 | $ | 1.8 | ||||
Asset Impairment | — | — | — | — | ||||||||
Lease Termination and Other Costs | — | 0.2 | 0.2 | — | ||||||||
Total | $ | — | $ | 7.8 | $ | 6.0 | $ | 1.8 | ||||
NOTE 9: SEGMENT INFORMATION
Our P&C Insurance operations are organized around our four business segments: Safeco Personal Insurance (SPI), Safeco Business Insurance (SBI), Surety and P&C Other. These business segments are a combination of reportable segments that have similar products and services and are managed separately, as described below.
SPI
SPI offers auto, homeowners and other property and specialty insurance products for individuals. The SPI operations are organized around three reportable segments – Auto, Property and Specialty.
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Auto – The Auto segment provides coverage for our customers’ liability to others for both bodily injury and property damage, for injuries sustained by our customers and for physical damage to our customers’ vehicles from collision and other hazards.
Property – The Property segment provides homeowners, dwelling fire, earthquake and inland marine coverage for individuals. Our Property coverages protect homes, condominiums and rental property contents against losses from a wide variety of hazards.
Specialty – Our Specialty segment provides individuals with umbrella, motorcycle, recreational vehicle and boat owners insurance.
SBI
SBI offers business owner policies, commercial auto, commercial multi-peril, workers’ compensation, commercial property and general liability policies. SBI’s operations are organized around two segments: SBI Regular and SBI Special Accounts Facility.
SBI Regular – SBI Regular is our core commercial segment, writing a variety of commercial insurance products for small- to mid-sized businesses (customers who pay annual premiums of $250,000 or less). Our principal business insurance products include business owner policies, commercial auto, commercial multi-peril, workers’ compensation, commercial property and general liability insurance.
SBI Special Accounts Facility – SBI Special Accounts Facility writes large-commercial accounts (customers who pay annual premiums of more than $250,000) for our key agents and brokers who sell our core commercial products. We also write three specialty commercial insurance programs, which provide agents’ errors and omissions insurance (predominantly for our agents), property and liability insurance for mini-storage and warehouse properties, and professional and general liability insurance for non-profit social service organizations.
SURETY
We offer surety bonds primarily for construction and commercial businesses. Our principal surety products are issued through a credit-based underwriting process primarily to medium to large-sized contractors and large commercial businesses. Contract surety bonds are generally for public works projects and are required by federal, state and local governments. Commercial bonds include surety bonds other than contract bonds, and generally cover obligations required by regulation or law.
P&C OTHER
P&C Other includes run-off assumed reinsurance, large-commercial business accounts and commercial specialty programs in runoff, our own self insurance, asbestos and environmental results, run-off religious institutions and other business and programs that we have exited.
CORPORATE
The Corporate segment includes certain transactions such as the interest expense we pay on our debt, debt repurchases, miscellaneous corporate investment income and intercompany eliminations, real estate holdings, contributions to the Safeco Insurance Foundation (the Foundation), merger-related expenses and other corporate activities that are not allocated to individual reportable segments.
OUR RESULTS
Our management measures P&C segment profit or loss based on underwriting results and combined ratios. Underwriting profit or loss is our net earned premiums less our losses from claims, LAE and underwriting expenses, net of Other Revenues on a pretax basis. Combined ratio is our losses, LAE and underwriting expenses divided by our net earned premiums. Management views underwriting results and combined ratios as critical measures to assess the effectiveness of our underwriting activities.
Underwriting results, combined ratios, and segment measures are not a substitute for consolidated net income determined in accordance with GAAP.
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The following tables present selected financial information by segment and reconcile segment revenues, underwriting and operating results to amounts reported in our Consolidated Statements of Income:
Revenues
THREE MONTHS ENDED JUNE 30, | SIX MONTHS ENDED JUNE 30, | |||||||||||
2008 | 2007 | 2008 | 2007 | |||||||||
Net Earned Premiums | ||||||||||||
SPI | ||||||||||||
Auto | $ | 615.0 | $ | 657.0 | $ | 1,240.0 | $ | 1,307.7 | ||||
Property | 248.6 | 232.8 | 491.7 | 459.5 | ||||||||
Specialty | 30.9 | 28.7 | 60.6 | 55.9 | ||||||||
Total SPI | 894.5 | 918.5 | 1,792.3 | 1,823.1 | ||||||||
SBI | ||||||||||||
SBI Regular | 322.3 | 322.4 | 646.8 | 636.2 | ||||||||
SBI Special Accounts Facility | 58.9 | 66.0 | 120.3 | 131.3 | ||||||||
Total SBI | 381.2 | 388.4 | 767.1 | 767.5 | ||||||||
Surety | 99.3 | 85.8 | 196.6 | 169.4 | ||||||||
P&C Other | 0.7 | 1.3 | 2.2 | 1.0 | ||||||||
Total Net Earned Premiums | 1,375.7 | 1,394.0 | 2,758.2 | 2,761.0 | ||||||||
P&C Net Investment Income | 109.5 | 120.1 | 218.7 | 241.2 | ||||||||
Service Fees and Other Revenues | 13.6 | 14.9 | 27.4 | 28.3 | ||||||||
Total P&C Revenues | 1,498.8 | 1,529.0 | 3,004.3 | 3,030.5 | ||||||||
Corporate Net Investment Income | 2.7 | 8.1 | 5.1 | 14.2 | ||||||||
Net Realized Investment Gains | 16.5 | 17.4 | 10.0 | 29.8 | ||||||||
Corporate Other Revenue | — | 0.3 | 0.2 | 1.5 | ||||||||
Total | $ | 1,518.0 | $ | 1,554.8 | $ | 3,019.6 | $ | 3,076.0 | ||||
Pretax Underwriting Profit (Loss) and Net Income
THREE MONTHS ENDED JUNE 30, | SIX MONTHS ENDED JUNE 30, | |||||||||||||||
2008 | 2007 | 2008 | 2007 | |||||||||||||
Underwriting Profit (Loss) | ||||||||||||||||
SPI | ||||||||||||||||
Auto | $ | 33.6 | $ | 17.3 | $ | 36.7 | $ | 34.5 | ||||||||
Property | (1.6 | ) | 37.1 | 9.8 | 81.9 | |||||||||||
Specialty | 4.0 | 5.3 | 12.0 | 14.0 | ||||||||||||
Total SPI | 36.0 | 59.7 | 58.5 | 130.4 | ||||||||||||
SBI | ||||||||||||||||
SBI Regular | (0.8 | ) | 31.8 | 14.5 | 67.6 | |||||||||||
SBI Special Accounts Facility | 0.2 | 20.1 | 9.9 | 33.2 | ||||||||||||
Total SBI | (0.6 | ) | 51.9 | 24.4 | 100.8 | |||||||||||
Surety | 54.7 | 37.3 | 94.9 | 73.1 | ||||||||||||
P&C Other | (7.9 | ) | (5.2 | ) | 0.8 | (21.3 | ) | |||||||||
Total Underwriting Profit | 82.2 | 143.7 | 178.6 | 283.0 | ||||||||||||
P&C Net Investment Income | 109.5 | 120.1 | 218.7 | 241.2 | ||||||||||||
Restructuring and Asset Impairment Charges | (3.2 | ) | (1.5 | ) | (7.8 | ) | (1.8 | ) | ||||||||
P&C Net Realized Investment Gains | 15.1 | 7.6 | — | 14.2 | ||||||||||||
Total P&C | 203.6 | 269.9 | 389.5 | 536.6 | ||||||||||||
Corporate | (4.1 | ) | (20.7 | ) | (8.3 | ) | (39.6 | ) | ||||||||
Corporate Net Realized Investment Gains | 1.4 | 9.8 | 10.0 | 15.6 | ||||||||||||
Merger Related Costs | (8.9 | ) | — | (8.9 | ) | — | ||||||||||
Income before Income Taxes | 192.0 | 259.0 | 382.3 | 512.6 | ||||||||||||
Provision for Income Taxes | 42.5 | 72.6 | 91.0 | 143.7 | ||||||||||||
Net Income | $ | 149.5 | $ | 186.4 | $ | 291.3 | $ | 368.9 | ||||||||
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COMBINED RATIOS +
THREE MONTHS ENDED JUNE 30, | SIX MONTHS ENDED JUNE 30, | |||||||||||
2008 | 2007 | 2008 | 2007 | |||||||||
SPI | ||||||||||||
Auto | 94.5 | % | 97.4 | % | 97.0 | % | 97.4 | % | ||||
Property | 100.6 | 84.0 | 98.0 | 82.2 | ||||||||
Specialty | 87.0 | 81.6 | 80.1 | 74.9 | ||||||||
Total SPI | 96.0 | 93.5 | 96.7 | 92.8 | ||||||||
SBI | ||||||||||||
SBI Regular | 100.2 | 90.2 | 97.8 | 89.4 | ||||||||
SBI Special Accounts Facility | 99.7 | 69.5 | 91.8 | 74.7 | ||||||||
Total SBI | 100.2 | 86.6 | 96.8 | 86.9 | ||||||||
Surety | 44.9 | 56.4 | 51.7 | 56.8 | ||||||||
P&C Other | * | * | * | * | ||||||||
Total Combined Ratio | 94.0 | % | 89.7 | % | 93.5 | 89.8 | % | |||||
+ | Combined ratios are expressed as a percentage equal to losses and expenses divided by net earned premiums. Service Fees and Other Revenues are included as a reduction of Other Underwriting and Operating Expenses for purposes of calculating our Combined Ratio. |
* | Not meaningful because this is a runoff business with declining premium. |
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ITEM 2 – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
(Dollar amounts in millions, except for ratios and share amounts, unless noted otherwise)
This discussion should be read with the Consolidated Financial Statements and Condensed Notes to Consolidated Financial Statements in Part I, Item 1 of this Form 10-Q and our 2007 Annual Report on Form 10-K filed with the Securities and Exchange Commission. Certain reclassifications have been made to prior-period financial information for consistency with the current-period presentation. We reclassified $15.2 from Other Underwriting Operating Expenses to Service Fees and Other Revenues for the three months ended June 30, 2007 and $29.8 for the six months ended June 30, 2007. These reclassifications did not affect assets, shareholders’ equity, net income or net cash flows from operations.
Forward-Looking Information
Forward-looking information contained in this report is subject to risk and uncertainty.
We have made forward-looking statements in this report, including this Management’s Discussion and Analysis of Financial Condition and Results of Operations. We have tried, wherever possible, to identify such statements by using words such as“will”,“anticipate”, estimate”, “expect”, “project”, “intend”, “plan”, “believe”,“target”, “forecast” and other words and terms of similar meaning in connection with any discussion of future operating or financial performance or business plans and prospects. We believe it is important to communicate our expectations to investors. However, there may be events in the future we are not able to predict accurately or that we do not fully control, which could cause actual results to differ materially from those expressed or implied by our forward-looking statements, including changes in general economic and business conditions, changes in the insurance industry and changes in our business strategies. Investors should bear this in mind as they consider forward-looking statements. Additional information on factors that may impact our forward-looking statements is included in Item 1A “Risk Factors” of our 2007 Annual Report on Form 10-K.
We undertake no obligation to publicly update forward-looking statements, whether as a result of new information, future events or otherwise. Investors are advised, however, to consult any further disclosures we make on related subjects in our Forms 10-Q, 8-K and 10-K reports to the Securities and Exchange Commission.
Overview
We have been in business serving the insurance needs of our customers since 1923. Safeco Corporation is an insurance holding company. We are licensed to provide property and casualty insurance along with related services to individuals and small to mid-size businesses in all 50 states through our insurance subsidiaries. We also sell surety bonds to contractors and businesses. Our revenues come primarily from the premiums we earn on the insurance policies we write and the income we earn from our investment of premium dollars.
We sell our insurance products principally through independent agents and deliver the majority of our products over our Safeco Now® automated platform. Safeco Now gives our agents a single point of entry to sell our core property and casualty products and select transactional surety bonds in a matter of minutes. Most of our pricing, underwriting and servicing processes are presented through this platform. Consumers can also purchase certain policies online at www.Safeco.com. Today, over 95% of our personal lines and small commercial business lines are automated and priced based on predictive models.
Overall Results
We measure our success by tracking our operating and financial performance according to the following indicators:
• | Combined ratio |
• | Earnings per share |
• | Return on Equity |
• | Revenue, premium and policy growth |
In addition, we track our operating performance with various productivity and efficiency measures. We report periodically on a subset of productivity measures, such as policies-in-force per full-time equivalent employee (PIF per FTE) and expense per policies-in-force (expense per PIF).
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The following table shows the trends in these key measures:
THREE MONTHS ENDED JUNE 30, | SIX MONTHS ENDED JUNE 30, | |||||||||||||||
2008 | 2007 | 2008 | 2007 | |||||||||||||
Combined Ratio | 94.0 | % | 89.7 | % | 93.5 | % | 89.8 | % | ||||||||
Net Income per Diluted Share | $ | 1.65 | $ | 1.75 | $ | 3.23 | $ | 3.46 | ||||||||
Net Return on Equity | 17.8 | % | 18.4 | % | 17.3 | % | 18.4 | % | ||||||||
Total Revenues | $ | 1,518.0 | $ | 1,554.8 | $ | 3,019.6 | $ | 3,076.0 | ||||||||
PIF per FTE | 609 | 583 | 609 | 578 | ||||||||||||
Expense per PIF1 | $ | 238 | $ | 237 | $ | 238 | $ | 238 | ||||||||
(1) | Expense represents annual (12 month trailing) General and Administrative expense and paid UAE (loss handling expenses). It excludes commissions, legal defense costs, premium taxes and certain other expenses. |
SUMMARY OF OVERALL RESULTS
Segment Results
How We Report Our Results
We manage our businesses in four business and seven reportable segments:
• | Safeco Personal Insurance (SPI) |
• | Auto |
• | Property |
• | Specialty |
• | Safeco Business Insurance (SBI) |
• | SBI Regular Auto |
• | SBI Special Accounts Facility |
• | Surety |
• | P&C Other |
In addition to the activities of these segments, we report certain transactions such as the interest expense we pay on our debt, debt repurchases, miscellaneous corporate investment income, intercompany eliminations, real estate holdings, contributions to Safeco Insurance Foundation, merger related expenses and other corporate activities in our Corporate segment and do not allocate these to individual reportable segments.
How We Measure Our Results
We look at three measures to assess the results of our business segments:
• | Premiums |
• | Underwriting profit or loss |
• | Combined ratio |
Written premiums are premiums charged for policies and bonds issued. We view net written premiums as a measure of business production for the period under review and a leading indicator of net earned premiums. We include premiums in revenues as they are earned over the terms of the insurance policies and bonds.
Underwriting profit or loss is our net earned premiums less our losses from claims, loss adjustment expenses (LAE) and underwriting expenses net of Service Fees and Other Revenues on a pretax basis.
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Our combined ratio is our losses, LAE and general expenses net of Other Revenues on a pretax basis divided by our net earned premiums. We report combined ratio as a percentage. For example, a combined ratio of 95% means that for every dollar of premium earned, 95 cents are spent on losses, LAE and general expenses, and 5 cents are underwriting profit. A lower combined ratio reflects better underwriting results than a higher combined ratio.
More information about our segment results can be found in Our P&C Operating Results.
Investment activities are an important part of our business. We don’t include our investment portfolio results when measuring the profitability of our individual segments because we manage them separately. Our first priority is to meet our promise to our policyholders that we will maintain resources to pay their claims. We invest the insurance premiums we receive in a diversified portfolio of primarily high-grade fixed maturities until they are needed to pay claims. This strategy is designed to provide protection for our policyholders.
Our investment philosophy is to:
• | Emphasize after-tax investment income, balanced with investment quality and risk |
• | Provide for liquidity when needed |
• | Reduce volatility in investment performance through prudent diversification |
We measure our investment results in two parts: the after-tax net investment income we earn on our invested assets, and the net realized investment gains or losses we recognize when we sell or impair investments. It is our intent to hold a diversified portfolio so we will achieve consistent investment performance. More information about our investment results can be found in Our Investment Results section.
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CONSOLIDATED RESULTS OF OPERATIONS
The following table presents summarized consolidated financial information. A detailed discussion of our results by segment follows.
THREE MONTHS ENDED JUNE 30, | SIX MONTHS ENDED JUNE 30, | |||||||||||
2008 | 2007 | 2008 | 2007 | |||||||||
REVENUES | ||||||||||||
Net Earned Premiums | $ | 1,375.7 | $ | 1,394.0 | $ | 2,758.2 | $ | 2,761.0 | ||||
Net Investment Income | 112.2 | 128.2 | 223.8 | 255.4 | ||||||||
Net Realized Investment Gains | 16.5 | 17.4 | 10.0 | 29.8 | ||||||||
Service Fees and Other Revenues | 13.6 | 15.2 | 27.6 | 29.8 | ||||||||
Total Revenues | 1,518.0 | 1,554.8 | 3,019.6 | 3,076.0 | ||||||||
EXPENSES | ||||||||||||
Losses and Loss Adjustment Expenses | 899.1 | 858.0 | 1,795.4 | 1,706.2 | ||||||||
Amortization of Deferred Policy Acquisition Costs | 241.2 | 231.3 | 483.4 | 467.5 | ||||||||
Other Underwriting and Operating Expenses | 175.8 | 183.0 | 336.9 | 341.7 | ||||||||
Interest Expense | 6.7 | 22.0 | 13.8 | 46.2 | ||||||||
Restructuring and Asset Impairment Charges | 3.2 | 1.5 | 7.8 | 1.8 | ||||||||
Total Expenses | 1,326.0 | 1,295.8 | 2,637.3 | 2,563.4 | ||||||||
Income before Income Taxes | 192.0 | 259.0 | 382.3 | 512.6 | ||||||||
Provision for Income Taxes | 42.5 | 72.6 | 91.0 | 143.7 | ||||||||
Net Income | $ | 149.5 | $ | 186.4 | $ | 291.3 | $ | 368.9 | ||||
REVENUES
Total revenues decreased 2.4% in the three months ended June 30, 2008 and decreased 1.8% in the six months ended June 30, 2008, compared with the same periods in 2007. The changes were primarily driven by:
• | Net earned premiums – Our net earned premiums decreased $18.3, or 1.3%, in the three months ended June 30, 2008 and $2.8, or 0.1%, in the six months ended June 30, 2008, compared with the same periods in 2007. The decrease in net earned premiums in the three months ended June 30, 2008 compared with the same period in 2007 reflects decreases of $42.0 in Auto and $7.1 in Special Accounts Facility, partially offset by increases of $15.8 in Property and $13.5 in Surety. The decrease in the six months ended June 30, 2008 compared with the same period in 2007 reflects decreases of $67.7 in Auto and $11.0 in Special Accounts Facility, partially offset by increases of $32.2 in Property, $27.2 in Surety and $10.6 in SBI Regular. |
• | Net investment income – Our net investment income decreased $16.0, or 12.5%, in the three months ended June 30, 2008 and $31.6, or 12.4%, in the six months ended June 30, 2008, compared with the same periods in 2007. The decrease in net investment income was the result of an overall lower invested asset base due primarily to the sale of securities to fund our debt maturity and redemption and the special dividend paid in July 2007 by our insurance subsidiaries to Safeco Corporation that was not reinvested. |
• | Net realized investment gains – Net realized investment gains decreased $0.9, or 5.2%, in the three months ended June 30, 2008 and $19.8, or 66.4%, in the six months ended June 30, 2008, compared with the same periods in 2007. The decrease in the three months ended June 30, 2008 compared with the same period in 2007 was due primarily to an increase of $37.5 in impairments on fixed maturities and marketable equity securities and losses of $6.7 on interest rate swaps partially offset by an increase of $38.8 in gains from the sale of fixed maturities and marketable equity securities. The decrease in the six months ended June 30, 2008 compared with the same period in 2007 is due primarily to an increase of $77.9 in impairments on fixed maturities and marketable equity securities partially offset by an increase of $65.7 in gains from the sale of fixed maturities and marketable equity securities. |
NET INCOME
Net income decreased 19.8% in three months ended June 30, 2008 and 21.0% in the six months ended June 30, 2008, compared with the same periods in 2007. The changes were primarily driven by the revenue changes described above, as well as the following:
• | Losses and loss adjustment expenses (LAE) – Losses and LAE increased 4.8% in the three months ended June 30, 2008, and 5.2% in the six months ended June 30, 2008, compared with the same periods in 2007. The change was largely driven by increased weather and catastrophe losses in Property and SBI Regular due to a higher level of weather-related |
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losses in the three and six months ended June 30, 2008 compared with very light weather impact during the same periods in 2007. We reduced our estimates for prior years’ loss and LAE reserves by $45.3 for the three months ended June 30, 2008 and by $64.2 for the six months ended June 30, 2008, primarily reflecting favorable prior-year reserve development in our Surety segment, compared with $23.4 of favorable prior-year reserve development for the three months ended June 30, 2007 and $48.0 for the six months ended June 30, 2007, primarily in our Property, Workers’ Compensation and Surety lines. |
• | Catastrophe losses – We categorize catastrophes as events resulting in losses greater than $1.0 per event and involving multiple claims and policyholders. We cannot predict when catastrophes may occur, and the number and types of catastrophes can vary widely. The losses they cause may significantly exceed our prior experience. Catastrophes can be caused by natural events, such as hurricanes, tornadoes, wildfires, earthquakes and hailstorms, or other factors such as terrorism, riots, hazardous materials releases or utility outages. Pretax after reinsurance catastrophe losses were $66.9 in the three months ended June 30, 2008, compared with $6.7 in the same period in 2007, and $89.7 in the six months ended June 30, 2008, compared with $5.4 in the same period in 2007. This increase in pretax catastrophe losses reflects an increase in hail and wind storms in 2008. |
• | Other underwriting and operating expenses – Other underwriting and operating expenses decreased 3.9% in the three months ended June 30, 2008 compared with the same period in 2007, and 1.4% in the six months ended June 30, 2008 compared with the same period in 2007. This decrease is due primarily to a decrease in payroll and employee benefit related expenses in the three months ended June 30, 2008, partially offset by an increase in professional services related to consulting and outsourcing contractor expenses. |
• | Interest expense – Interest expense decreased $15.3 in the three months ended June 30, 2008 compared with the same period in 2007, and $32.4 in the six months ended June 30, 2008, compared with the same period in 2007. The decrease is a result of the repayment of our debt in February 2008 and the redemption and maturity of our debt in July 2007. |
• | Restructuring and asset impairment charges – The restructuring charges in 2008 were primarily related to employee termination benefits. The restructuring and asset impairment charges in 2007 were related to the organizational design initiative we commenced in 2006 and completed in 2007. |
• | Net realized investment gains – After-tax net realized investment gains were $10.7 in the three months ended June 30, 2008 compared with $11.4 in the same period in 2007, and $4.6 in the six months ended June 30, 2008, compared with $19.3 in the same period in 2007, due to an increase in impairments on fixed maturities and marketable equity securities. |
• | Provision for income taxes – Our provision for income taxes decreased $30.1 in the three months ended June 30, 2008 and $52.7 in the six months ended June 30, 2008, compared with the same periods in 2007. Our effective tax rate was 22.1% in the three months ended June 30, 2008, compared with 28.0% in the same period in 2007, and 23.8% in the six months ended June 30, 2008, compared with 28.0% in the same period in 2007. The decrease in our effective tax rate in 2008 is due to an increased percentage of tax exempt income as a percentage of total projected annual income. |
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OTHER UNDERWRITING AND OPERATING EXPENSE
The following table details the categories of our other underwriting and operating expenses:
THREE MONTHS ENDED JUNE 30, | SIX MONTHS ENDED JUNE 30, | |||||||||||||||
2008 | 2007 | 2008 | 2007 | |||||||||||||
Commissions (Including Bonus Commissions) | $ | 228.8 | $ | 234.6 | $ | 439.5 | $ | 453.2 | ||||||||
Salaries | 118.5 | 118.7 | 241.5 | 234.5 | ||||||||||||
Legal Defense Costs | 47.3 | 50.6 | 97.4 | 105.4 | ||||||||||||
Employee Benefits | 43.2 | 44.0 | 72.9 | 70.2 | ||||||||||||
Premium Taxes | 30.9 | 32.3 | 59.9 | 62.5 | ||||||||||||
Office Expenses | 27.3 | 25.4 | 54.0 | 49.1 | ||||||||||||
Professional Services | 25.9 | 16.4 | 50.4 | 32.1 | ||||||||||||
Rent and Depreciation | 19.1 | 21.4 | 38.6 | 41.1 | ||||||||||||
Risk and Cost Containment | 13.3 | 17.0 | 27.9 | 35.3 | ||||||||||||
Travel and Entertainment | 10.0 | 7.9 | 18.9 | 14.2 | ||||||||||||
Other Expenses | 11.5 | 12.9 | 18.9 | 22.6 | ||||||||||||
Advertising | 5.1 | 8.3 | 10.9 | 12.8 | ||||||||||||
Other Taxes, Licenses and Fees | 3.7 | 1.9 | 6.2 | 5.7 | ||||||||||||
Changes in Deferred Policy Acquisition Costs | (14.2 | ) | (21.0 | ) | (13.1 | ) | (28.9 | ) | ||||||||
Total | $ | 570.4 | $ | 570.4 | $ | 1,123.9 | $ | 1,109.8 | ||||||||
Loss Adjustment Expenses | 153.4 | 156.1 | 303.6 | 300.6 | ||||||||||||
Operating Expenses + | 417.0 | 414.3 | 820.3 | 809.2 | ||||||||||||
Total | $ | 570.4 | $ | 570.4 | $ | 1,123.9 | $ | 1,109.8 | ||||||||
+ | Includes Amortization of Deferred Policy Acquisition Costs and Other Underwriting and Operating Expenses. |
Our other underwriting and operating expenses were flat in the three months ended June 30, 2008 and increased $11.1 in the six months ended June 30, 2008, compared with the same periods in 2007. These changes are primarily due to increases in amortization of deferred policy acquisition costs related to premium growth in Property and Surety, and professional services related to consulting and outsourcing contractor expenses. The overall increase was partially offset by decreases in our agent commissions, legal defense costs and expenses related to risk and cost containment.
RECONCILING SEGMENT RESULTS
The following table assists in reconciling our GAAP results, specifically the “Income before Income Taxes” line from our Consolidated Statements of Income to our operating results:
THREE MONTHS ENDED JUNE 30, | SIX MONTHS ENDED JUNE 30, | |||||||||||||||
2008 | 2007 | 2008 | 2007 | |||||||||||||
P&C | $ | 203.6 | $ | 269.9 | $ | 389.5 | $ | 536.6 | ||||||||
Corporate | (11.6 | ) | (10.9 | ) | (7.2 | ) | (24.0 | ) | ||||||||
Income before Income Taxes | $ | 192.0 | $ | 259.0 | $ | 382.3 | $ | 512.6 | ||||||||
In addition to financial measures presented in the consolidated financial statements prepared in accordance with U.S. generally accepted accounting principles (GAAP), we also use certain non-GAAP financial measures to analyze and report our financial results. Management believes that these non-GAAP measures, when used in conjunction with the consolidated financial statements, can aid in understanding our financial condition and results of operations. These non-GAAP measures are not a substitute for GAAP measures, and where these measures are described we provide tables that reconcile the non-GAAP measures to the GAAP measures reported in our consolidated financial statements.
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OUR P&C OPERATING RESULTS
The primary measures of our operating results include our premiums, underwriting profit or loss and combined ratios. The following tables report those key items – by our reportable segments – for the three and six months ended June 30, 2008 and 2007. More information about the results – also by reportable segment – follows the tables.
Premiums are the primary driver of our revenues, along with net investment income and net realized investment gains or losses. Net written premiums are a non-GAAP measure representing the amount of premium charged for policies issued with effective dates during the period. Premiums are included as revenue in the Consolidated Statements of Income as they are earned over the underlying policy period. Net written premiums applicable to the unexpired term of a policy are recorded as unearned premiums on our Consolidated Balance Sheets.
We view net written premiums as a measure of business production for the period under review and a leading indicator of net earned premiums. The following table reconciles net written premiums to net earned premiums by reportable segment, the most directly comparable GAAP measure on our Consolidated Statements of Income:
THREE MONTHS ENDED JUNE 30, | SIX MONTHS ENDED JUNE 30, | |||||||||||||||
2008 | 2007 | 2008 | 2007 | |||||||||||||
Net Written Premiums | ||||||||||||||||
Safeco Personal Insurance (SPI) | ||||||||||||||||
Auto | $ | 598.0 | $ | 643.4 | $ | 1,225.5 | $ | 1,312.1 | ||||||||
Property | 284.5 | 259.2 | 506.2 | 464.6 | ||||||||||||
Specialty | 39.9 | 36.6 | 68.8 | 63.1 | ||||||||||||
Total SPI | 922.4 | 939.2 | 1,800.5 | 1,839.8 | ||||||||||||
Safeco Business Insurance (SBI) | ||||||||||||||||
SBI Regular | 328.6 | 354.4 | 652.5 | 683.5 | ||||||||||||
SBI Special Accounts Facility | 55.6 | 64.3 | 111.8 | 128.9 | ||||||||||||
Total SBI | 384.2 | 418.7 | 764.3 | 812.4 | ||||||||||||
Surety | 121.2 | 106.9 | 224.4 | 199.6 | ||||||||||||
P&C Other | 0.5 | 0.7 | — | 3.7 | ||||||||||||
Total Net Written Premiums | 1,428.3 | 1,465.5 | 2,789.2 | 2,855.5 | ||||||||||||
Change in Net Unearned Premiums | (52.6 | ) | (71.5 | ) | (31.0 | ) | (94.5 | ) | ||||||||
Net Earned Premiums | $ | 1,375.7 | $ | 1,394.0 | $ | 2,758.2 | $ | 2,761.0 | ||||||||
Our net earned premiums by reportable segment were:
THREE MONTHS ENDED JUNE 30, | SIX MONTHS ENDED JUNE 30, | |||||||||||
2008 | 2007 | 2008 | 2007 | |||||||||
Net Earned Premiums | ||||||||||||
Safeco Personal Insurance (SPI) | ||||||||||||
Auto | $ | 615.0 | $ | 657.0 | $ | 1,240.0 | $ | 1,307.7 | ||||
Property | 248.6 | 232.8 | 491.7 | 459.5 | ||||||||
Specialty | 30.9 | 28.7 | 60.6 | 55.9 | ||||||||
Total SPI | 894.5 | 918.5 | 1,792.3 | 1,823.1 | ||||||||
Safeco Business Insurance (SBI) | ||||||||||||
SBI Regular | 322.3 | 322.4 | 646.8 | 636.2 | ||||||||
SBI Special Accounts Facility | 58.9 | 66.0 | 120.3 | 131.3 | ||||||||
Total SBI | 381.2 | 388.4 | 767.1 | 767.5 | ||||||||
Surety | 99.3 | 85.8 | 196.6 | 169.4 | ||||||||
P&C Other | 0.7 | 1.3 | 2.2 | 1.0 | ||||||||
Net Earned Premiums | $ | 1,375.7 | $ | 1,394.0 | $ | 2,758.2 | $ | 2,761.0 | ||||
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Underwriting profit (loss) is our measure of each segment’s performance. Underwriting profit (loss) is our net earned premiums less our losses from claims, LAE and underwriting expenses net of Other Revenues on a pretax basis:
THREE MONTHS ENDED JUNE 30, | SIX MONTHS ENDED JUNE 30, | |||||||||||||||
2008 | 2007 | 2008 | 2007 | |||||||||||||
Underwriting Profit (Loss) | ||||||||||||||||
Safeco Personal Insurance (SPI) | ||||||||||||||||
Auto | $ | 33.6 | $ | 17.3 | $ | 36.7 | $ | 34.5 | ||||||||
Property | (1.6 | ) | 37.1 | 9.8 | 81.9 | |||||||||||
Specialty | 4.0 | 5.3 | 12.0 | 14.0 | ||||||||||||
Total SPI | 36.0 | 59.7 | 58.5 | 130.4 | ||||||||||||
Safeco Business Insurance (SBI) | ||||||||||||||||
SBI Regular | (0.8 | ) | 31.8 | 14.5 | 67.6 | |||||||||||
SBI Special Accounts Facility | 0.2 | 20.1 | 9.9 | 33.2 | ||||||||||||
Total SBI | (0.6 | ) | 51.9 | 24.4 | 100.8 | |||||||||||
Surety | 54.7 | 37.3 | 94.9 | 73.1 | ||||||||||||
P&C Other | (7.9 | ) | (5.2 | ) | 0.8 | (21.3 | ) | |||||||||
Total Underwriting Profit | 82.2 | 143.7 | 178.6 | 283.0 | ||||||||||||
P&C Net Investment Income | 109.5 | 120.1 | 218.7 | 241.2 | ||||||||||||
Restructuring and Asset Impairment Charges | (3.2 | ) | (1.5 | ) | (7.8 | ) | (1.8 | ) | ||||||||
Net Realized Investment Gains | 15.1 | 7.6 | — | 14.2 | ||||||||||||
P&C Income before Income Taxes | $ | 203.6 | $ | 269.9 | $ | 389.5 | $ | 536.6 | ||||||||
Combined ratios show the relationship between underwriting profit and net earned premiums. Using ratios helps us see our operating trends without the effect of changes in the volume of net earned premiums:
THREE MONTHS ENDED JUNE 30, | SIX MONTHS ENDED JUNE 30, | |||||||||||
2008 | 2007 | 2008 | 2007 | |||||||||
Combined Ratios | ||||||||||||
Safeco Personal Insurance (SPI) | ||||||||||||
Auto | 94.5 | % | 97.4 | % | 97.0 | % | 97.4 | % | ||||
Property | 100.6 | 84.0 | 98.0 | 82.2 | ||||||||
Specialty | 87.0 | 81.6 | 80.1 | 74.9 | ||||||||
SPI Total | 96.0 | 93.5 | 96.7 | 92.8 | ||||||||
Safeco Business Insurance (SBI) | ||||||||||||
SBI Regular | 100.2 | 90.2 | 97.8 | 89.4 | ||||||||
SBI Special Accounts Facility | 99.7 | 69.5 | 91.8 | 74.7 | ||||||||
SBI Total | 100.2 | 86.6 | 96.8 | 86.9 | ||||||||
Surety | 44.9 | 56.4 | 51.7 | 56.8 | ||||||||
P&C Other | * | * | * | * | ||||||||
Total Combined Ratio + | 94.0 | % | 89.7 | % | 93.5 | % | 89.8 | % | ||||
+ | Combined ratios are expressed as a percentage equal to losses and expense divided by net earned premiums. Service Fees and Other Revenues are included as a reduction of Other Underwriting and Operating Expenses for purposes of calculating our Combined Ratio. |
* | Not meaningful because this is a runoff business with declining premium. |
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AUTO
THREE MONTHS ENDED JUNE 30, | SIX MONTHS ENDED JUNE 30, | |||||||||||||||
2008 | 2007 | 2008 | 2007 | |||||||||||||
Net Written Premiums | $ | 598.0 | $ | 643.4 | $ | 1,225.5 | $ | 1,312.1 | ||||||||
Net Earned Premiums | 615.0 | 657.0 | 1,240.0 | 1,307.7 | ||||||||||||
Underwriting Profit | 33.6 | 17.3 | 36.7 | 34.5 | ||||||||||||
Favorable Prior-Year Reserve Development | 9.1 | 6.2 | 9.9 | 5.5 | ||||||||||||
Pretax Catastrophe Losses | 10.2 | 1.9 | 12.1 | 2.7 | ||||||||||||
Loss and LAE Ratio | 69.3 | % | 73.9 | % | 72.1 | % | 73.8 | % | ||||||||
Expense Ratio | 25.2 | 23.5 | 24.9 | 23.6 | ||||||||||||
Combined Ratio | 94.5 | % | 97.4 | % | 97.0 | % | 97.4 | % | ||||||||
Our Auto segment provides coverage for the liability of our policyholders to others for both bodily injury and property damage, for injuries sustained by our policyholders and for physical damage to our customers’ vehicles from collision and other hazards.
Premiums
Net written premiums decreased $45.4, or 7.1%, in the three months ended June 30, 2008 and decreased $86.6, or 6.6%, in the six months ended June 30, 2008 compared with the same periods in 2007. The changes in net written premiums were primarily driven by:
• | Policies-in-force (PIF) – PIF at June 30, 2008 decreased 6.8% compared with June 30, 2007, primarily due to increasing competition. As we have taken rate increases to offset higher loss costs, our new policies sold declined 22.5% in the three months ended June 30, 2008, and 23.5% in the six months ended June 30, 2008, compared with the same periods in 2007. Auto retention rates declined from 80.2% as of June 30, 2007 to 78.6% as of June 30, 2008. |
• | Changes in average premiums – We file rate changes on a state-by-state basis. Rate changes are reflected on existing policies at renewal and are earned in our revenues over the six-month policy term. Overall, we received approval for average rate increases of 3.7% in the first six months of 2008, compared with a 1.3% increase in the same period in 2007. Average premiums are also affected by changes in the risk profile of our policyholders, as well as the increased pricing for those policies that insure newer and more expensive cars, which we refer to as premium trend. Premium trend was negative in the second quarter of 2008, due to a change in our mix of business to lower average premium policies. This is primarily the result of fewer non-standard policies in our business mix, and our Safeco True Pricing™ model that offers additional preferred underwriting tiers and generally lower rates for customers without accidents and motor vehicle violations. |
Net earned premiums decreased $42.0, or 6.4%, in the three months ended June 30, 2008, and $67.7, or 5.2%, in the six months ended June 30, 2008, compared with the same periods in 2007. The changes in net earned premiums were primarily driven by Policies-in-force (PIF) – Lower average PIF decreased net earned premiums by $44.4 in the three months ended June 30, 2008 and $71.6 in the six months ended June 30, 2008, compared with the same periods in 2007.
Underwriting Results and Combined Ratio
Our underwriting profit in Auto increased $16.3 and our combined ratio decreased by 2.9 points in the three months ended June 30, 2008 compared with the same period in 2007. Our underwriting profit increased $2.2 and our combined ratio decreased by 0.4 points in the six months ended June 30, 2008, compared with the same period in 2007. Our underwriting profit and combined ratio were primarily driven by:
• | Loss costs – Our auto loss costs decreased in the three months ended June 30, 2008 and in the first six months of 2008, compared with the same periods in 2007. These were driven by percentage changes in both frequency and severity in the negative low-single-digits. These factors, net of reinsurance, decreased our combined ratio by 4.3 points in the three months ended June 30, 2008 and by 2.8 points in the six months ended June 30, 2008 compared with the same periods in 2007. Higher LAE costs increased our combined ratio by 0.8 points in the three months ended June 30, 2008 and 1.1 points in the six months ended June 30, 2008 compared with the same periods in 2007, primarily due to investments in claims business process and technology improvements. |
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• | Reserve development – The favorable prior-year reserve development in 2008 was a result of lower-than-expected bodily injury severity, primarily in accident year 2005. The change in prior-year reserve development decreased our combined ratio by 0.5 points in the three months ended June 30, 2008 and 0.4 points in the six months ended June 30, 2008, compared with the same periods in 2007. In addition, our underwriting results included favorable current-year prior-quarter reserve development of $8.6 in the three months ended June 30, 2008 compared with no current-year prior-quarter reserve development for the three months ended June 30, 2007. The change in prior-quarter reserve development decreased our combined ratio by 1.4 points for the three months ended June 30, 2008. |
• | Catastrophe losses – The increase in catastrophe losses was due to more high magnitude wind and hail storms in the first six months of 2008, compared with the same period in 2007. Excluding the impact of prior-year reserve development, the catastrophe losses in the three months ended June 30, 2008 increased the combined ratio by 1.4 points compared with the same period in 2007. The change in catastrophe losses in the six months ended June 30, 2008 increased the combined ratio by 0.9 points compared with the same period in 2007. |
• | Expenses – Our agent compensation increased 1.2 points in the three months ended June 30, 2008 and 0.6 points in the six months ended June 30, 2008, compared with the same periods in 2007. Our expense ratio increased 1.7 points in the three months ended June 30, 2008 and 1.3 points in the six months ended June 30, 2008, compared with the same periods in 2007 due to increased agent compensation and an investment in our online strategy. |
Outlook – Our long-term target is a 96.0% combined ratio. Our outlook for 2008 includes improvement in our profitability while competitive pressures continue to challenge our growth. Actions we are taking to improve our profitability include: implementing rate increases in the mid-single digit range, completing the rollout of our auto True Pricing Model, the cancellation of several hundred unprofitable agencies, and enhancements to our point of sale data verification capabilities. Safeco True Pricing not only improves our segmentation relative to our competitors, but it also improves our new business competitiveness on many customer segments even as we implement rate changes. During the first six months of 2008, we implemented 37 rate revisions for an average earned increase of 3.7% across our entire auto book of business.
PROPERTY
THREE MONTHS ENDED JUNE 30, | SIX MONTHS ENDED JUNE 30, | |||||||||||||||
2008 | 2007 | 2008 | 2007 | |||||||||||||
Net Written Premiums | $ | 284.5 | $ | 259.2 | $ | 506.2 | $ | 464.6 | ||||||||
Net Earned Premiums | 248.6 | 232.8 | 491.7 | 459.5 | ||||||||||||
Underwriting Profit (Loss) | (1.6 | ) | 37.1 | 9.8 | 81.9 | |||||||||||
Favorable (Unfavorable) Prior-Year Reserve Development | 2.8 | (4.8 | ) | 0.7 | 10.2 | |||||||||||
Pretax Catastrophe Losses | 35.7 | 9.9 | 51.8 | 9.1 | ||||||||||||
Loss and LAE Ratio | 72.5 | % | 54.5 | % | 69.3 | % | 53.7 | % | ||||||||
Expense Ratio | 28.1 | 29.5 | 28.7 | 28.5 | ||||||||||||
Combined Ratio | 100.6 | % | 84.0 | % | 98.0 | % | 82.2 | % | ||||||||
Our Property segment provides homeowners, dwelling fire, earthquake and inland marine coverage for individuals. Our Property coverages protect homes, condominiums and rental property contents against losses from a wide variety of hazards.
Premiums
Net written premiums increased $25.3, or 9.8%, in the three months ended June 30, 2008 and $41.6, or 9.0%, in the six months ended June 30, 2008, compared with the same periods in 2007. This reflected:
• | Changes in PIF – PIF increased 7.2% as of June 30, 2008 compared with the same period in 2007. This included a decrease in new business of 3.1% in the three months ended June 30, 2008 and 1.8% in the six months ended June 30, 2008, compared with the same periods in 2007. Our retention rate increased to 86.4% as of June 30, 2008 compared with 85.4% during the same period in 2007. |
• | Changes in average premiums – We file rate changes on a state-by-state basis. Rate changes are reflected on existing policies on renewal and are earned in our revenues over the 12-month policy term. Overall, we received approval for average rate increases in our property business of 1.4% in the first six months of 2008, compared with a decrease of 6.1% in the same period in 2007. Average premiums are also affected by automatic increases in the amount of insurance coverage to adjust for inflation in building costs and by shifts in the mix of our business, which we refer to as premium trend. Premium trend resulted in an increase to net written premiums in the first three and six months of 2008, compared with the same periods in 2007, due in part to inflation guard increases and new business from higher average premium states. |
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Net earned premiums increased $15.8, or 6.8%, in the three months ended June 30, 2008 and $32.2, or 7.0%, in the six months ended June 30, 2008, compared with the same periods in 2007. This reflected:
• | Changes in PIF – Higher average PIF increased net earned premiums by $11.2 in the three months ended June 30, 2008 and $22.9 in the six months ended June 30, 2008 compared with the same periods in 2007. |
• | Changes in average premiums – Higher average premiums increased net earned premiums by $4.6 in the three months ended June 30, 2008, and $9.7 in the six months ended June 30, 2008, compared with the same periods in 2007. |
Underwriting Results and Combined Ratio
Our underwriting results in Property decreased $38.7 and our combined ratio increased 16.6 points in the three months ended June 30, 2008 compared with the same period in 2007. Our underwriting results in Property decreased $72.1 and our combined ratio increased 15.8 points in the six months ended June 30, 2008 compared with the same period in 2007. Our underwriting results and combined ratio changes were primarily driven by:
• | Changes in average premiums – Our property rate changes, combined with premium trend, decreased our Property combined ratio by 1.6 points in the three months ended June 30, 2008 and 1.7 points in the six months ended June 30, 2008, compared with the same periods in 2007. |
• | Loss costs – Our Property loss costs experienced increases in the high teens in the three months ended June 30, 2008, and in the mid teens in the six months ended June 30, 2008 compared with the same periods in 2007 due primarily to increased frequency of non-catastrophe weather losses and increased severity due to large fire losses. These factors, net of reinsurance, increased our Property combined ratio by 7.9 points in the three months ended June 30, 2008 and by 6.7 points in the six months ended June 30, 2008 compared with the same period in 2007. |
• | Prior-year reserve development – The favorable prior-year reserve development in 2008 was primarily due to favorable adjustments to catastrophe loss estimates. The change in prior-year reserve development decreased our combined ratio by 3.2 points in the three months ended June 30, 2008 and increased by 2.1 points in the six months ended June 30, 2008, compared with the same periods in 2007. |
• | Catastrophe losses – The increase in catastrophe losses was primarily due to more high magnitude wind and hail storms compared with 2007. Excluding the impact of prior-year reserve development, the catastrophe losses increased our combined ratio by 13.0 points in the three months ended June 30, 2008 and by 7.9 points in the six months ended June 30, 2008, compared with the same periods in 2007. |
• | Expenses – Our expense ratio decreased by 1.4 points in the three months ended June 30, 2008 and increased 0.2 points in the six months ended June 30, 2008, compared with the same periods in 2007. The decrease in the three months ended June 30, 2008 was the result of reduced agent compensation. The increase in the six months ended June 30, 2008 was driven by an investment in our online strategy, higher sales and marketing costs, partially offset by lower agent compensation. |
Outlook – Our disciplined approach to pricing and catastrophe management, in combination with our use of multivariate predictive pricing models in all of our property lines, sets the course for us to operate at or below our long-term target combined ratio of 92.0% by the fourth quarter of 2008. We will be taking modest rate increases on a state-by-state basis consistent with anticipated loss and premium trends. Our rollout of our home True-Pricing model will continue through the remainder of 2008. Overall new business growth trends have flattened but remain at a healthy level, especially in light of the year over year decrease we have seen in residential home sales across the United States.
SPECIALTY
THREE MONTHS ENDED JUNE 30, | SIX MONTHS ENDED JUNE 30, | |||||||||||||||
2008 | 2007 | 2008 | 2007 | |||||||||||||
Net Written Premiums | $ | 39.9 | $ | 36.6 | $ | 68.8 | $ | 63.1 | ||||||||
Net Earned Premiums | 30.9 | 28.7 | 60.6 | 55.9 | ||||||||||||
Underwriting Profit | 4.0 | 5.3 | 12.0 | 14.0 | ||||||||||||
Favorable (Unfavorable) Prior-Year Reserve Development | — | 0.3 | (0.1 | ) | 1.8 | |||||||||||
Pretax Catastrophe Losses | 0.7 | — | 1.0 | (0.8 | ) | |||||||||||
Loss and LAE Ratio | 59.8 | % | 52.9 | % | 51.8 | % | 46.2 | % | ||||||||
Expense Ratio | 27.2 | 28.7 | 28.3 | 28.7 | ||||||||||||
Combined Ratio | 87.0 | % | 81.6 | % | 80.1 | % | 74.9 | % | ||||||||
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Our Specialty segment provides individuals with umbrella, motorcycle, recreational vehicle, and boat owners insurance.
Premiums
Net written premiums increased $3.3, or 9.0%, in the three months ended June 30, 2008 and $5.7, or 9.0%, in the six months ended June 30, 2008, compared with the same periods in 2007. New-business policies sold increased 19.0% in the three months ended June 30, 2008 and increased 16.0% in the six months ended June 30, 2008, compared with the same periods in 2007. Net written premium growth was primarily driven by an increase in new business in umbrella and motorcycle product sales. New business growth has been primarily driven by improvements in automation, rating and increased customer awareness of our product. Net earned premiums increased $2.2, or 7.7%, in the three months ended June 30, 2008 and $4.7, or 8.4%, in the six months ended June 30, 2008, compared with the same periods in 2007.
Underwriting Results and Combined Ratio
Our underwriting profit in Specialty decreased $1.3 and our combined ratio increased 5.4 points in the three months ended June 30, 2008 compared with the same period in 2007. Our underwriting profit in Specialty decreased $2.0 and our combined ratio increased 5.2 points in the six months ended June 30, 2008 compared with the same period in 2007. Our underwriting results and combined ratio were primarily driven by:
• | Loss costs – Our specialty loss costs increased for the three and six months ended June 30, 2008 compared with the same periods in 2007. These increases were due to higher loss costs for Specialty Auto, offset to a small degree by lower costs for boatowners. The net effect on the combined ratio was an increase of 3.5 points for the three months ended June 30, 2008 and an increase of 0.8 points for the six months ended June 30, 2008 compared with the same periods in 2007. |
• | Prior-year reserve development – We experienced slightly favorable prior-year reserve development in the three months ended June 30, 2008 and in the six months ended June 30, 2008 compared with the same periods in the prior year. The change in prior-year reserve development increased our combined ratio by 1.0 points in the three months ended June 30, 2008 and 3.2 points in the six months ended June 30, 2008, compared with the same periods in 2007. |
• | Expenses – Our expense ratio decreased 1.5 points in the three months ended June 30, 2008 and 0.4 points in the six months ended June 30, 2008, compared with the same periods in 2007 due to our ongoing process improvement efforts and expense reduction initiatives partially offset by increased agent compensation. |
• | Catastrophe losses – The increase in catastrophe losses was due to increased wind and hail storms which affected primarily the boatowners’ line. The catastrophe losses in the three months ended June 30, 2008 increased the combined ratio by 2.7 points compared to the same period in 2007. The catastrophe losses in the six months ended June 30, 2008 increased the combined ratio by 2.2 points compared with the same period in 2007. |
Outlook – In 2008, we expect Specialty to operate at or below its long-term target combined ratio of 92%. We continue to price by product, on a state-by-state basis, using our multi-variate predictive model.
SBI REGULAR
THREE MONTHS ENDED JUNE 30, | SIX MONTHS ENDED JUNE 30, | |||||||||||||||
2008 | 2007 | 2008 | 2007 | |||||||||||||
Net Written Premiums | $ | 328.6 | $ | 354.4 | $ | 652.5 | $ | 683.5 | ||||||||
Net Earned Premiums | 322.3 | 322.4 | 646.8 | 636.2 | ||||||||||||
Underwriting Profit (Loss) | (0.8 | ) | 31.8 | 14.5 | 67.6 | |||||||||||
Favorable Prior-Year Reserve Development | 12.4 | 9.0 | 12.8 | 10.3 | ||||||||||||
Pretax Catastrophe Losses | 15.2 | 0.5 | 18.9 | 1.5 | ||||||||||||
Loss and LAE Ratio | 67.5 | % | 57.0 | % | 65.2 | % | 56.8 | % | ||||||||
Expense Ratio | 32.7 | 33.2 | 32.6 | 32.6 | ||||||||||||
Combined Ratio | 100.2 | % | 90.2 | % | 97.8 | % | 89.4 | % | ||||||||
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Our SBI Regular segment provides insurance for small- to mid-sized businesses (those with annual premiums of $250,000 or less). This is our core commercial lines business, featuring these main products:
• | Business owner policies (BOP) |
• | Commercial auto |
• | Commercial multi-peril (CMP) |
• | Workers compensation |
• | Commercial property |
• | General liability |
Premiums
Net written premiums decreased $25.9, or 7.3%, in the three months ended June 30, 2008, and $31.0, or 4.5%, in the six months ended June 30, 2008, compared with the same periods in 2007. The changes in net written premiums were primarily driven by:
• | Changes in PIF – PIF decreased 1.5% as of June 30, 2008 compared with the same period in 2007. Our retention rate of 79.4% as of June 30, 2008 was lower compared with 81.7% as of June 30, 2007. Our new policies sold decreased 21.3% in the three months ended June 30, 2008, and 17.7% in the six months ended June 30, 2008, compared with the same periods in 2007. |
• | Price changes – We file rate changes on a state-by-state basis. Our average prices, which include filed rate changes and exposure growth, increased slightly in the three months and six month periods ended June 30, 2008, compared with the same periods in 2007. Prices are affected by growth in the exposures we cover due to factors such as changes in payroll, the number of employees, sales receipts and property building values for the businesses we insure. Price changes are reflected in existing policies at renewal. |
• | Mix of business – In addition to price changes, premiums are affected by changes in average policy size and mix of policy lines. |
Net earned premiums remained flat in the three months ended June 30, 2008 and increased $10.6, or 1.7%, in the six months ended June 30, 2008, compared with the same periods in 2007. The changes in net earned premiums were driven by:
• | Changes in PIF – Growth in average PIF decreased net earned premiums by $0.9 in the three months ended June 30, 2008 and increased net earned premiums by $4.6 in the six months ended June 30, 2008, compared with the same periods in 2007. |
• | Price changes – Price changes increased net earned premiums by $3.7 in the three months ended June 30, 2008 and $5.6 in the six months ended June 30, 2008, compared with the same periods in 2007. |
• | Mix of business – Mix of business decreased net earned premiums by $2.9 in the three months ended June 30, 2008 and increased net earned premiums by $0.3 in the six months ended June 30, 2008, compared with the same periods in 2007. |
Underwriting Results and Combined Ratio
Our underwriting results in SBI Regular decreased $32.6, or 102.5%, and our combined ratio increased 10.0 points in the three months ended June 30, 2008, compared with the same period in 2007. Our underwriting results in SBI Regular decreased $53.1, or 78.5%, and our combined ratio increased 8.4 points in the six months ended June 30, 2008, compared with the same periods in 2007. Our underwriting results and combined ratio primarily reflected:
• | Price changes – Our price changes decreased our combined ratio by 1.0 points in the three months ended June 30, 2008 and 0.7 points in the six months ended June 30, 2008, compared with the same periods in 2007. |
• | Loss costs – We experienced rising loss severity which increased the combined ratio by 7.4 points in the three months ended June 30, 2008, and 6.1 points in the six months ended June 30, 2008, compared with the same periods in 2007. |
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• | Prior-year reserve development – Prior-year development in the three and six months ended June 30, 2008 decreased the combined ratio by 1.0 points in the three months ended June 30, 2008 and 0.4 points in the six months ended June 30, 2008, compared with the same periods in 2007. |
• | Catastrophe losses – Excluding the impact of prior-year reserve development, the higher catastrophe losses increased the combined ratio by 4.0 points in the three months ended June 30, 2008 and 2.3 points in the six months ended June 30, 2008 compared with the same periods in 2007. |
• | Expenses – The decrease in our expense ratio of 0.5 points in the three months ended June 30, 2008 compared with the same period in 2007 is due to reduced agent compensation expense. For the six months ended June 30, 2008, the expense ratio remained flat compared with the same period in 2007. |
Outlook – We anticipate a challenging market for premium growth in our SBI Regular segment in 2008, in a continuing soft market in which loss cost increases may outpace earned price increases. Our long-term target combined ratio is 95.0%.
SBI SPECIAL ACCOUNTS FACILITY
THREE MONTHS ENDED JUNE 30, | SIX MONTHS ENDED JUNE 30, | |||||||||||||||
2008 | 2007 | 2008 | 2007 | |||||||||||||
Net Written Premiums | $ | 55.6 | $ | 64.3 | $ | 111.8 | $ | 128.9 | ||||||||
Net Earned Premiums | 58.9 | 66.0 | 120.3 | 131.3 | ||||||||||||
Underwriting Profit | 0.2 | 20.1 | 9.9 | 33.2 | ||||||||||||
Favorable Prior-Year Reserve Development | 4.9 | 12.0 | 8.7 | 16.5 | ||||||||||||
Pretax Catastrophe Losses | 5.0 | 0.4 | 5.5 | 0.6 | ||||||||||||
Loss and LAE Ratio | 66.5 | % | 35.6 | % | 59.8 | % | 41.5 | % | ||||||||
Expense Ratio | 33.2 | 33.9 | 32.0 | 33.2 | ||||||||||||
Combined Ratio | 99.7 | % | 69.5 | % | 91.8 | % | 74.7 | % | ||||||||
Our SBI Special Accounts Facility segment includes insurance for large-commercial accounts (those with annual premiums greater than $250,000). While our main focus is the small- to mid-sized market, we continue to serve some large-commercial accounts on behalf of key agents and brokers who sell our core commercial products.
Special Accounts Facility also provides insurance for the following commercial programs:
• | Agents’ errors and omissions insurance |
• | Property and liability insurance for mini-storage and warehouse properties |
• | Professional and general liability insurance for non-profit social service organizations |
Premiums
Net written premiums decreased $8.7, or 13.5%, in the three months ended June 30, 2008 and $17.1, or 13.3%, in the six months ended June 30, 2008, compared with the same periods in 2007. Competitive market conditions continue to exert downward pressure in this segment.
Net earned premiums decreased $7.1, or 10.8%, in the three months ended June 30, 2008 and $11.0, or 8.4%, in the six months ended June 30, 2008, compared with the same periods in 2007.
Underwriting Results and Combined Ratio
Our underwriting profit in SBI Special Accounts Facility decreased $19.9 and our combined ratio increased 30.2 points in the three months ended June 30, 2008, compared with the same period in 2007. Our underwriting profit in SBI Special Accounts Facility decreased $23.3 and our combined ratio increased 17.1 points in the six months ended June 30, 2008, compared with the same period in 2007. Our underwriting results and combined ratios were primarily driven by:
• | Price changes – Price reductions increased our combined ratio by 1.8 points in the three months ended June 30, 2008 and 1.7 points in the six months ended June 30, 2008, compared with the same periods in 2007. |
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• | Loss costs – We experienced increasing claims severity in the three and six months ended June 30, 2008 which increased our combined ratio by 10.6 points in the three months ended June 30, 2008 and 6.9 points in the six months ended June 30, 2008, compared with the same periods in 2007. In the six months ended June 30, 2007 we experienced unusually low loss cost emergence trends. |
• | Prior-year reserve development – We experienced favorable prior-year reserve development in the three and six months ended June 30, 2008 and 2007, driven by favorable loss experience in property lines. The change in the favorable prior-year reserve development increased our combined ratio by 9.9 points in the three months ended June 30, 2008 and 5.3 points in the six months ended June 30, 2008, compared with the same periods in 2007. |
• | Catastrophe losses – Our catastrophe loss experience in the three and six months ended June 30, 2007 was low due to unusually low impact of weather-related losses in 2007. Higher loss levels prevailed in the three and six months ended June 30, 2008, which increased our combined ratio by 7.6 points in the three months ended June 30, 2008 and 4.4 points in the six months ended June 30, 2008, compared with the same periods in 2007. |
• | Expenses - Our expense ratio decreased 0.7 points in the three months ended June 30, 2008 and 1.2 points in the six months ended June 30, 2008 compared with the same periods in the 2007 due to reduced agent compensation, partially offset by an increase in technology investments and higher sales and marketing expenses. |
Outlook – We plan to continue providing a limited large-commercial resource for those agents and brokers who are also writing auto, property or small- to mid-sized commercial insurance with us, and to continue writing specialty insurance programs to the extent market conditions provide reasonable margins.
SURETY
THREE MONTHS ENDED JUNE 30, | SIX MONTHS ENDED JUNE 30, | |||||||||||||||
2008 | 2007 | 2008 | 2007 | |||||||||||||
Net Written Premiums | $ | 121.2 | $ | 106.9 | $ | 224.4 | $ | 199.6 | ||||||||
Net Earned Premiums | 99.3 | 85.8 | 196.6 | 169.4 | ||||||||||||
Underwriting Profit | 54.7 | 37.3 | 94.9 | 73.1 | ||||||||||||
Favorable Prior-Year Reserve Development | 23.0 | 6.6 | 36.7 | 22.8 | ||||||||||||
Loss and LAE Ratio | 4.2 | % | 16.9 | % | 10.8 | % | 16.2 | % | ||||||||
Expense Ratio | 40.7 | 39.5 | 40.9 | 40.6 | ||||||||||||
Combined Ratio | 44.9 | % | 56.4 | % | 51.7 | % | 56.8 | % | ||||||||
Our Surety segment provides surety bonds for construction and commercial businesses.
Premiums
Net written premiums increased $14.3, or 13.4%, in the three months ended June 30, 2008 and $24.8, or 12.4%, in the six months ended June 30, 2008, compared with the same periods in 2007. Strength in construction markets and continued focus on our highest quality accounts drove the increase in net written premiums.
Net earned premiums increased $13.5, or 15.6% in the three months ended June 30, 2008 and $27.2, or 16.1%, in the six months ended June 30, 2008, compared with the same periods in 2007. New business increased net earned premiums by $12.2 in the three months ended June 30, 2008 and $20.3 in the six months ended June 30, 2008, compared with the same periods in 2007.
Underwriting Results and Combined Ratio
Our underwriting profit in Surety increased $17.4 in the three months ended June 30, 2008 and $21.8 in the six months ended June 30, 2008, compared with the same periods in 2007. The increase in underwriting profit was driven by premium growth, combined with a low level of loss experience and expense management. Our combined ratio decreased 11.5 points in the three months ended June 30, 2008 and 5.1 points in the six months ended June 30, 2008 as loss experience was lower than the same periods in 2007.
Outlook –Industry results remained stable in the first six months of 2008 and we expect the surety market to remain healthy through 2008. While we expect that infrastructure improvement needs will continue to drive demand, current economic uncertainty
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may alter our risk assessments and temper future growth. Overall, we expect our growth rates will moderate and loss experience to shift from historically low levels in the remainder of 2008.
P&C OTHER
THREE MONTHS ENDED JUNE 30, | SIX MONTHS ENDED JUNE 30, | |||||||||||||||
2008 | 2007 | 2008 | 2007 | |||||||||||||
Net Written Premiums | $ | 0.5 | $ | 0.7 | $ | — | $ | 3.7 | ||||||||
Net Earned Premiums | 0.7 | 1.3 | 2.2 | 1.0 | ||||||||||||
Underwriting Profit (Loss) | (7.9 | ) | (5.2 | ) | 0.8 | (21.3 | ) | |||||||||
Unfavorable Prior-Year Reserve Development | $ | (6.9 | ) | $ | (5.9 | ) | $ | (4.5 | ) | $ | (19.1 | ) | ||||
Pretax Catastrophe Losses | $ | 0.1 | $ | (6.0 | ) | $ | 0.4 | $ | (7.6 | ) | ||||||
Our P&C Other segment includes:
• | Run-off assumed reinsurance business |
• | Large-commercial business accounts in runoff and specialty programs that we have exited |
• | Our own self-insurance |
• | Asbestos and environmental results |
• | Run-off religious institutions |
• | Results of business related to Safeco Financial Institution Solutions (SFIS), our lender-placed property insurance business, which we sold on April 30, 2006 |
Premiums
Net written premiums decreased $0.2 in the three months ended June 30, 2008 and $3.7 in the six months ended June 30, 2008, compared with the same periods in 2007. Net earned premiums decreased $0.6 in the three months ended June 30, 2008 and increased $1.2 in the six months ended June 30, 2008, compared with the same periods in 2007. The increase in the six months ended June 30, 2008 compared with the same period in 2007 was due to increased premiums in large commercial accounts in run-off.
Underwriting Results
Our underwriting results in P&C Other decreased $2.6 in the three months ended June 30, 2008 and increased $22.1 in the six months ended June 30, 2008, compared with the same periods in 2007 primarily due to the unfavorable prior-year reserve development $4.5 in the first six months of 2008 compared with the unfavorable prior-year reserve development of $19.1 in the first six months of 2007 relating to assumed reinsurance treaties and religious institutions. The underwriting profit in the first six months of 2008 also includes $3.1 of service fee commission income related to SFIS.
Our Corporate Results
THREE MONTHS ENDED JUNE 30, | SIX MONTHS ENDED JUNE 30, | |||||||||||||||
2008 | 2007 | 2008 | 2007 | |||||||||||||
Corporate Segment Results | $ | (13.0 | ) | $ | (20.7 | ) | $ | (17.2 | ) | $ | (39.6 | ) | ||||
Net Realized Investment Gains | 1.4 | 9.8 | 10.0 | 15.6 | ||||||||||||
Loss before Income Taxes | $ | (11.6 | ) | $ | (10.9 | ) | $ | (7.2 | ) | $ | (24.0 | ) | ||||
In our Corporate segment we include:
• | Interest expense on our debt |
• | Miscellaneous corporate investment and other activities, including real estate holdings and transactions and losses on debt repurchases and contributions to the Safeco Insurance Foundation |
• | Our intercompany eliminations |
• | Merger related expenses |
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Our interest expense was $6.7 in the three months ended June 30, 2008, compared with $22.0 in the three months ended June 30, 2007. Our interest expense was $13.8 in the six months ended June 30, 2008, compared with $46.2 in the six months ended June 30, 2007. The decrease in interest expense reflects a reduction in outstanding debt due to the maturity of debt in February 2008 and maturity and the redemption of debt in 2007.
We repaid $200.0 in principal amount of 4.200% senior notes that matured on February 1, 2008.
OUR INVESTMENT RESULTS
INVESTMENT PORTFOLIO
These tables summarize our investment portfolio at June 30, 2008 and December 31, 2007:
JUNE 30, 2008 | COST OR AMORTIZED COST | GROSS UNREALIZED GAINS | GROSS UNREALIZED LOSSES | NET UNREALIZED GAINS (LOSSES) | CARRYING VALUE | ||||||||||||
P&C | |||||||||||||||||
Fixed Maturities – Taxable | $ | 2,551.2 | $ | 59.1 | $ | (39.7 | ) | $ | 19.4 | $ | 2,570.6 | ||||||
Fixed Maturities – Non-taxable | 4,795.0 | 83.5 | (141.1 | ) | (57.6 | ) | 4,737.4 | ||||||||||
Marketable Equity Securities | 1,058.5 | 262.4 | (25.0 | ) | 237.4 | 1,295.9 | |||||||||||
Short-Term Investments | 1.5 | — | — | — | 1.5 | ||||||||||||
Other Invested Assets | 52.1 | — | — | — | 52.1 | ||||||||||||
Total P&C | 8,458.3 | 405.0 | (205.8 | ) | 199.2 | 8,657.5 | |||||||||||
Corporate | |||||||||||||||||
Fixed Maturities – Taxable | 100.2 | 0.8 | (1.5 | ) | (0.7 | ) | 99.5 | ||||||||||
Marketable Equity Securities | 49.6 | 2.0 | (1.6 | ) | 0.4 | 50.0 | |||||||||||
Short-Term Investments | 11.0 | — | — | — | 11.0 | ||||||||||||
Other Invested Assets | 1.1 | — | — | — | 1.1 | ||||||||||||
Total Corporate | 161.9 | 2.8 | (3.1 | ) | (0.3 | ) | 161.6 | ||||||||||
Total Investment Portfolio | $ | 8,620.2 | $ | 407.8 | $ | (208.9 | ) | $ | 198.9 | $ | 8,819.1 | ||||||
DECEMBER 31, 2007 | COST OR AMORTIZED COST | GROSS UNREALIZED GAINS | GROSS UNREALIZED LOSSES | NET UNREALIZED GAINS | CARRYING VALUE | ||||||||||||
P&C | |||||||||||||||||
Fixed Maturities – Taxable | $ | 2,766.6 | $ | 80.6 | $ | (14.0 | ) | $ | 66.6 | $ | 2,833.2 | ||||||
Fixed Maturities – Non-taxable | 4,685.2 | 132.6 | (52.1 | ) | 80.5 | 4,765.7 | |||||||||||
Marketable Equity Securities | 950.7 | 410.3 | (13.4 | ) | 396.9 | 1,347.6 | |||||||||||
Other Invested Assets | 47.0 | — | — | — | 47.0 | ||||||||||||
Total P&C | 8,449.5 | 623.5 | (79.5 | ) | 544.0 | 8,993.5 | |||||||||||
Corporate | |||||||||||||||||
Fixed Maturities – Taxable | 163.4 | 1.9 | (0.3 | ) | 1.6 | 165.0 | |||||||||||
Marketable Equity Securities | 42.5 | 13.2 | (0.7 | ) | 12.5 | 55.0 | |||||||||||
Other Invested Assets | 1.6 | — | — | — | 1.6 | ||||||||||||
Total Corporate | 207.5 | 15.1 | (1.0 | ) | 14.1 | 221.6 | |||||||||||
Total Investment Portfolio | $ | 8,657.0 | $ | 638.6 | $ | (80.5 | ) | $ | 558.1 | $ | 9,215.1 | ||||||
At June 30, 2008 and December 31, 2007, there were no investments in any one industry that accounted for more than 10% of our total gross unrealized losses.
We reviewed all our investments with unrealized losses as of June 30, 2008. For all investments other than those for which we recognized an impairment charge, our evaluation determined that their declines in fair value were temporary, and we have the intent and ability to hold these securities until they recover in value.
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This table shows, by maturity, the total amount of gross unrealized losses on fixed maturities and marketable equity securities at June 30, 2008:
JUNE 30, 2008 | COST OR AMORTIZED COST | FAIR VALUE | COST IN EXCESS OF FAIR VALUE | ||||||
Fixed Maturities | |||||||||
One Year or Less | $ | 32.9 | $ | 32.8 | $ | 0.1 | |||
Over One Year through Five Years | 475.0 | 467.2 | 7.8 | ||||||
Over Five Years through Ten Years | 405.7 | 394.2 | 11.5 | ||||||
Over Ten Years | 2,700.4 | 2,561.0 | 139.4 | ||||||
Mortgage-Backed Securities | 526.2 | 502.7 | 23.5 | ||||||
Total Fixed Maturities | 4,140.2 | 3,957.9 | 182.3 | ||||||
Total Marketable Equity Securities | 452.0 | 425.4 | 26.6 | ||||||
Total | $ | 4,592.2 | $ | 4,383.3 | $ | 208.9 | |||
Unrealized losses on our fixed maturities that have been in a loss position for more than a year at June 30, 2008 were $93.1 compared with $6.1 at December 31, 2007. There were no unrealized losses on our marketable equity securities that were in a loss position for more than a year at June 30, 2008 or December 31, 2007. Total unrealized losses were less than 2.4% of our total portfolio value at June 30, 2008 and less than 1% at December 31, 2007.
We continue to monitor these securities as part of our overall portfolio evaluation. If we determine that an unrealized loss is other-than-temporary, we report an impairment loss in the period that we make that determination.
FAIR VALUE OF INVESTMENTS
The total fair value of assets measured using significant unobservable inputs (Level 3) was $184.8 as of June 30, 2008, which is 2% of our total assets measured at fair value on a recurring basis. During the six months ended June 30, 2008, fixed income securities with a fair value of $27.9 were transferred from Level 3 to Level 2 because new prices were obtained during the period that were based on observable inputs. The fair value of these securities decreased by $9.3, of which $7.5 was recognized as a realized loss for certain securities that became impaired during the period due to credit related events. Private placement fixed income securities with a total fair value of $19.8 were transferred from Level 2 to Level 3 during the period because prices using observable inputs were not available as of June 30, 2008. The fair value of these securities decreased by $0.6 which was reported as a change in unrealized gains in other comprehensive income.
DIVERSIFICATION
Our investment portfolio is diversified by issuer and industry type with no single issuer exceeding 1% of the fair value of our consolidated investment portfolio, except the U.S. Government fixed maturities and investments in several funds managed by BlackRock, Inc. As of June 30, 2008, the total fair value of our investments in funds managed by BlackRock, Inc. was $254.2, which is 2.9% of the fair value of our consolidated investment portfolio. Our investment portfolio adviser is BlackRock Financial Management, Inc., a wholly-owned subsidiary of BlackRock, Inc. We do not rely on the presence of bond insurance in the selection of securities for our portfolio. We evaluate the underlying credit worthiness of the entity in our selection process.
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These tables show our investment types and industries of our fixed maturities and marketable equity securities that exceed 3% of our portfolio at June 30, 2008 and December 31, 2007:
JUNE 30, 2008 | CARRYING VALUE | PERCENT OF TOTAL | ||||
States and Political Subdivisions | $ | 4,826.7 | 54.7 | % | ||
Banks | 305.7 | 3.5 | ||||
U.S. Government and Agencies | 336.7 | 3.8 | ||||
Mortgage-Backed Securities | 873.4 | 9.9 | ||||
Other | 2,423.4 | 27.5 | ||||
Total Fixed Maturities and Marketable Equity Securities | 8,765.9 | 99.4 | ||||
Other Invested Assets | 53.2 | 0.6 | ||||
Total Investment Portfolio | $ | 8,819.1 | 100.0 | % | ||
DECEMBER 31, 2007 | CARRYING VALUE | PERCENT OF TOTAL | ||||
States and Political Subdivisions | $ | 4,825.9 | 52.4 | % | ||
Banks | 322.1 | 3.5 | ||||
U.S. Government and Agencies | 384.2 | 4.2 | ||||
Mortgage-Backed Securities | 1,012.0 | 11.0 | ||||
Diversified Financial Services | 233.5 | 2.5 | ||||
Other | 2,388.8 | 25.9 | ||||
Total Fixed Maturities and Marketable Equity Securities | 9,166.5 | 99.5 | ||||
Other Invested Assets | 48.6 | 0.5 | ||||
Total Investment Portfolio | $ | 9,215.1 | 100.0 | % | ||
INVESTMENT PORTFOLIO QUALITY
The quality ratings of our fixed maturities portfolio were:
RATING | PERCENT AT JUNE 30, 2008 | PERCENT AT DECEMBER 31, 2007 | ||||
AAA | 39 | % | 59 | % | ||
AA | 33 | 16 | ||||
A | 14 | 12 | ||||
BBB | 9 | 8 | ||||
Subtotal | 95 | 95 | ||||
BB or lower | 3 | 3 | ||||
Not Rated | 2 | 2 | ||||
Total | 100 | % | 100 | % | ||
The significant shift in our portfolio from AAA to AA is primarily due to downgrades within our municipal holdings.
Below Investment Grade and Other Securities– A security is considered below investment grade if it has a rating below BBB. This table shows the details of our below investment grade fixed maturities at June 30, 2008 and December 31, 2007:
JUNE 30, 2008 | DECEMBER 31, 2007 | |||||||
Amortized Cost | $ | 231.2 | $ | 229.1 | ||||
Gross Unrealized Gains | 2.3 | 2.9 | ||||||
Gross Unrealized Losses | (6.8 | ) | (3.8 | ) | ||||
Fair Value | $ | 226.7 | $ | 228.2 | ||||
Percent of Total Fixed Maturities | 3.1 | % | 2.9 | % |
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This table shows the non-publicly traded and not-rated securities in our portfolio at June 30, 2008 and December 31, 2007:
JUNE 30, 2008 | DECEMBER 31, 2007 | |||||||||||
FAIR VALUE | PERCENT OF TOTAL PORTFOLIO | FAIR VALUE | PERCENT OF TOTAL PORTFOLIO | |||||||||
Non-Publicly Traded Fixed Maturities and Marketable Equity Securities | $ | 156.2 | 1.8 | % | $ | 149.8 | 1.6 | % | ||||
Not-Rated Fixed Maturities | $ | 150.3 | 1.7 | % | $ | 127.5 | 1.4 | % |
MORTGAGE-BACKED SECURITIES
Our mortgage-backed securities consist mainly of commercial mortgage-based securities (CMBSs), residential collateralized mortgage obligations (CMOs) and residential mortgage-bonded pass-throughs. We have no collateralized debt obligations (CDOs), home equity lines of credit (HELOCs) or similar securities in our portfolio.
NET INVESTMENT INCOME
This table summarizes our pretax net investment income by portfolio:
THREE MONTHS ENDED JUNE 30, | SIX MONTHS ENDED JUNE 30, | |||||||||||
2008 | 2007 | 2008 | 2007 | |||||||||
P&C | $ | 109.5 | $ | 120.1 | $ | 218.7 | $ | 241.2 | ||||
Corporate | 2.7 | 8.1 | 5.1 | 14.2 | ||||||||
Total Net Investment Income | $ | 112.2 | $ | 128.2 | $ | 223.8 | $ | 255.4 | ||||
Our annualized investment income yields were:
THREE MONTHS ENDED JUNE 30, | SIX MONTHS ENDED JUNE 30, | |||||||||||
2008 | 2007 | 2008 | 2007 | |||||||||
Pretax | 5.1 | % | 5.3 | % | 5.0 | % | 5.2 | % | ||||
After Tax | 4.1 | % | 4.2 | % | 4.1 | % | 4.1 | % |
The decrease of $16.0 in net investment income in the three months and $31.6 in the six months ended June 30, 2008 compared with the same periods in 2007 was a result of an overall lower invested asset base due primarily to the sale of securities to fund our debt maturity and redemption, share repurchases and the special dividend paid by our insurance subsidiaries to Safeco Corporation in 2007 that were not reinvested.
Our after-tax yields decreased slightly in the three and six months ended June 30, 2008, compared with the same periods in 2007.
Our portfolio duration is an important part of our investment returns. Duration is a measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates. Duration is expressed as a number of years. The larger the duration number, the greater the interest-rate risk or reward for bond prices. Our effective duration was 5.2 at June 30, 2008 compared with 4.8 at December 31, 2007. The fixed income portfolio has not materially changed during the three and six months ended June 30, 2008. The change in duration reflects the drop in municipal bond prices experienced during 2008. At December 31, 2007, many of the municipals in the portfolio were priced and modeled to the earliest call date. During the six months ended June 30, 2008, municipal bond prices fell as the market grew concerned about bond insurers and as liquidity in the market was reduced. This drop in price caused the municipal bonds to be modeled to their respective maturity date. Since many bonds are now priced to the maturity date, instead of the call date, the overall duration of the fixed income portfolio is now longer than it was compared with the same period in the prior year.
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NET REALIZED INVESTMENT GAINS AND LOSSES
Pretax net realized investment gains by portfolio were:
THREE MONTHS ENDED JUNE 30, | SIX MONTHS ENDED JUNE 30, | |||||||||||
2008 | 2007 | 2008 | 2007 | |||||||||
P&C | $ | 15.2 | $ | 7.6 | $ | 0.1 | $ | 14.2 | ||||
Corporate | 1.3 | 9.8 | 9.9 | 15.6 | ||||||||
Total Pretax Net Realized Investment Gains | $ | 16.5 | $ | 17.4 | $ | 10.0 | $ | 29.8 | ||||
Pretax net realized investment gains and losses by component were:
THREE MONTHS ENDED JUNE 30, | SIX MONTHS ENDED JUNE 30, | |||||||||||||||
2008 | 2007 | 2008 | 2007 | |||||||||||||
Fixed Maturities Transactions: | ||||||||||||||||
Gross Gains | $ | 9.4 | $ | 5.3 | $ | 12.3 | $ | 8.7 | ||||||||
Gross Losses | (0.8 | ) | (1.6 | ) | (2.9 | ) | (2.3 | ) | ||||||||
Marketable Equity Securities Transactions: | ||||||||||||||||
Gross Gains | 50.2 | 6.4 | 92.5 | 15.0 | ||||||||||||
Gross Losses | (5.6 | ) | — | (11.9 | ) | (2.3 | ) | |||||||||
Total Net Gains on Securities Transactions | 53.2 | 10.1 | 90.0 | 19.1 | ||||||||||||
Impairments on Fixed Maturities | (7.0 | ) | (2.9 | ) | (24.2 | ) | (3.5 | ) | ||||||||
Impairments on Marketable Equity Securities | (33.4 | ) | — | (59.0 | ) | (1.8 | ) | |||||||||
Total Impairments | (40.4 | ) | (2.9 | ) | (83.2 | ) | (5.3 | ) | ||||||||
Other, Net | 3.7 | 10.2 | 3.2 | 16.0 | ||||||||||||
Total Pretax Net Realized Investment Gains | $ | 16.5 | $ | 17.4 | $ | 10.0 | $ | 29.8 | ||||||||
NET GAINS ON SECURITIES TRANSACTIONS
The fair value and total net realized investment loss of fixed maturities and marketable equity securities that we sold at a loss were:
THREE MONTHS ENDED JUNE 30, | SIX MONTHS ENDED JUNE 30, | |||||||||||
2008 | 2007 | 2008 | 2007 | |||||||||
Fair Value | $ | 34.7 | $ | 155.7 | $ | 81.6 | $ | 314.4 | ||||
Total Net Realized Investment Loss | 6.2 | 1.4 | 14.3 | 4.2 |
The securities sold at a loss in the three and six months ended June 30, 2008 primarily related to securities with credit-related losses in connection with market volatility. The securities sold at a loss in the three and six months ended June 30, 2007 primarily related to non-performing securities.
We recognized net realized gains of $44.6 on sales of marketable equity securities in the three months ended June 30, 2008 and $80.6 in the six months ended June 30, 2008, primarily due to sales of securities to restructure the equity portfolio and increase investment in international securities.
IMPAIRMENTS
We closely monitor every investment that has declined in fair value to below cost or amortized cost. If we determine that the decline is other-than-temporary, we write down the security to its fair value and report the charge as an impairment in Net Realized Investment Gains in the Consolidated Statements of Income in the period that we make this determination. More information about our process of estimating investment impairments can be found in the discussion of Application of Critical Accounting Estimates in the MD&A section of our 2007 Annual Report on Form 10-K.
In our impairment determination process, we consider our intent and ability to hold to maturity investments that decline in value. Our intent to hold an investment could change due to changes in the financial condition and near-term prospects of the issuer or significant changes in our cash needs as a result of a major catastrophe.
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We continually monitor our investment portfolio and markets for opportunities to:
• | Manage credit quality |
• | Reduce our exposure to companies and industries with credit problems |
• | Manage call risk |
Pretax investment impairments by portfolio were:
THREE MONTHS ENDED JUNE 30, | SIX MONTHS ENDED JUNE 30, | |||||||||||
2008 | 2007 | 2008 | 2007 | |||||||||
P&C | ||||||||||||
Fixed Maturities | $ | 6.9 | $ | 1.6 | $ | 24.1 | $ | 2.2 | ||||
Marketable Equity Securities | 30.2 | — | 54.9 | 1.8 | ||||||||
Corporate | ||||||||||||
Fixed Maturities | 0.1 | 1.3 | 0.1 | 1.3 | ||||||||
Marketable Equity Securities | 3.2 | — | 4.1 | — | ||||||||
Total Pretax Investment Impairments | $ | 40.4 | $ | 2.9 | $ | 83.2 | $ | 5.3 | ||||
The increase in impairments in the three and six months ended June 30, 2008 compared with the same periods in 2007 was due to credit-related events due to recent volatility in the credit market, and included additional impairments on previously impaired securities.
CAPITAL RESOURCES AND LIQUIDITY
OUR LIQUIDITY NEEDS
Liquidity is a measure of our ability to generate sufficient cash flows to meet the short- and long-term cash requirements of our insurance operations.
P&C insurance liabilities are somewhat unpredictable and largely short term in duration. Our payments to policyholders depend upon losses they suffer from accidents or other unpredictable events that are covered by insurance. Although we estimate how much cash we’ll need and when we’ll need it based on prior experience and the mix of business we write, we cannot predict all future events, particularly catastrophes. As a result, we invest most of our money in high-quality liquid securities – investments that can quickly be turned into cash – to support our projected or potential need for liquidity.
We believe that cash flows from our operations, investment portfolio and bank credit facility are sufficient to meet our future liquidity needs. For more information about our financial abilities, see the Financial Strength Ratings section.
SOURCES OF OUR FUNDS
We get cash from insurance premiums, dividends from our subsidiaries, investment income, sales or maturity of investments, and debt and equity offerings.
We have not engaged in the sale of investments or other assets by securitization.
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Our cash flow for the six months ended June 30, 2008 and 2007 was:
2008 | 2007 | |||||||
Cash and Cash Equivalents – Beginning of Period | $ | 532.0 | $ | 287.6 | ||||
Net Cash Provided by (Used in): | ||||||||
Operating Activities | 238.3 | 266.4 | ||||||
Investing Activities | 88.6 | 569.3 | ||||||
Financing Activities | (314.6 | ) | (427.8 | ) | ||||
Cash and Cash Equivalents – End of Period | $ | 544.3 | $ | 695.5 | ||||
Net cash provided by operating activities decreased by $28.1, or 10.5%, in the six months ended June 30, 2008, compared with the same period in the prior year driven primarily by lower insurance premiums received, lower interest and dividends received, and higher loss and loss adjustment expenses paid, offset by lower underwriting costs and lower interest payments.
Net cash provided by investing activities decreased $480.7, or 84.4%, in the six months ended June 30, 2008, compared with the same period in the prior year, primarily due to increased sales and decreased purchases of marketable equity securities, offset by decreased purchases and sales of fixed maturities, an increase in short-term investments and a decrease in securities lending collateral invested.
Net cash used in by financing activities decreased $113.2, or 26.5%, in the six months ended June 30, 2008, compared with the same period in the period year, primarily as a result of reductions in payments of securities lending collateral and common stock reacquired, partially offset by our repayment of $200.0 of the 4.20% senior notes which matured on February 1, 2008.
The changes in cash from financing activities were a result of our share and debt repurchases described below.
HOW WE USE OUR FUNDS
We use funds to support our operations, make interest and principal payments on debt, and grow our investment portfolio.
We use cash from insurance operations primarily to pay claims, underwriting expenses and claim adjustment expenses. We require insurance premiums to be paid in advance. As a result, cash flows into our business before or at the time premium revenues are recognized. Cash flows out of our business in subsequent months or years as claims are paid and expenses incurred.
In the first six months of 2008 we used $200.0 to repay debt, compared with no such activity in the first six months of 2007.
OUR CAPITAL STRUCTURE
Capital resources protect our policyholders, provide us with financial strength and facilitate continued business growth. Our capital structure consists of debt and equity as follows:
JUNE 30, 2008 | DECEMBER 31, 2007 | |||||||
Total Debt | $ | 504.0 | $ | 704.0 | ||||
Equity Excluding Accumulated Other Comprehensive Income (AOCI) | 3,254.1 | 3,025.3 | ||||||
AOCI | 130.8 | 367.3 | ||||||
Total Shareholders’ Equity | 3,384.9 | 3,392.6 | ||||||
Total Capitalization | $ | 3,888.9 | $ | 4,096.6 | ||||
Ratio of Debt to Equity | 14.9 | % | 20.8 | % | ||||
Ratio of Debt to Capitalization | 13.0 | % | 17.2 | % | ||||
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Repurchases of Debt – We repaid $200.0 in principal amount of 4.200% senior notes that matured on February 1, 2008.
Our Bank Credit Facility – We maintain a $300.0 revolving credit facility, which may be used for working capital and general corporate purposes. The terms of the bank credit facility – which runs through March 2010 – require us to:
• | Pay a fee to have these funds available |
• | Maintain a minimum level of $2,700.0 shareholders’ equity plus 50% of accumulated net income |
• | Keep our debt-to-capitalization ratio below a maximum of 37.5% |
The bank credit facility does not require us to maintain any deposits as compensating balances. As of June 30, 2008, we had no borrowings under the bank credit facility and we were in compliance with all its covenants.
Share Repurchases – In December 2007, we received approval from the Board to repurchase up to $500.0 of our outstanding common stock in open market purchases. As of June 30, 2008, we purchased no shares under this authorization.
OFF-BALANCE SHEET ARRANGEMENTS
We have no material off-balance sheet arrangements.
MERGER AGREEMENT
On April 23, 2008, we entered into an Agreement and Plan of Merger (the “Merger Agreement”) with Liberty Mutual Insurance Company, a Massachusetts stock insurance company (“Liberty Mutual”), and Big Apple Merger Corporation, a Washington corporation and a wholly owned subsidiary of Liberty Mutual (“Merger Sub”).
Subject to the terms and conditions of the Merger Agreement, Merger Sub will merge with and into us and we will continue as the surviving corporation and a wholly owned subsidiary of Liberty Mutual (the “Merger”). At the effective time of the Merger, each outstanding share of our common stock, other than shares owned by us or Liberty Mutual and any dissenting shares in the Merger, will be automatically converted into the right to receive $68.25 in cash, without interest, subject to any applicable withholding tax.
The Merger Agreement has been approved by Safeco’s and Liberty Mutual’s respective Boards of Directors. The consummation of the Merger is subject to a number of customary closing conditions, including, but not limited to, (i) approval of the Merger Agreement by our shareholders, (ii) expiration or termination of the applicable Hart-Scott-Rodino Act (“HSR Act”) waiting period, (iii) receipt of specified regulatory consents and approvals, including state insurance department approvals in Washington, Missouri, Illinois, Texas, Indiana, Oregon and California, (iv) the absence of any law, order or injunction prohibiting the consummation of the Merger and (v) the absence of any material governmental litigation seeking to challenge, restrain, or prohibit consummation of the Merger. As of June 3, 2008, the 30-day statutory waiting period under the HSR Act expired.
The Merger Agreement contains certain termination rights for both Safeco and Liberty Mutual, and further provides that, upon termination of the Merger Agreement under specified circumstances, Safeco may be required to pay Liberty Mutual a termination fee of $182.5.
Following the announcement that we had entered into a merger agreement with Liberty Mutual and Merger Sub, the outlook for our credit ratings was updated by A.M. Best, Standard and Poor’s, Moody’s Investors and Fitch Rating, which left us on a negative rating watch. All agencies have indicated that their ratings outlook would be revised upon the closing of the transaction in the third quarter of 2008.
The transaction is not subject to financing contingencies and is expected to close by the end of the third quarter of 2008. The Merger Agreement does not restrict our ability to declare or pay dividends. The Merger is contingent upon approval by a two-thirds vote of our shares outstanding at our annual meeting scheduled to be held July 29, 2008.
APPLICATION OF CRITICAL ACCOUNTING ESTIMATES
We have identified the accounting estimates for loss and loss adjustment expense reserves, reinsurance recoverables, and valuation of investments as critical to understanding our results of operations and financial condition. The application of these accounting estimates requires us to use judgments involving assumptions and estimates about future results, trends or other developments that could significantly influence our results if actual experience differs from those assumptions and estimates. We review these judgments frequently.
Please see additional discussion of critical accounting estimates in the MD&A section of our 2007 Annual Report on Form 10-K.
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NEW ACCOUNTING STANDARDS
A discussion of new accounting standards can be found in Note 1 to our Consolidated Financial Statements.
ITEM 4 – CONTROLS AND PROCEDURES
DISCLOSURE CONTROLS AND PROCEDURES
As required by Rule 13a-15(b) of the Securities Exchange Act of 1934 (the Exchange Act), under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we have evaluated the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Exchange Act). Based on that evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures were effective as of the end of the period covered by this report in providing a reasonable level of assurance that information we are required to disclose in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms, and a reasonable level of assurance that information required to be disclosed by us in such reports is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.
CHANGES IN INTERNAL CONTROL OVER FINANCIAL REPORTING
As required by Rule 13a-15(d) of the Exchange Act, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we have evaluated our internal control over financial reporting and determined that there were no changes that occurred during the quarter covered by this report that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. Based on that evaluation, there has been no such change during the second quarter.
Safeco Corporation and Subsidiaries
In common with the insurance and financial service industries in general, we are subject to legal actions filed or threatened, including claims for punitive damages, in the ordinary course of our operations. Generally, our involvement in legal actions involves defending third-party claims brought against our insureds (in our role as liability insurer) or principals of surety bonds and defending policy coverage claims brought against us.
Litigation arising from claims settlement activities is generally considered in the establishment of our reserve for Loss and Loss Adjustment Expenses (LAE). However, in certain circumstances, we may deem it necessary to provide disclosure due to the size or nature of the potential liability to us.
Based on information currently known to us, we believe that the ultimate outcome of any pending matters is not likely to have a material adverse effect on our financial position or results of operations.
On May 9, 2008, a purported class action complaint,Loren v. Brown, et al, Action No. CV80733 RSM, was filed against Safeco and its directors, allegedly on behalf of Safeco shareholders, in the United States District Court for the Western District of Washington. The complaint alleges, among other matters, that the terms on which the Safeco board of directors agreed for Safeco to be acquired by Liberty Mutual constitute a breach of the directors’ fiduciary and other duties due to the inadequacy of the consideration to be received by the class and the defendants’ alleged failure to explore other alternatives. The complaint seeks injunctive and other relief against consummation of the merger and unspecified monetary damages.
On June 2, 2008 a purported class action complaint on behalf of Safeco’s shareholders,Gotham Investors v. Reynolds, et al., was filed against Safeco, Safeco’s directors and Liberty Mutual in King County, Washington Superior Court. That action was subsequently removed by defendants to the U.S. District Court for the Western District of Washington where it bears No. 2:08-cv-980. The complaint alleges that the merger agreement advances the interests of Safeco’s directors and Liberty Mutual at the expense of Safeco shareholders, principally because of an alleged failure to explore other possible transactions, and that the preliminary proxy statement filed by Safeco on or about May 23, 2008, was deficient in failing to disclose the amount of the compensation received by Morgan Stanley for its prior work on behalf of Liberty Mutual and its expectation of future work, as well as certain details of the methodologies used in assessing the consideration to be received pursuant to the merger agreement.
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The plaintiffs, Safeco and Liberty Mutual entered into a memorandum of understanding reflecting a settlement in principle of the complaints in theLoren v. Brown, et al. andGotham Investors v. Reynolds, et al. actions on June 24, 2008. In connection with the settlement, (1) Safeco has included certain additional disclosures in its proxy statement and (2) Liberty Mutual has agreed that for the six month period beginning on the date of closing of the Merger, Liberty Mutual will not, and will use its reasonable best efforts to cause its affiliates not to, consummate any transaction in which it sells 90% or more of Safeco’s assets (as existing on the date of consummation of the Merger) to an unaffiliated third party, whether by merger, consolidation, or otherwise, for an amount in excess of 120% of the amount that Liberty Mutual paid in connection with the Merger (including transaction costs incurred by Liberty Mutual and Safeco and any debt assumed or issued in connection with the Merger), which is referred to as a flip transaction, unless Liberty Mutual pays or causes to be paid to the members of the shareholder class an amount equal to 10% of any amount in excess of 120% of the amount that Liberty Mutual paid in connection with the merger (including transaction costs incurred by Liberty Mutual and Safeco and any debt assumed or issued in connection with the merger), up to a maximum payment of $15.0.
The settlement will not affect the amount or form of the merger consideration that Safeco shareholders are entitled to receive in the proposed merger or otherwise modify the terms of the transaction, other than in connection with the consummation of a flip transaction as described above. Under the terms of the settlement, the parties have agreed to enter into a stipulation of settlement that will dismiss the claims in the two complaints with prejudice and release the defendants, Liberty Mutual, Safeco, and the current and former directors of Safeco, and their current and former affiliates, representatives and advisors from all of the claims that were or could have been brought in the settled litigation, including all claims relating to the merger, the merger agreement and any disclosure made in connection therewith. Liberty Mutual has agreed to pay on behalf of all of the defendants without contribution from them the sum of $850,000 to plaintiffs’ counsel for attorneys’ fees and expenses within five business days after final dismissal of the two actions. The settlement will be contingent upon, among other things, confirmatory due diligence, consummation of the merger and final court approval.
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31.1 | Certification of Chief Executive Officer of Safeco Corporation dated July 28, 2008, in accordance with Rule 13a-14 or 15d-14 of the Securities Exchange Act of 1934 as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. | |
31.2 | Certification of Chief Financial Officer of Safeco Corporation dated July 28, 2008, in accordance with Rule 13a-14 or 15d-14 of the Securities Exchange Act of 1934 as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. | |
32.1 | Certification of Chief Executive Officer of Safeco Corporation dated July 28, 2008, in accordance with 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. | |
32.2 | Certification of Chief Financial Officer of Safeco Corporation, dated July 28, 2008, in accordance with 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
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Safeco Corporation
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized on July 28, 2008.
Safeco Corporation Registrant | ||
/s/ Kris L. Hill | ||
Kris L. Hill Vice President, Controller and Principal Accounting Officer |
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