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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, 2005.
-------------
[ ] Transition Report Pursuant to Section 13 or 15 (d) of the Securities
Exchange Act of 1934
For the transition period from to
---------------- -------------
Commission File Number 0-05544
OHIO CASUALTY CORPORATION
(Exact name of registrant as specified in its charter)
OHIO 31-0783294
(State or other jurisdiction of) (I.R.S. Employer)
incorporation or organization) Identification No.)
9450 Seward Road, Fairfield, Ohio 45014
(Address of principal executive offices) (Zip Code)
(513) 603-2400
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15 (d) of the Securities Exchange Act
of 1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to
such filing requirements for the past 90 days.
Yes X No
Indicate by check mark whether the registrant is an accelerated filer
(as defined in Rule 12b-2 of the Exchange Act).
Yes X No
On July 25, 2005, there were 64,487,792 shares of common stock
outstanding.
Page 1 of 33
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INDEX
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Page
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PART I FINANCIAL INFORMATION
Item 1. Financial Statements 3
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations 18
Item 3. Quantitative and Qualitative Disclosures about
Market Risk 31
Item 4. Controls and Procedures 31
PART II OTHER INFORMATION
Item 4. Submission of Matters to a Vote of
Security Holders 32
Item 6. Exhibits 32
Signature 33
Exhibit 10 Ohio Casualty Corporation 2005 Incentive Plan
Exhibit 31.1 Certification of Chief Executive Officer of
Ohio Casualty Corporation in accordance with
SEC Rule 13(a)-14(a) and Rule 15(d)-14(a)
Exhibit 31.2 Certification of Chief Financial Officer of
Ohio Casualty Corporation in accordance with
SEC Rule 13(a)-14(a) and Rule 15(d)-14(a)
Exhibit 32.1 Certification of Chief Executive Officer of
Ohio Casualty Corporation in accordance with
Section 1350 of the Sarbanes-Oxley Act of 2002
Exhibit 32.2 Certification of Chief Financial Officer of
Ohio Casualty Corporation in accordance with
Section 1350 of the Sarbanes-Oxley Act of 2002
2
PART I FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
Ohio Casualty Corporation & Subsidiaries
CONSOLIDATED BALANCE SHEETS
June 30, December 31,
(in millions, except share data) 2005 2004
===========================================================================================
Assets (Unaudited)
Investments, at fair value:
Fixed maturities:
Available-for-sale, at fair value
(amortized cost: $3,354.5 and $3,176.8) $ 3,521.7 $ 3,346.1
Held-to-maturity, at amortized cost
(fair value: $287.1 and $303.1) 283.3 301.4
Equity securities, at fair value
(cost: $102.2 and $98.9) 356.8 357.4
Short-term investments, at fair value 24.7 239.1
- -------------------------------------------------------------------------------------------
Total investments 4,186.5 4,244.0
Cash 10.0 13.5
Premiums and other receivables, net of allowance 334.2 350.8
Deferred policy acquisition costs 152.9 159.8
Property and equipment, net of accumulated depreciation 81.9 82.9
Reinsurance recoverable, net of allowance 703.8 666.5
Agent relationships, net of accumulated amortization 114.3 122.0
Interest and dividends due or accrued 52.2 49.9
Other assets 50.3 25.6
- -------------------------------------------------------------------------------------------
Total assets $ 5,686.1 $ 5,715.0
===========================================================================================
Liabilities
Insurance reserves:
Losses $ 2,357.2 $ 2,269.6
Loss adjustment expenses 501.4 486.8
Unearned premiums 706.6 715.5
Debt 200.6 383.3
Reinsuance treaty funds held 171.6 195.0
Deferred income taxes 28.1 21.9
Other liabilities 309.9 348.0
- -------------------------------------------------------------------------------------------
Total liabilities 4,275.4 4,420.1
Shareholders' Equity
Common stock, $.125 par value
Authorized: 150,000,000
Issued shares: 72,418,344; 72,418,344 9.0 9.0
Additional paid-in capital 15.2 -
Accumulated other comprehensive income 254.5 259.1
Retained earnings 1,237.4 1,161.5
Treasury stock, at cost:
(Shares: 7,963,160; 10,209,215) (105.4) (134.7)
- -------------------------------------------------------------------------------------------
Total shareholders' equity 1,410.7 1,294.9
- -------------------------------------------------------------------------------------------
Total liabilities and shareholders' equity $ 5,686.1 $ 5,715.0
===========================================================================================
Accompanying notes are an integral part of these consolidated financial
statements. For complete disclosures see Notes to Consolidated Financial
Statements on pages 54-71 of the Corporation's 2004 Form 10-K.
3
ITEM 1. Continued
Ohio Casualty Corporation & Subsidiaries
CONSOLIDATED STATEMENTS OF INCOME
Three Months
Ended June 30,
(in millions, except share and per share data) (Unaudited) 2005 2004
- -------------------------------------------------------------------------------------------
Premiums and finance charges earned $ 365.5 $ 367.2
Investment income, less expenses 48.6 48.6
Investment gains realized, net 13.8 3.2
- -------------------------------------------------------------------------------------------
Total revenues 427.9 419.0
Losses and benefits for policyholders 191.7 203.1
Loss adjustment expenses 40.4 40.1
General operating expenses 120.4 125.8
Write-down and amortization of agent relationships 3.3 4.3
Amortization of deferred policy acquisition costs 84.7 91.9
Deferral of deferred policy acquisition costs (83.4) (96.5)
Depreciation and amortization expense 2.8 3.3
Loss on retirement of convertible debt, including
debt conversion expenses 8.3 -
- -------------------------------------------------------------------------------------------
Total expenses 368.2 372.0
- -------------------------------------------------------------------------------------------
Income before income taxes 59.7 47.0
Income tax expense:
Current 15.4 12.3
Deferred 2.2 2.0
- -------------------------------------------------------------------------------------------
Total income tax expense 17.6 14.3
- -------------------------------------------------------------------------------------------
Net income $ 42.1 $ 32.7
===========================================================================================
Average shares outstanding - basic 63,679,352 61,344,980
===========================================================================================
Earnings per share - basic:
Net income, per share $ 0.66 $ 0.53
===========================================================================================
Average shares outstanding - diluted 66,997,317 71,371,586
===========================================================================================
Earnings per share - diluted:
Net income, per share $ 0.63 $ 0.48
===========================================================================================
Accompanying notes are an integral part of these consolidated financial
statements. For complete disclosures see Notes to Consolidated Financial
Statements on pages 54-71 of the Corporation's 2004 Form 10-K.
4
ITEM 1. Continued
Ohio Casualty Corporation & Subsidiaries
CONSOLIDATED STATEMENTS OF INCOME
Six Months
Ended June 30,
(in millions, except share and per share data) (Unaudited) 2005 2004
- -------------------------------------------------------------------------------------------
Premiums and finance charges earned $ 727.8 $ 728.3
Investment income, less expenses 97.0 99.1
Investment gains realized, net 13.8 6.9
- -------------------------------------------------------------------------------------------
Total revenues 838.6 834.3
Losses and benefits for policyholders 382.8 398.3
Loss adjustment expenses 83.3 78.4
General operating expenses 233.7 266.0
Write-down and amortization of agent relationships 7.7 11.5
Amortization of deferred policy acquisition costs 171.8 184.2
Deferral of deferred policy acquisition costs (164.8) (187.5)
Depreciation and amortization expense 5.7 6.5
Loss on retirement of convertible debt, including
debt conversion expenses 9.0 -
- -------------------------------------------------------------------------------------------
Total expenses 729.2 757.4
- -------------------------------------------------------------------------------------------
Income before income taxes 109.4 76.9
Income tax expense (benefit):
Current 21.0 23.6
Deferred 8.6 (0.2)
- -------------------------------------------------------------------------------------------
Total income tax expense 29.6 23.4
- -------------------------------------------------------------------------------------------
Income before cumulative effect of an accounting change 79.8 53.5
Cumulative effect of an accounting change, net of tax - 1.6
- -------------------------------------------------------------------------------------------
Net income $ 79.8 $ 51.9
===========================================================================================
Average shares outstanding - basic 63,023,233 61,204,730
===========================================================================================
Earnings per share - basic:
Net income, per share $ 1.27 $ 0.85
===========================================================================================
Average shares outstanding - diluted 69,327,993 71,204,439
===========================================================================================
Earnings per share - diluted:
Net income, per share $ 1.18 $ 0.78
===========================================================================================
Accompanying notes are an integral part of these consolidated financial
statements. For complete disclosures see Notes to Consolidated Financial
Statements on pages 54-71 of the Corporation's 2004 Form 10-K.
5
ITEM 1. Continued
Ohio Casualty Corporation & Subsidiaries
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
Accumulated
Additional other Total
(in millions, except Common paid-in comprehensive Retained Treasury shareholders'
share data) (Unaudited) Stock capital income earnings stock equity
- -------------------------------------------------------------------------------------------------------------------
Balance
January 1, 2004 $ 9.0 $ - $ 254.7 $1,033.4 $(151.3) $1,145.8
Net income 51.9 51.9
Change in unrealized gain,
net of deferred income tax
benefit of $21.3 (39.6) (39.6)
Change in minimum pension
liability, net of deferred
income tax benefit of $8.9 16.4 16.4
---------
Other comprehensive income 28.7
Net issuance of restricted
stock (59,284 shares) (0.4) 0.9 0.5
Net issuance of treasury
stock (418,558 shares) (0.5) 5.5 5.0
- --------------------------------------------------------------------------------------------------------------------
Balance,
June 30, 2004 $ 9.0 $ - $ 231.5 $1,084.4 $(144.9) $1,180.0
====================================================================================================================
Balance
January 1, 2005 $ 9.0 $ - $ 259.1 $1,161.5 $(134.7) $1,294.9
Net income 79.8 79.8
Change in unrealized gain,
net of deferred income tax
benefit of $2.4 (4.6) (4.6)
---------
Other comprehensive income 75.2
Net issuance of restricted
stock (13,664 shares) 0.2 0.2
Net issuance of treasury
stock (926,806 shares) 4.0 (0.1) 11.8 15.7
Cash dividends paid
($0.06 per share) (3.8) (3.8)
Issuance of common stock
pursuant to Convertible
Note transaction
(See Note VII) 11.2 17.3 28.5
- --------------------------------------------------------------------------------------------------------------------
Balance,
June 30, 2005 $ 9.0 $ 15.2 $ 254.5 $1,237.4 $(105.4) $1,410.7
====================================================================================================================
Accompanying notes are an integral part of these consolidated financial
statements. For complete disclosures see Notes to Consolidated Financial
Statements on pages 54-71 of the Corporation's 2004 Form 10-K.
6
ITEM 1. Continued
Ohio Casualty Corporation & Subsidiaries
CONSOLIDATED STATEMENTS OF CASH FLOWS
Six Months
Ended June 30,
(in millions) (Unaudited) 2005 2004
- -------------------------------------------------------------------------------------------------
Cash Flows from Operating Activities:
Operating Activities
Net income $ 79.8 $ 51.9
Adjustments to reconcile net income to cash
from operations:
Changes in:
Insurance reserves 93.3 129.5
Reinsurance treaty funds held (23.4) 14.9
Income taxes (5.4) (9.9)
Premiums and other receivables 16.6 (16.3)
Deferred policy acquisition costs 6.9 (3.3)
Reinsurance recoverable (37.3) (69.6)
Other assets (5.7) (7.3)
Other liabilities (48.9) (6.2)
Loss on retirement of convertible debt, including
debt conversion expenses 9.0 -
Income tax benefit from stock option exercises 3.1 -
Amortization and write-down of agent relationships 7.7 11.5
Depreciation and amortization 11.4 8.9
Investment gains realized, net (13.8) (6.9)
- -------------------------------------------------------------------------------------------------
Net cash provided by operating activities 93.3 97.2
- -------------------------------------------------------------------------------------------------
Cash Flows from Investing Activities:
Purchase of securities:
Fixed maturity, available-for-sale (619.0) (627.5)
Fixed maturity, held-to-maturity (0.4) (1.4)
Equity (3.7) (7.2)
Proceeds from sales of securities:
Fixed maturity, available-for-sale 416.7 444.4
Equity 7.9 5.2
Proceeds from maturities and calls of securities:
Fixed maturity, available-for-sale 29.6 65.6
Fixed maturity, held-to-maturity 17.4 27.3
Equity - 3.2
Property and equipment
Purchases (4.9) (2.2)
Sales 0.1 0.3
- -------------------------------------------------------------------------------------------------
Net cash used in investing activities (156.3) (92.3)
- -------------------------------------------------------------------------------------------------
Cash Flows from Financing Activities:
Debt:
Repayments (160.0) (0.3)
Proceeds from the issuance of senior notes - 199.3
Payment of issuance costs - (1.3)
Loss on retirement of convertible debt,
including conversion expense (3.6) -
Proceeds from exercise of stock options 12.5 4.8
Dividends paid to shareholders (3.8) -
- -------------------------------------------------------------------------------------------------
Net cash (used in) provided by financing activities (154.9) 202.5
- -------------------------------------------------------------------------------------------------
Net (decrease) increase in cash and cash equivalents (217.9) 207.4
Cash and cash equivalents, beginning of period 252.6 56.9
- -------------------------------------------------------------------------------------------------
Cash and cash equivalents, end of period $ 34.7 $ 264.3
=================================================================================================
Accompanying notes are an integral part of these consolidated financial
statements. For complete disclosures see Notes to Consolidated Financial
Statements on pages 54-71 of the Corporation's 2004 Form 10-K.
7
Ohio Casualty Corporation & Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
Ohio Casualty Corporation (the Corporation) is the holding company of The
Ohio Casualty Insurance Company (the Company), which is one of six property-
casualty insurance companies that make up the Ohio Casualty Group (the
Group). All dollar amounts, except per share data, presented in the Notes to
Consolidated Financial Statements are in millions unless otherwise noted.
NOTE I - INTERIM ADJUSTMENTS
We prepared the Consolidated Balance Sheet as of June 30, 2005 and the
Consolidated Statements of Income, Shareholders' Equity and Cash Flows all
for the three and six months ended June 30, 2005 and 2004, without an audit.
In the opinion of management, all adjustments necessary to fairly present the
financial position, results of operations and cash flows at June 30, 2005 and
for all periods presented have been made.
We prepared the accompanying unaudited Consolidated Financial Statements in
accordance with accounting principles generally accepted in the United States
for interim financial information and with the instructions to the Quarterly
Report on Form 10-Q and Article 10 of Regulation S-X.
Certain information and footnote disclosures normally included in financial
statements prepared in accordance with accounting principles generally
accepted in the United States have been omitted. The unaudited Consolidated
Financial Statements should be read together with the consolidated financial
statements and notes thereto included in the Corporation's 2004 Annual Report
on Form 10-K. The results of operation for the period ended June 30, 2005
are not necessarily indicative of the results of operation for the full year.
The preparation of financial statements in conformity with accounting
principles generally accepted in the United States requires management to
make estimates and assumptions that affect the reported amounts of assets and
liabilities, the disclosure of contingent assets and liabilities at the date
of the financial statements and the reported amounts of revenues and expenses
during the reporting period. Actual results could differ from those
estimates.
The premiums receivable balance is presented net of bad debt allowances
determined by management of $4.0 at June 30, 2005 and $4.3 at December 31,
2004. Property and equipment are carried at cost less accumulated
depreciation of $171.9 and $167.4 at June 30, 2005 and December 31, 2004,
respectively. Amounts recoverable from reinsurers are calculated in a manner
consistent with the reinsurance contract and are reported net of allowance of
$2.3 at June 30, 2005 and December 31, 2004.
NOTE II - STOCK OPTIONS
The Corporation accounts for stock options issued to employees and directors
in accordance with Accounting Principles Board Opinion (APB) No. 25,
"Accounting for Stock Issued to Employees." Under APB 25, the Corporation
recognizes expense based on the intrinsic value of options. Had the
Corporation adopted income statement recognition requirements of Financial
Accounting Standards Board (FASB) 123 "Accounting for Stock Based
Compensation," the Corporation's net income and earnings per share would have
been reduced to the pro forma amounts disclosed below:
8
Three Months Ended Six Months Ended
June 30 June 30
2005 2004 2005 2004
- -------------------------------------------------------------------------------
Net income
As reported $42.1 $32.7 $79.8 $51.9
Add: Stock-based employee
compensation reported in
net income, net of related
tax effect 0.2 0.1 0.3 0.1
Deduct: Total stock-based
employee compensation, net
of related tax effect 1.6 1.5 2.6 2.8
----- ----- ----- -----
Pro forma $40.7 $31.3 $77.5 $49.2
Basic EPS
As reported $0.66 $0.53 $1.27 $0.85
Pro Forma $0.64 $0.51 $1.23 $0.80
Diluted EPS*
As reported $0.63 $0.48 $1.18 $0.78
Pro Forma $0.61 $0.46 $1.14 $0.74
===============================================================================
*Diluted EPS has been adjusted for the effect of EITF Issue No. 04-8 for the
three and six months ended June 30, 2005. Also see Note III.
See Note X - Recently Issued Accounting Standards for additional information
pertaining to FASB 123(R) - "Share-Based Payment."
NOTE III - EARNINGS PER SHARE
Basic and diluted earnings per share are summarized as follows:
Three Months Ended Six Months Ended
June 30 June 30
2005 2004 2005 2004
- -------------------------------------------------------------------------------------
Net income $42.1 $32.7 $79.8 $ 51.9
Weighted average common shares
outstanding - basic (thousands) 63,679 61,345 63,023 61,205
Income before cumulative effect of
an accounting change $0.66 $0.53 $1.27 $ 0.88
Cumulative effect of an accounting
change - - - $(0.03)
Basic net income per weighted
average share $0.66 $0.53 $1.27 $ 0.85
=====================================================================================
Net income $42.1 $32.7 $79.8 $ 51.9
Effect of EITF 04-8 on net income
using "if-converted" method 0.2 1.7 1.8 3.3
Adjusted net income using
"if-converted" method 42.3 34.4 81.6 55.2
Weighted average common shares
outstanding (thousands) 63,679 61,345 63,023 61,205
Effect of dilutive securities
(thousands) 1,199 1,130 1,273 1,102
Effect of EITF 04-8 (thousands) 2,119 8,897 5,032 8,897
- ------------------------------------------------------------------------------------
Weighted average common shares
outstanding - diluted (thousands) 66,997 71,372 69,328 71,204
Income before cumulative effect of an
accounting change $0.63 $0.48 $1.18 $ 0.80
Cumulative effect of an accounting
change - - - $(0.02)
Diluted net income per weighted
average share $0.63 $0.48 $1.18 $ 0.78
=====================================================================================
In accordance with Emerging Issues Task Force (EITF) 04-8 "The Effect of
Contingently Convertible Debt on Diluted Earnings Per Share," the earnings
per share treatment of those securities that contain a contingent conversion
feature require all of the shares underlying the convertible securities to be
treated as outstanding using the "if-converted" method. As required by the
EITF, all prior period earnings per share
9
amounts would need to be restated for periods presented subsequent to the
March 2002 Convertible Notes issuance. The "if-converted" method gives
effect to the add back to net income of interest expense and amortization of
debt issuance costs, net of tax, associated with the convertible instruments.
The adoption of EITF 04-8 reduced previously reported diluted earnings per
share by $0.04 and $0.05 for the three and six months ended June 30, 2004,
respectively.
NOTE IV -- SEGMENT INFORMATION
The Corporation has determined its reportable segments based upon its method
of internal reporting, which is organized by product line. The property and
casualty segments are Commercial, Specialty, and Personal Lines. These
segments generate revenues by selling a wide variety of commercial, surety
and personal insurance products. The Corporation also has an all other
segment which derives its revenues from investment income. The other
expenses included in this segment consist principally of costs related to the
retirement of the convertible debt and interest expense in 2005. In 2004,
the other expenses consist primarily of interest expense.
Each segment of the Corporation is managed separately. The property and
casualty segments are managed by assessing the performance and profitability
of the segments through analysis of industry financial measurements
determined on a GAAP basis, which includes loss, loss adjustment and
underwriting expense ratios, combined ratio, premiums earned, underwriting
gain/loss and statutory premiums written. The following tables present
information by segment as it is reported internally to management. Asset
information by reportable segment is not reported, since the Corporation does
not produce such information internally.
Three Months Ended June 30
Commercial Lines Segment 2005 2004
- ---------------------------------------------------------------------------
Net premiums written $221.8 $220.3
% Change 0.7% 5.0%
Net premiums earned 206.8 202.4
% Change 2.2% 5.8%
Underwriting loss (before tax) (5.4) (4.3)
Specialty Lines Segment 2005 2004
- ---------------------------------------------------------------------------
Net premiums written $39.7 $ 39.1
% Change 1.5% (9.4)%
Net premiums earned 36.4 40.8
% Change (10.8)% 0.5%
Underwriting gain (before tax) 1.7 2.0
Personal Lines Segment 2005 2004
- ---------------------------------------------------------------------------
Net premiums written $123.4 $127.3
% Change (3.1)% 3.7%
Net premiums earned 122.3 124.0
% Change (1.4)% 3.9%
Underwriting gain (before tax) 19.8 5.3
Total Property & Casualty 2005 2004
- ---------------------------------------------------------------------------
Net premiums written $384.9 $386.7
% Change (0.5)% 2.9%
Net premiums earned 365.5 367.2
% Change (0.5)% 4.6%
Underwriting gain (before tax) 16.1 3.0
All Other 2005 2004
- ---------------------------------------------------------------------------
Revenues $ 9.0 $ 2.2
Write-down and amortization of
agent relationships (3.3) (4.3)
Other expenses (15.5) (3.5)
- ---------------------------------------------------------------------------
Net loss before income taxes $ (9.8) $(5.6)
10
Reconciliation of Revenues 2005 2004
- ---------------------------------------------------------------------------
Net premiums earned for reportable segments $365.5 $367.2
Net investment income 44.9 47.6
Realized gains/(losses), net 9.0 (1.3)
- ---------------------------------------------------------------------------
Total property and casualty revenues
(Statutory basis) 419.4 413.5
Property and casualty statutory to GAAP
adjustment (0.5) 3.3
- ---------------------------------------------------------------------------
Total revenues property and casualty
(GAAP basis) 418.9 416.8
Other segment revenues 9.0 2.2
- ---------------------------------------------------------------------------
Total revenues $427.9 $419.0
===========================================================================
Reconciliation of Underwriting Gain (before tax) 2005 2004
- ---------------------------------------------------------------------------
Property and casualty underwriting
gain (before tax) (Statutory basis) $ 15.3 $ 0.1
Statutory to GAAP adjustment 0.8 2.9
- ---------------------------------------------------------------------------
Property and casualty underwriting
gain (before tax) (GAAP basis) 16.1 3.0
Net investment income 48.6 48.6
Realized gains, net 13.8 3.2
Write-down and amortization of agent
relationships (3.3) (4.3)
Other expenses (15.5) (3.5)
- ---------------------------------------------------------------------------
Income before income taxes and
cumulative effect of an accounting
change $ 59.7 $ 47.0
===========================================================================
Six Months Ended June 30
Commercial Lines Segment 2005 2004
- ---------------------------------------------------------------------------
Net premiums written $427.4 $432.5
% Change (1.2)% 4.2%
Net premiums earned 412.4 400.2
% Change 3.0% 5.0%
Underwriting loss (before tax) (18.3) (10.0)
Specialty Lines Segment 2005 2004
- ---------------------------------------------------------------------------
Net premiums written $78.8 $73.9
% Change 6.6% (2.9)%
Net premiums earned 71.5 82.5
% Change (13.3)% 4.4%
Underwriting gain (before tax) 3.0 6.1
Personal Lines Segment 2005 2004
- ---------------------------------------------------------------------------
Net premiums written $237.2 $244.3
% Change (2.9)% 3.1%
Net premiums earned 243.9 245.6
% Change (0.7)% 2.2%
Underwriting gain/(loss) (before tax) 47.5 (7.0)
Total Property & Casualty 2005 2004
- ---------------------------------------------------------------------------
Net premiums written $743.4 $750.7
% Change (1.0)% 3.1%
Net premiums earned 727.8 728.3
% Change (0.1)% 4.0%
Underwriting gain/(loss) (before tax) 32.2 (10.9)
All Other 2005 2004
- ---------------------------------------------------------------------------
Revenues $ 12.1 $ 3.7
Write-down and amortization of
agent relationships (7.7) (11.5)
Other expenses (25.9) (6.7)
- ---------------------------------------------------------------------------
Net loss before income taxes $(21.5) $(14.5)
11
Reconciliation of Revenues 2005 2004
- ---------------------------------------------------------------------------
Net premiums earned for reportable segments $ 727.8 $728.3
Net investment income 89.1 97.2
Realized gains, net(a) 145.3 3.7
- ---------------------------------------------------------------------------
Total property and casualty revenues
(Statutory basis) 962.2 829.2
Property and casualty statutory to
GAAP adjustment (135.7) 1.4
- ---------------------------------------------------------------------------
Total revenues property and casualty
(GAAP basis) 826.5 830.6
Other segment revenues 12.1 3.7
- ---------------------------------------------------------------------------
Total revenues $ 838.6 $834.3
===========================================================================
(a) The net realized gains reflected above on a statutory accounting basis
are the result of inter-company transfers of equity securities within the
Group, which for statutory purposes are recorded as if the securities were
sold. For GAAP accounting, the statutory realized gains/losses on inter-
company transfers of securities are not recognized until the security is
disposed of outside of the Corporation.
Reconciliation of Underwriting
Gain/(Loss) (before tax) 2005 2004
- ---------------------------------------------------------------------------
Property and casualty underwriting
gain/(loss) (before tax) (Statutory basis) $ 35.8 $ (3.8)
Statutory to GAAP adjustment (3.6) (7.1)
- ---------------------------------------------------------------------------
Property and casualty underwriting gain/(loss)
(before tax) (GAAP basis) 32.2 (10.9)
Net investment income 97.0 99.1
Realized gains, net 13.8 6.9
Write-down and amortization of agent
relationships (7.7) (11.5)
Other expenses (25.9) (6.7)
- ---------------------------------------------------------------------------
Income before income taxes and cumulative
effect of an accounting change $109.4 $ 76.9
===========================================================================
NOTE V - AGENT RELATIONSHIPS
The agent relationships asset is an identifiable intangible asset acquired in
connection with the 1998 Great American Insurance Company (GAI) commercial
lines acquisition. The Corporation follows the practice of allocating
purchase price to specifically identifiable intangible assets based on their
estimated values as determined by appropriate valuation methods. In the GAI
acquisition, the purchase price was allocated to agent relationships and
deferred policy acquisition costs. Agent relationships are evaluated
quarterly as events or circumstances indicate a possible inability to recover
their carrying amount. As a result of the evaluation, the agent relationship
asset was written down before tax by $1.7 and $2.6 in the second quarter of
2005 and 2004, respectively. For the six months ended June 30, 2005 and
2004, the asset was written down before tax by $4.5 and $8.0, respectively.
The write-downs are a result of agency cancellations and certain agents
determined to be impaired based on updated estimated future undiscounted cash
flows that were insufficient to recover the carrying amount of the asset for
the agent. The remaining portion of the agent relationships asset will be
amortized on a straight-line basis over the remaining useful period of
approximately 19 years. For the three month and six month periods ended June
30, 2005, the Corporation recorded amortization expense of $1.6 and $3.2
which compares to $1.7 and $3.5 for the same periods of the prior year. At
June 30, 2005 and December 31, 2004, the unamortized carrying value of the
agent relationships asset was $114.3 and $122.0, respectively. The agent
relationships asset is recorded net of accumulated amortization of $43.0 and
$41.4 at June 30, 2005 and December 31, 2004, respectively.
Future cancellation of agents included in the agent relationships intangible
asset or a diminution of certain former Great American agents' estimated
future revenues or profitability is likely to cause further impairment losses
beyond the quarterly amortization of the remaining asset value over the
remaining useful lives.
NOTE VI - INTERNALLY DEVELOPED SOFTWARE
In accordance with Statement of Position 98-1, "Accounting for the Costs of
Computer Software Developed or Obtained for Internal Use," the Corporation
capitalizes costs incurred during the application development stage for the
development of internal-use software. These costs primarily relate to
payroll and payroll-related costs for employees along with costs incurred for
external consultants who are directly associated with the internal-use
software project. Costs such as maintenance, training, data conversion,
overhead and general and administrative are expensed as incurred. Management
believes the expected future value of
12
the asset exceeds the carrying value. Management evaluates the asset on an
annual basis for impairment. The costs associated with the software are
amortized on a straight-line basis over an estimated useful life of 10 years
commencing when the software is substantially complete and ready for its
intended use. Capitalized software costs and accumulated amortization
amounts included in the consolidated balance sheets were $56.4 and $13.7 at
June 30, 2005 and $55.2 and $11.4 at December 31, 2004, respectively.
NOTE VII - DEBT
On March 19, 2002, the Corporation issued $201.3 aggregate principal amount
of 5.00% Convertible Notes due March 19, 2022 (Old Notes). On March 22, 2005
the Corporation exchanged $65.6 of its Old Notes for $65.6 of new 5.00%
Convertible Notes due March 19, 2022 (New Notes and collectively the
Convertible Notes). The only change in the New Notes was the incorporation
of a net share settlement feature. The Corporation paid a premium to the
holders electing the exchange to the New Notes. Also on this date, the
Corporation announced its intention to fully redeem before maturity the
Convertible Notes at their regular redemption price of 102% of the principal
amount plus accrued interest to, but excluding, the redemption date of May 2,
2005. In connection with this announced redemption, holders of the
Convertible Notes could elect to convert their Convertible Notes into shares
of the Corporation's common stock. Upon conversion of the Old Notes, the
Corporation delivered 44.2112 of its common stock for each $1,000 principal
amount of Old Notes surrendered for conversion. Upon conversion of the New
Notes, the Corporation paid the principal amount in cash and any conversion
consideration in excess of the principal amount in the Corporation's common
stock. The above transactions impacted the Corporation's consolidated
results of operations and consolidated balance sheet as follows:
2005
Loss on retirement
of Convertible Debt, Impact on
Old New including debt Shareholders'
Notes Notes conversion expenses Equity
----------------------------------------------------------
Initial Issuance $201.3 $ - $ - $ -
Repurchases in unsolicited
negotiated transactions (a) (52.8) - (2.5) -
Impact of exchange offer
and related exchange premium (65.6) 65.6 (0.3) -
Call Elections:
Cash redemption (b) (53.9) (55.0) (5.7) -
Equity conversion (c) (29.0) (10.6) (0.5) 28.5
- -------------------------------------------------------------------------------------------
June 30, 2005 $ - $ - $(9.0) $28.5
===========================================================================================
(a) These repurchases were completed in the following periods: $35.8 in the
second quarter of 2005, $4.5 in the first quarter of 2005 and $12.5 in
the fourth quarter of 2004. As a result of these repurchases, the
Corporation wrote off a proportionate amount of unamortized debt issuance
costs of $1.2 in the second quarter of 2005, $0.1 in the first quarter of
2005 and $0.4 in the fourth quarter of 2004, which was included in the
2004 results of operations. In addition, the Corporation paid a premium
on the repurchases of $0.8 in the second quarter of 2005, $0.4 in first
quarter 2005 and $0.6 in the fourth quarter of 2004, which was also
included in the 2004 results of operations. The loss on retirement of
debt attributable to 2004 relating to the repurchase transactions are not
included in the above table.
(b) In connection with the cash redemption, the Corporation paid a call
premium in the amount of $2.2 and wrote off the proportionate amount of
unamortized debt issuance costs in the amount of $3.5 in the second
quarter of 2005.
(c) In connection with the equity conversion, the Corporation issued
1,282,123 shares of its common stock for conversion of the Old Notes,
issued 23,462 shares of its common stock for conversion of the New Notes,
recognized $0.5 in debt conversion expenses related to the New Notes,
which represents the conversion price of $22.62 multiplied by 23,462
shares issued, and increased shareholders' equity by
13
$28.5 in the second quarter of 2005. The increase in shareholders'
equity consists principally of the conversion of the principle amount of
Old Notes ($29.0) and accrued interest through the date of conversion
($0.2) offset by the write-off of the proportionate amount of unamortized
debt issuance cost ($1.4).
On June 29, 2004, the Corporation issued $200.0 of 7.3% Senior Notes due June
15, 2014 (Senior Notes) and received net proceeds after related fees and
discount of $198.0. The Corporation used part of the net proceeds to
repurchase $52.8 of the Old Notes in unsolicited negotiated transactions,
prior to the redemption discussed above. A substantial portion of the net
proceeds was also used to redeem the Convertible Notes on May 2, 2005, as
discussed above. Interest is payable on the Senior Notes on June 15 and
December 15.
The Senior Notes are reported on the consolidated balance sheet net of
unamortized issuance-related costs and discount totaling $2.4 at June 30,
2005. The Convertible Notes and Senior Notes were reported on the
consolidated balance sheet net of unamortized issuance-related costs and
discount totaling $8.7 ($6.3 related to the Convertible Notes and $2.4
related to the Senior Notes) at December 31, 2004. The Corporation uses the
effective interest rate method to record interest expense, amortization of
issuance-related costs and amortization of the discount.
The impact of the Convertible Notes on diluted earnings per share is based
upon the "if-converted" method. In accordance with EITF 04-8, all diluted
earnings per share amounts have been restated since the issuance of the
Convertible Notes in March 2002. See Note III - Earnings Per Share of this
Quarterly Report on Form 10-Q and Item 15, Notes to Consolidated Financial
Statements, Footnote 10 on pages 66 and 67 of the Corporation's 2004 Annual
Report on Form 10-K for further discussion.
On July 31, 2002, the Corporation entered into a revolving credit agreement
with an expiration date of March 15, 2005. In February 2005, the revolving
credit agreement was renewed, under substantially the same terms and
conditions, and will expire on March 15, 2006. Under the terms of the
revolving credit agreement, the lenders agreed to make loans to the
Corporation in an aggregate amount up to $80.0 for general corporate
purposes. Interest is payable in arrears, and the interest rate on
borrowings under the revolving credit agreement is based on a margin over
LIBOR or the LaSalle Bank Prime Rate, at the option of the Corporation. The
Corporation is obligated to pay agency fees and facility fees of up to $0.2
annually. These fees are expensed when incurred by the Corporation. The
revolving credit agreement requires the Corporation to maintain minimum net
worth of $800.0. The credit agreement also includes a minimum statutory
surplus for the Company of $650.0. Additionally, other financial covenants
and other customary provisions, as defined in the agreement, exist. At June
30, 2005, the Corporation was in compliance with all financial covenants and
other provisions of this agreement. There were no amounts outstanding under
this revolving credit agreement at either June 30, 2005 or December 31, 2004.
In addition to the debt described above, the Corporation has a $6.5 loan with
the State of Ohio that is secured by a mortgage on the Corporation's home
office property. As of and for the three and six months ended June 30, 2005,
the loan bears a fixed interest rate of 3%, compared to an interest rate of
2% as of and for the three and six months ended June 30, 2004. The loan
requires annual principal payments of approximately $0.6 and expires in
November 2009. The remaining balance at June 30, 2005 was $3.0, compared to
$3.2 at December 31, 2004.
Interest expense incurred for the six month period ending June 30, 2005 and
2004 was $10.4 and $5.2, respectively. Interest expense incurred for the
three month period ending June 30, 2005 and 2004 was $4.4 and $2.6,
respectively. The increase in interest expense incurred in the three and six
month periods ending June 30, 2005 is related to the issuance of the Senior
Notes on June 29, 2004.
NOTE VIII - CONTINGENCIES
In the fourth quarter of 2001, Ohio Casualty of New Jersey, Inc. (OCNJ)
entered into an agreement to transfer its obligations to renew private
passenger auto business in New Jersey to Proformance Insurance Company
(Proformance). The contract stipulated that a premiums-to-surplus ratio of
2.5 to 1 must be maintained on the transferred business during the period
March 2002 through December 2004. If this
14
criteria was not met, OCNJ would have to pay up to a maximum cumulative
amount of $15.6 to Proformance to maintain this premiums-to-surplus ratio.
Based on data provided by Proformance, the Group paid $6.8 in July 2004 to
Proformance in settlement of this obligation through December 31, 2003. At
December 31, 2004, based upon information provided by Proformance, the Group
had accrued $8.8 to cover this estimated additional liability. Late in the
first quarter of 2005, the Group, based on revised information provided by
Proformance subsequent to the Corporation filing its 2004 Annual Report on
Form 10-K, reduced its estimated liability and related accrual to $4.4 at
March 31, 2005. In June 2005, the Group reached a settlement with
Proformance for the final payment related to this obligation in the amount of
$3.7 and in return received from Proformance a release of any and all future
obligations related to this surplus guarantee. Accordingly, at June 30,
2005, no additional amounts are recorded on the Consolidated Balance Sheet
pursuant to this surplus guarantee. The total amount paid by the Group
pursuant to the surplus guarantee was $10.5, compared to the maximum
cumulative exposure of $15.6.
A proceeding entitled Carol Murray v. the Corporation, the Company, Avomark
Insurance Co., Ohio Security Insurance Co. (Ohio Security), West American
Insurance Co. (West American), American Fire and Casualty Insurance Co.
(American Fire), and OCNJ was filed in the United States District Court for
the District of Columbia on February 5, 2004. A motion to change venue was
granted on May 25, 2004 with the proceeding assigned to the U.S. District
Court for the Southern District of Ohio, Eastern Division, Columbus, Ohio.
The plaintiff, a former automobile physical damage claim adjuster, originally
sought to certify a nationwide collective action consisting of all current
and former salaried employees since February 5, 2001 who are/were employed to
process claims by policyholders and other persons for automobile property
damage. The plaintiff has filed motions to expand the definition to include
claim specialists, representative trainees, and representatives performing
claims adjusting services. The complaint seeks overtime compensation for the
plaintiff and the class of persons plaintiff seeks to represent. The
defendants deny the allegations made in the complaint and are vigorously
defending themselves.
A proceeding entitled Carol Lazarus v. the Group was brought against West
American in the Court of Common Pleas Cuyahoga County, Ohio on October 25,
1999. The Court ordered the case to proceed solely against West American on
July 10, 2003. The complaint alleges West American improperly charged for
uninsured motorists coverage following an October 1994 decision of the
Supreme Court of Ohio in Martin v. Midwestern Insurance Company. The Martin
decision was overruled legislatively in September 1997. West American filed
a motion for summary judgment on December 16, 2003. Plaintiff filed a motion
for class certification on February 23, 2004. West American has responded to
the motion for class certification stating the motion is untimely (filed more
than four years after the initial complaint) and that Carol Lazarus failed to
provide sufficient evidence to satisfy the requirements for class
certification.
A proceeding entitled Douglas and Carla Scott v. the Company, West American,
American Fire, and Ohio Security was filed in the District Court of Tulsa
County, State of Oklahoma and served on January 3, 2005. The proceeding
challenges the use of a certain vendor in valuing total loss automobiles.
Plaintiff alleges that use of the database results in valuations to the
detriment of the insureds. Plaintiff is seeking class status and alleges
breach of contract, fraud and bad faith. The lawsuit is in its early stages
and will be vigorously defended.
The proceedings described above and various other legal and regulatory
proceedings are currently pending that involve the Corporation and specific
aspects of the conduct of its business. The outcome of these proceedings is
currently unpredictable. However, at this time, based on their present
status, it is the opinion of management that the ultimate liability, if any,
in one or more of these proceedings in excess of amounts currently reserved
is not expected to have a material adverse effect on the financial condition,
liquidity or results of operation of the Corporation.
15
NOTE IX - EMPLOYEE BENEFITS
The Corporation has a non-contributory defined benefit retirement plan and a
contributory health care plan. The net periodic pension cost as of June 30 is
determined as follows:
Three Months Ended Six Months Ended
June 30 June 30
2005 2004 2005 2004
- ------------------------------------------------------------------------------------------
Service cost earned during the period $ 1.8 $ 1.9 $ 3.6 $ 4.0
Interest cost on projected benefit
obligation 4.3 4.1 8.6 8.6
Expected return on plan assets (5.4) (5.4) (10.8) (10.7)
Amortization of accumulated losses 0.9 0.7 1.8 1.4
Amortization of unrecognized prior
service cost (0.5) (0.6) (1.1) (0.7)
Curtailment cost - - - 0.1
- ------------------------------------------------------------------------------------------
Net periodic pension cost $ 1.1 $ 0.7 $ 2.1 $ 2.7
==========================================================================================
The Corporation contributed approximately $1.9 and $3.8 in the three month
and six month periods ended June 30, 2005, respectively, to the defined
benefit retirement plan. The Corporation contributed approximately $7.5 in
the first six months of 2004. The Corporation expects to contribute
approximately $8.0 during the fiscal year 2005.
In March 2004, the Corporation announced changes to the defined benefit
retirement plan which were effective June 30, 2004, which freezes accrued
benefits under the plan's current formula and incorporates a new benefit
formula beginning July 2004. As a result of these changes and staff
reductions announced in the first six months of 2004, the Corporation
recognized a curtailment charge of $0.1 in 2004.
The components of the Corporation's net periodic postretirement benefit cost
as of June 30:
Three Months Ended Six Months Ended
June 30 June 30
2005 2004 2005 2004
- ------------------------------------------------------------------------------------------
Service cost $ - $ 0.1 $ 0.1 $ 0.7
Interest cost 0.8 0.8 1.5 2.3
Amortization of accumulated losses - 0.1 - 0.2
Amortization of unrecognized prior
service cost (1.5) (1.5) (3.0) (2.0)
Curtailment cost - - - 0.1
- ------------------------------------------------------------------------------------------
Net periodic postretirement benefit cost $(0.7) $(0.5) $(1.4) $ 1.3
==========================================================================================
In March 2004, the Corporation announced changes related to the
postretirement health care plan effective July 1, 2004 that limits
eligibility for subsidized retiree medical and dental coverage to then
current retirees and employees with 25 or more years of service. Other
employees are eligible for access to unsubsidized retiree dental coverage and
medical coverage up to age 65. As a result of these changes and staff
reductions, the Corporation recognized a curtailment charge of $0.1 in 2004.
NOTE X - RECENTLY ISSUED ACCOUNTING STANDARDS
In December 2004, the FASB finalized Statement 123(R), "Share-Based Payment."
On April 14, 2005, the Securities and Exchange Commission (SEC) announced a
phased-in implementation process that would allow the Corporation to defer
the implementation of the statement no later than the beginning of the first
fiscal year beginning after June 15, 2005. For the Corporation this would
mean January 1, 2006. Statement 123(R) supersedes APB Opinion No. 25,
"Accounting for Stock Issued to Employees," and amends FASB Statement No. 95,
"Statement of Cash Flows." FASB 123(R) requires all share-based payments to
employees, including grants of employee stock options, to be recognized as
compensation expense in the income statement at fair value. Pro forma
disclosure is no longer an alternative. The Corporation currently intends to
adopt the provisions of FASB 123(R) effective January 1, 2006.
16
FASB 123(R) permits public companies to adopt its requirements using one of
two methods: (1) modified prospective or (2) modified retrospective. The
Corporation currently intends to adopt using the modified prospective method
in which compensation expense would be recognized beginning January 1, 2006
(a) based on the requirements of FASB 123(R) for all share-based payments
granted after the January 1, 2006 and (b) based on the requirements of FASB
123 for all awards granted to employees prior to January 1, 2006 that remain
unvested on that date.
The adoption of FASB 123(R) fair value method is expected to increase the
Corporation's compensation expense by approximately $3.0 to $4.0 in 2006.
These estimated impacts could change materially from these estimates based
upon the Corporation's use of equity-based awards granted in the future. Had
the Corporation adopted FASB 123(R) in prior periods, the impact of that
standard would have approximated the impact of FASB 123 as described in the
disclosure of pro forma net income and earnings per share in Note II.
FASB 123(R) also requires the benefits of tax deductions in excess of
recognized compensation expense to be reported as a financing cash flow,
rather than as an operating cash flow as required under current accounting
literature. This requirement will reduce net operating cash flows and
increase net financing cash flows in periods after the adoption.
In March 2004, the FASB approved the consensus reached on the EITF Issue No.
03-1, "The Meaning of Other-Than-Temporary Impairment and Its Application to
Certain Investments." The objective of this consensus is to provide guidance
for identifying impaired investments. EITF 03-1 also provides new disclosure
requirements for investments that are deemed to be temporarily impaired.
Originally, the accounting provisions of EITF 03-1 were effective for all
reporting periods beginning after June 15, 2004, while the disclosure
requirements are effective only for annual periods ending after June 15,
2004. In September 2004, the FASB issued two FASB Staff Positions (FSP), FSP
EITF 03-1-a and FSP EITF 03-1-1, which delayed the measurement and
recognition paragraphs of the consensus for further discussion. The
disclosure requirements remain effective as originally issued under EITF 03-1
and have been adopted by the Corporation. In June 2005, the FASB issued a
final FSP EITF 03-1-a (retitled FSP FAS 115-1, "The Meaning of Other-Than-
Temporary Impairment and Its Application to Certain Investments") which will
replace the guidance set forth in paragraphs 10-18 of Issue 03-1 and
clarifies when an investor should recognize an impairment loss. The
provisions of FSP FAS 115-1 are effective for other-than-temporary impairment
analysis conducted in periods beginning after September 15, 2005. The
Corporation has evaluated the provisions of FSP FAS 115-1 and believes the
impact will be immaterial on the Corporation's overall results of operations
or financial position.
In May 2005, the FASB issued FASB Statement 154 "Accounting Changes and Error
Corrections" which replaces APB Opinion No. 20 "Accounting Changes" and FASB
Statement 3 "Reporting Accounting Changes in Interim Financial Statements."
This statement changes the requirements for the accounting for and reporting
of a change in accounting principle. This statement applies to all voluntary
changes in accounting principle. It also applies to changes required by an
accounting pronouncement in the unusual instance that the pronouncement does
not include specific transition provisions. This statement requires
voluntary changes in accounting principles be recognized retrospectively to
prior periods' financial statements, rather than recognition in the net
income of the current period. Retrospective application requires
restatements of prior period financial statements as if that accounting
principle had always been used. This statement carries forward without
change the guidance contained in Opinion 20 for reporting the correction of
an error in previously issued financial statements and a change in accounting
estimate. The provisions of FASB Statement 154 are effective for accounting
changes and corrections of errors made in fiscal years beginning after
December 15, 2005.
NOTE XI - SUBSEQUENT EVENT
In May 2005, the Corporation's shareholders approved the 2005 Incentive Plan
(the Plan). The Plan is a performance-based stock unit and cash award
designed to foster and promote the long-term financial success of the
Corporation and its subsidiaries and to align the interests of management and
directors with that of the Corporation's shareholders. The 2005 Officer Long
Term Incentive award under the Plan is tied to the long term strategic plan
approved by the Board of Directors. The performance period will begin on
17
July 1, 2005 and will be based on the Corporation's achievement of its after-
tax operating income targets for the 30 month period from July 1, 2005 to
December 31, 2007. The award will be settled 50% in cash and 50% in shares
of the Corporation's common stock. The Corporation will account for the
award using APB 25 "Accounting for Stock Issued to Employees" and Financial
Interpretation 44 "Accounting for Certain Transactions Involving Stock
Compensation" for the period of July 1, 2005 through December 31, 2005. The
Corporation will account for the award using FASB 123(R) upon adoption on
January 1, 2006 as discussed in Note X, Recently Issued Accounting Standards.
ITEM 2. Management's Discussion and Analysis of Financial Condition and
Results of Operation
Ohio Casualty Corporation (the Corporation) is the holding company of The
Ohio Casualty Insurance Company (the Company), which is one of six property-
casualty insurance companies that make up the Ohio Casualty Group (the
Group). All dollar amounts in this Management Discussion and Analysis (MD&A)
are in millions unless otherwise noted.
RESULTS OF OPERATIONS
Net income
The Corporation reported net income of $79.8, or $1.18 per share for the six
months ending June 30, 2005, compared with $51.9, or $0.78 per share in the
same period of 2004. For the second quarter of 2005, net income was $42.1,
or $0.63 per share, compared with net income of $32.7, or $0.48 per share in
the same quarter of 2004.
Management of the Corporation believes the significant volatility of realized
investment gains and losses limits the usefulness of net income as a measure
of current operating performance. Therefore, management uses the non-GAAP
financial measure of operating income to further evaluate current operating
performance. Operating income is reconciled to net income in the table
below:
Three Months Six Months
Ended June 30 Ended June 30
2005 2004 2005 2004
- -----------------------------------------------------------------------------------
Operating income $33.2 $30.6 $70.9 $49.0
After-tax net realized gains 8.9 2.1 8.9 4.5
Cumulative effect of accounting change - - - (1.6)
- -----------------------------------------------------------------------------------
Net income $42.1 $32.7 $79.8 $51.9
===================================================================================
Operating income per
share - diluted $0.50 $0.45 $1.05 $0.74
After-tax net realized gains
per share - diluted 0.13 0.03 0.13 0.06
Cumulative effect of accounting change
per share - diluted - - - (0.02)
- -----------------------------------------------------------------------------------
Net income per share - diluted $0.63 $0.48 $1.18 $0.78
===================================================================================
Investment Results
For the six months ended June 30, 2005 and 2004, consolidated before-tax net
investment income was $97.0 ($70.6 after tax) and $99.1 ($66.4 after tax),
respectively. The effective tax rate on investment income for the first six
months of 2005 was 27.2%, compared with 33.0% for the same period of 2004.
Second quarter 2005 and 2004 consolidated before-tax investment income was
$48.6 ($35.2 after tax) and $48.6 ($32.5 after tax), respectively. The
effective tax rate on investment income in the second quarter was 27.5%,
compared with 33.2% for the same period of 2004. Before-tax investment
income for the three month and six month periods ending June 30, 2005 was
comparable to the same periods of the prior year, as the impact of lower
before-tax investment yields in 2005 were offset by growth in our investment
portfolio
18
as the insurance operations continue to generate positive cash flows.
Before-tax and after-tax investment income comparisons are impacted by
investments in tax exempt securities. As a result of the Corporation's
return to profitability, management has invested more funds into tax exempt
securities to maximize after-tax income. This investment strategy results in
the Corporation's effective tax rate on investment income being lower in the
current year when compared to prior periods.
For the six months and three months ended June 30, 2005, net realized gains
were $13.8, compared to $6.9 and $3.2, respectively, for the same periods of
2004. Included in the net realized gains for the three months ended June 30,
2005 is $7.0 attributable to the sale of 665,000 shares of National Atlantic
Holding Corporation and subsidiaries ("NAHC"), the parent of Proformance,
common stock. The Corporation acquired these shares in connection with the
transaction discussed in Note VIII - Contingencies and continues to hold
202,955 NAHC shares. During the second quarter of 2005, the Group recorded
realized losses of $1.2 on the disposal of several fixed maturity securities
in the automotive industry, which had experienced market value declines
during the second quarter resulting from negative financial news about the
issuers. There were no material losses on the disposal of any securities in
the second quarter of 2004.
Invested assets comprise a majority of the consolidated assets.
Consequently, accounting policies related to investments are critical. For
further discussion of investment accounting policies, see the "Critical
Accounting Policies" section on pages 31 and 32 of the Corporation's 2004
Annual Report on Form 10-K. Investments are continually evaluated based on
current economic conditions, credit loss experience and other developments.
The difference between the cost/amortized cost and estimated fair value of
investments is continually evaluated to determine whether a decline in value
is temporary or other than temporary in nature. This determination involves
a degree of uncertainty. If a decline in the fair value of a security is
determined to be temporary, the decline is recorded as an unrealized loss in
shareholders' equity. If a decline in a security's fair value is considered
to be other than temporary, the security is written down to the estimated
fair value with a corresponding realized loss recognized in the current
consolidated statement of income.
The assessment of whether a decline in fair value is considered temporary or
other than temporary includes management's judgement as to the financial
position and future prospects of the entity issuing the security. It is not
possible to accurately predict when it may be determined that a specific
security will become impaired. Future impairment charges could be material
to the results of operations. There were no impairment charges recorded
during the six months ended June 30, 2005. The before-tax impairment charge
recorded in the six months and three months ended June 30, 2004 was $5.2 and
$1.4, respectively.
Management believes that it will recover the cost basis in the securities
held with unrealized losses as it has both the intent and ability to hold the
securities until they mature or recover in value. Securities are sold to
achieve management's investment goals, which include the diversification of
credit risk, the maintenance of adequate portfolio liquidity, the generation
of a competitive investment yield and the management of interest rate risk.
In order to achieve these goals, sales of investments are based upon current
market conditions, liquidity needs and estimates of the future market value
of the individual securities.
The following table summarizes, for all available-for-sale securities and
held-to-maturity securities, the total gross unrealized losses, excluding
gross unrealized gains, by investment category and length of time the
securities have continuously been in an unrealized loss position as of June
30, 2005:
19
Available-for-sale with
unrealized losses:
Less than 12 months 12 months or longer Total
------------------- ------------------- -------------------
Fair Unrealized Fair Unrealized Fair Unrealized
Value Losses Value Losses Value Losses
------------------- ------------------- -------------------
Fixed securities:
States, municipalities
and political
subdivisions $ 69.6 $(0.4) $ 9.1 $ - $ 78.7 $(0.4)
Corporate securities 77.3 (2.0) 26.5 (0.6) 103.8 (2.6)
Mortgage-backed
securities 43.4 (0.3) 8.0 (0.2) 51.4 (0.5)
- ----------------------------------------------------------------------------------------------
Total fixed maturities 190.3 (2.7) 43.6 (0.8) 233.9 (3.5)
Equity securities 30.2 (2.2) 0.6 (0.2) 30.8 (2.4)
- ----------------------------------------------------------------------------------------------
Total temporarily impaired
securities $220.5 $(4.9) $44.2 $(1.0) $264.7 $(5.9)
==============================================================================================
Held-to-maturity with
unrealized losses:
Less than 12 months 12 months or longer Total
------------------- ------------------- -------------------
Fair Unrealized Fair Unrealized Fair Unrealized
Value Losses Value Losses Value Losses
------------------- ------------------- -------------------
Fixed securities:
Corporate securities $12.9 $ - $52.1 $(0.6) $ 65.0 $(0.6)
Mortgage-backed
securities 19.9 (0.4) 17.0 (0.2) 36.9 (0.6)
- ----------------------------------------------------------------------------------------------
Total temporarily impaired
securities $32.8 $(0.4) $69.1 $(0.8) $101.9 $(1.2)
==============================================================================================
As part of the evaluation of the entire $7.1 aggregate unrealized loss on the
investment portfolio, management performed a more intensive review of
securities with a relatively higher degree of unrealized loss. Based on a
review of each security, management believes that unrealized losses on these
securities were temporary declines in value at June 30, 2005. In the tables
above, there are approximately 120 securities represented. Of this total, 15
securities have unrealized loss positions greater than 5% of their book
values at June 30, 2005, one of which is an equity security with an
unrealized loss position exceeding 20% of its book value. This group
represents $3.5, or 49.2% of the total unrealized loss position. Of this
group, nine securities, representing approximately $3.0 in unrealized losses,
have been in an unrealized loss position for less than twelve months. Of the
remaining six securities, which have been in an unrealized loss position for
longer than twelve months and total $0.5, management believes that it is
probable that all contract terms of the security will be satisfied; the
unrealized loss position is due to the changes in the interest rate
environment; and that it has positive intent and the ability to hold the
securities until they mature or recover in value. As noted above, one equity
security had an unrealized loss position that exceeded 20% at June 30, 2005.
This company operates in the pharmaceutical industry, which has experienced
industry-wide product news that has negatively impacted the market values of
the entire industry. Based on the company's strong financial position and
strong product development pipelines, management believes that current
decline in market value of the security does not represent an other than
temporary decline in value.
All securities are monitored by portfolio managers who consider many factors
such as an issuer's degree of financial flexibility, management competence
and industry fundamentals in evaluating whether the decline in fair value is
temporary. In addition, management considers whether it is probable that all
contract terms of the security will be satisfied and whether the unrealized
loss position is due to changes in the interest rate environment. Should
management subsequently conclude the decline in fair value is other than
temporary, the book value of the security is written down to fair value with
the realized loss being recognized in the then current consolidated statement
of income.
20
The amortized cost and estimated fair value of available-for-sale and held-
to-maturity fixed maturity securities in an unrealized loss position at June
30, 2005, by contractual maturity are shown below. Expected maturities will
differ from contractual maturities because borrowers may have the right to
call or prepay obligations with or without call or prepayment penalties.
Available-for-sale: Amortized Estimated Unrealized
Cost Fair Value Loss
- ------------------------------------------------------------------------------------
Due in one year or less $ - $ - $ -
Due after one year through five years 48.7 47.7 (1.0)
Due after five years through ten years 100.1 98.6 (1.5)
Due after ten years 36.7 36.2 (0.5)
Mortgage-backed securities 51.9 51.4 (0.5)
- ------------------------------------------------------------------------------------
Total $237.4 $233.9 $(3.5)
====================================================================================
Held-to-maturity: Amortized Estimated Unrealized
Cost Fair Value Loss
- ------------------------------------------------------------------------------------
Due in one year or less $ 2.0 $ 2.0 $ -
Due after one year through five years 23.0 22.6 (0.4)
Due after five years through ten years 37.4 37.2 (0.2)
Due after ten years 3.2 3.2 -
Mortgage-backed securities 37.5 36.9 (0.6)
- ------------------------------------------------------------------------------------
Total $103.1 $101.9 $(1.2)
====================================================================================
For additional discussion relative to the Corporation's investment portfolio,
see the "Investment Portfolio" section under "Liquidity and Capital
Resources" on pages 26-28 of this MD&A.
Agent Relationships
The agent relationships asset is an identifiable intangible asset
representing the excess of cost over fair value of net assets acquired in
connection with the acquisition of the commercial lines business from Great
American Insurance Company (GAI) in 1998. Generally Accepted Accounting
Principles (GAAP) requires the Corporation to perform periodic reviews for
possible impairment. These reviews consist of a comparison of estimated
future cash flows to the carrying value of the intangible asset. If the
estimated future cash flows are less than the carrying value for any
individual agent included in the asset, that portion of the asset must be
written down to its estimated fair value. The calculation of impairment
follows accounting guidelines that do not permit increasing the intangible
value for agents who are projected to generate more profit than was expected
at the time of the initial assignment of the intangible value to each agent.
The determination of impairment involves the use of management estimates and
assumptions. Due to the inherent uncertainties and judgments involved in
developing assumptions for each agent and the fact that the asset cannot be
increased for any agent, further reductions in the valuation of the agent
relationships asset are likely to occur in the future. These reductions
could be significant if actual agent revenue production or profitability, or
both, differ materially from current assumptions. Management has considered
these and other factors in determining the remaining useful life of 19 years
for this asset. Overall, the estimated future cash flows for the remaining
acquired agents assigned an intangible value exceed the remaining asset book
value of $114.3 recorded at June 30, 2005. For additional information
regarding agent relationships asset, please refer to Note V in the Notes to
the Consolidated Financial Statements on page 12 in the Quarterly Report on
Form 10-Q.
Operating Results
Insurance industry regulators require the Group to report its financial
condition and results of operations, among other things, using statutory
accounting principles. Management uses industry standard financial measures
determined on a statutory basis, as well as those determined on a GAAP basis
to analyze the Group's property and casualty operations. These insurance
industry financial measures include loss and loss adjustment expense (LAE)
ratios, underwriting expense ratio, combined ratio, net premiums written
21
and net premiums earned. The combined ratio is a commonly used gauge of
underwriting performance measuring the percentage of premium dollars used to
pay insurance losses and related expenses. The combined ratio is the sum of
the loss, LAE and underwriting expense ratios. All references to combined
ratio or its components in this MD&A are calculated on a GAAP basis, unless
otherwise indicated, and are calculated on a calendar year basis unless
specified as calculated on an accident year basis. Insurance industry
financial measures are included in the next several sections of this MD&A
that discuss results of operations. A discussion of the differences between
statutory accounting and generally accepted accounting principles in the
United States is included in Item 15, page 69 of the Corporation's 2004
Annual Report on Form 10-K.
At June 30, 2005 and December 31, 2004, statutory surplus, a financial
measure that is required by insurance regulators and used to monitor
financial strength, was $929.1 and $972.0, respectively. The ratio of twelve
months ended net premiums written to statutory surplus as of June 30, 2005
was 1.6 to 1.0 compared to 1.5 to 1.0 at December 31, 2004. The decrease in
statutory surplus during the first six months of 2005 is primarily a result
of dividend declarations by the Company to the Corporation in the amount of
$111.6 ($81.6 of which was paid in the first half of 2005 and the balance was
paid on July 1, 2005).
Premium Revenue Results
Premium revenue reflects premiums earned by the Group. The Group's premiums
are earned principally on a monthly pro rata basis over the term of the
policy. Management analyzes premium revenues primarily by premiums written
in the current period. Net premiums written differs from gross premiums
written by premiums ceded to reinsurers.
The table below summarizes property and casualty premium on a gross and net
basis compared with the same period of the prior year:
Three months ended June 30, Six months ended June 30,
2005 2004 % Chg 2005 2004 % Chg
---- ---- ----- ---- ---- -----
Gross Premiums Written
- ----------------------
Commercial Lines $223.9 $225.9 (0.9)% $435.1 $446.3 (2.5)%
Specialty Lines 54.2 66.8 (18.9)% 107.4 128.6 (16.5)%
Personal Lines 123.2 127.6 (3.4)% 238.1 246.5 (3.4)%
------ ------ ------ ------
All Lines $401.3 $420.3 (4.5)% $780.6 $821.4 (5.0)%
Three months ended June 30, Six months ended June 30,
2005 2004 % Chg 2005 2004 % Chg
---- ---- ----- ---- ---- -----
Net Premiums Written
- --------------------
Commercial Lines $221.8 $220.3 0.7% $427.4 $432.5 (1.2)%
Specialty Lines 39.7 39.1 1.5% 78.8 73.9 6.6%
Personal Lines 123.4 127.3 (3.1)% 237.2 244.3 (2.9)%
------ ------ ------ ------
All Lines $384.9 $386.7 (0.5)% $743.4 $750.7 (1.0)%
Gross premiums written for the Commercial and Personal Lines segments
declined for the three months and six months ended June 30, 2005, primarily
as a result of a reduction in new business premium production for both
segments and a decline in average renewal price increases. The Group is
devoting more attention in 2005 to identifying opportunities to enhance
premium growth through establishment of service centers, improved sales force
effectiveness and facilitating agency management system interfaces.
Specialty Lines gross premiums written declined as a result of lower new
business production.
The decline in net premiums written was partially offset by lower reinsurance
costs due to increases in reinsurance retention in 2005 and $5.5 of return
ceded premium on experience based reinsurance contracts in the second quarter
of 2005, compared to $5.0 of return ceded premium in the second quarter of
2004. The experience rated reinsurance contracts are for a funded layer of
casualty excess of loss reinsurance coverage. See the Corporation's 2004
Annual Report on Form 10-K Item 7, Reinsurance Programs on page 42 for
greater detail.
22
Commercial Lines renewal price increases averaged 1.6% in the second quarter
2005 compared to 4.5% in the second quarter 2004. This decrease period over
period is the result of a broad market trend of increased competitive pricing
pressure. Renewal price increase means the average increase in premium for
policies renewed by the Group. The average increase in premium for each
renewed policy is calculated by comparing the total expiring premium for the
policy with the total renewal premium for the same policy. Renewal price
increases include, among other things, the effects of rate increases and
changes in the underlying insured exposures of the policy. Only policies
issued by the Group in the previous policy term with the same policy
identification codes are included. Therefore, renewal price increases do not
include changes in premiums for newly issued policies or business assumed
through reinsurance agreements. Renewal price increases also do not reflect
the cost of any reinsurance purchased on the policies issued.
All Lines Discussion
The following table provides key financial measures for All Lines:
Three Months Ended Six Months Ended
June 30 June 30
2005 2004 2005 2004
---- ---- ---- ----
All Lines
- ---------
Loss ratio 52.4% 55.3% 52.6% 54.7%
Loss adjustment expense ratio 11.0% 10.1% 11.4% 10.8%
Underwriting expense ratio 32.1% 33.8% 31.5% 36.0%
----- ----- ----- ------
Combined ratio 95.5% 99.2% 95.5% 101.5%
The All Lines combined ratio for the second quarter 2005 improved 3.7 points
driven by a 2.9 point improvement in the loss ratio and a 1.7 point
improvement in the underwriting expense ratio, partially offset by a 0.9
point deterioration of the loss adjustment expense ratio. The loss ratio
improvement included lower catastrophe losses compared to the second quarter
last year and includes favorable results from the Group's continued focus on
underwriting quality and improved pricing levels, as reflected below. The
underwriting ratio improvement is described below and includes the full
impact of staff reductions related to the 2004 Cost Structure Efficiency
(CSE) Initiative.
The table below summarizes the impact of changes in provision for all prior
accident year losses and LAE:
Three Months Six Months
Ended June 30 Ended June 30
2005 2004 2005 2004
---- ---- ---- ----
Statutory net liabilities,
beginning of period $2,200.7 $2,141.9 $2,183.8 $2,128.9
Decrease in provision for prior
accident year claims $(2.9) $(10.2) $(6.7) $(12.7)
Decrease in provision for prior
accident year claims as % of
premiums earned (0.8)% (2.8)% (0.9)% (1.7)%
Catastrophe losses for the second quarter 2005 were $5.7 or 1.5 points
compared to $11.7 or 3.2 points in the second quarter 2004, a decrease of 1.7
points. The effect of future catastrophes on the Corporation's results of
operations cannot be accurately predicted. As such, severe weather patterns,
acts of war or terrorist activities could have a material adverse impact on
the Corporation's results of operations, reinsurance pricing and availability
of reinsurance. During the second quarter of 2005, there were five
catastrophes with the largest catastrophe generating $1.4 in incurred losses
as compared with six catastrophes in the second quarter of 2004 with the
largest catastrophe generating $3.8 in incurred losses. For additional
disclosure of catastrophe losses, refer to Item 15, Losses and LAE Reserves
in the Notes to the Consolidated Financial Statements on page 66 of the
Corporation's 2004 Annual Report on Form 10-K.
The deterioration in the loss adjustment expense ratio is related to adverse
development on prior year reserves, primarily in the casualty lines, a change
in the mix of premium, as commercial lines grows as a percent of the
portfolio and bears a higher LAE ratio, and higher reinsurance retention and
costs compared to last year.
23
The table below summarizes the variance in the underwriting expense ratio for
the second quarter 2004 compared to the second quarter 2005:
Underwriting expense ratio variance
-----------------------------------
Underwriting expense ratio -
second quarter 2004 33.8%
Contingent liability to Proformance (0.2)%
Decrease to professional fees (0.6)%
2004 Severance related expense due to
work force reduction (0.8)%
Impact of all other underwriting expense
ratio items (0.1)%
------
Underwriting expense ratio - second
quarter 2005 32.1%
=====
The underwriting expense ratio for the second quarter of 2005 includes a $0.7
reduction to the surplus guarantee accrual recorded at March 31, 2005 related
to final settlement with Proformance. The changes in the accrual for the
surplus guarantee favorably impacted the results of operations for the first
six months of 2005 by 0.7 points and increased last year's ratio 1.2 points.
See Note VIII - Contingencies on pages 14 and 15 of this Quarterly Report on
Form 10-Q.
The remainder of the improvement in the underwriting expense ratio is related
to the benefit of the CSE initiative. The largest portion of the CSE
initiative's planned savings were implemented within the second quarter last
year. The CSE initiative is ongoing and we continue to explore new cost
savings and process improvement ideas.
The employee count remained relatively flat when compared to December 31,
2004. As of June 30, 2005, the employee count was 2,170, compared with 2,190
at December 31, 2004 and approximately 2,200 at June 30, 2004.
In both the second quarter 2005 and 2004, underwriting expenses included $0.8
of software amortization expense before tax, related to the rollout of
P.A.R.I.S.(sm). On a GAAP accounting basis, the new application is being
amortized over a ten-year period. This amortization expense is expected to
be offset in part by reduced labor costs related to underwriting and policy
processing.
In 2001, the Group introduced into operation, P.A.R.I.S.(sm) for Commercial
Lines. At the end of 2004, P.A.R.I.S.(sm) was deployed for the Specialty Lines
commercial umbrella excess capacity product line. Further implementation for
other Specialty and Personal Lines products is expected during 2005 and 2006.
The P.A.R.I.S.(sm) system provides the policy administration environment used
internally by the Group's associates. An extension of P.A.R.I.S.(sm) called
P.A.R.I.S. Express(sm) leverages the P.A.R.I.S.(sm) system to provide
underwriting, rating, inquiry and policy processing functionality to our
agents. P.A.R.I.S. Express(sm) is a proprietary internet interface that uses
the P.A.R.I.S.(sm) system to provide real-time functionality through a web
browser to our agents. In addition, the Group is simultaneously introducing
P.A.R.I.S. Connect(tm) which allows agents to transact with the Group directly
from their agency management system without requiring re-entering of customer
or agency information.
For selected Commercial Lines agents, P.A.R.I.S. Express(sm) and P.A.R.I.S.
Connect(tm) provides on-line quoting capability. In February of 2005,
P.A.R.I.S. Express(sm) was extended to support issuance and endorsement
processing for selected pilot agents; nationwide rollout is expected during
2005. Personal Lines currently offers on-line and real time quoting and
issuance for new business and endorsements through existing (non-
P.A.R.I.S.(sm)) systems.
Agents want a cost effective, timely and simple system for issuing and
maintaining insurance policies. P.A.R.I.S. Express(sm) and P.A.R.I.S.
Connect(tm) are the cornerstone in the Group's strategy of focusing on
superior agent service. The success of this strategic plan depends in
part on the ability to provide agents with the technological advantages of
these tools. If they do not work as expected, or fail to satisfy agents'
needs, the Group may lose business to insurers with preferred technologies.
24
Segment Discussion
The Corporation's organizational structure consists of three operating units:
Commercial, Specialty and Personal Lines. The Corporation also has an all
other segment, which derives its revenue from investment income. The
following tables provide key financial measures for each of the property and
casualty reportable segments:
Commercial Lines Segment
Three Months Ended Six Months Ended
June 30 June 30
Commercial Lines Segment 2005 2004 2005 2004
- --------------------------------------------------------------------------------
Net premiums written $221.8 $220.3 $427.4 $432.5
Net premiums earned 206.8 202.4 412.4 400.2
Loss ratio 55.7% 53.4% 56.5% 52.9%
Loss adjustment expense ratio 12.9% 13.0% 14.0% 12.5%
Underwriting expense ratio 34.0% 35.7% 33.9% 37.1%
------ ------ ------ ------
Combined ratio 102.6% 102.1% 104.4% 102.5%
The combined ratio for the three month period ended June 30, 2005 slightly
deteriorated, compared to the same period last year, primarily due to adverse
loss and LAE reserve development concentrated in the workers' compensation
and general liability product lines, somewhat offset by favorable development
in the commercial auto product line. The adverse prior year reserve
development added 2.4 points to the second quarter 2005 loss and LAE ratios
compared to favorable development of 1.0 points in the second quarter 2004.
For the first six months of 2005, Commercial Lines loss and LAE reserves were
adversely impacted by prior year development of 4.2 points compared to
favorable development of 2.2 points in 2004. The adverse development on the
workers' compensation product line for both periods is related to the ongoing
review of lifetime claims and other severe cases. Also impacting the loss
and LAE ratio for these periods were increased assessments for the National
Workers' Compensation Pool, which added 2.8 points to the second quarter 2005
loss and LAE ratio, compared with 0.5 points for the comparable period of the
prior year. The increased assessments this quarter were partially
attributable to settlements between Kemper and the various Workers'
Compensation Pools, in which the cash proceeds from the settlements as well
as the net liabilities to the Pools of the Kemper Insurance Companies were
reallocated and distributed to the remaining participating Pool companies.
The Group continues to focus on improving profitability in the general
liability and workers' compensation product lines. The Group has restricted
writings in states where the workers' compensation product line has
historically been unprofitable and is focused on growing this product line in
profitable states. The first six months of 2005 Commercial Lines loss ratio
included 1.0 points related to catastrophe losses compared to 0.8 points
during the same period in 2004. The 3.2 point improvement in the
underwriting expense ratio for the six months ended is the result of CSE
initiatives.
Specialty Lines Segment
Three Months Ended Six Months Ended
June 30 June 30
Specialty Lines Segment 2005 2004 2005 2004
- --------------------------------------------------------------------------------
Net premiums written $39.7 $39.1 $78.8 $73.9
Net premiums earned 36.4 40.8 71.5 82.5
Loss ratio 41.6% 45.8% 42.3% 42.9%
Loss adjustment expense ratio 9.8% 3.0% 8.9% 3.5%
Underwriting expense ratio 43.9% 46.3% 44.6% 46.2%
----- ----- ----- -----
Combined ratio 95.3% 95.1% 95.8% 92.6%
The Specialty Lines combined ratio for the three months ended June 30, 2005
was comparable to the same period last year as favorable reserve development
on bonds was offset by higher loss and LAE ratios related to increased
retention on commercial umbrella risks. The Specialty Lines loss and LAE
ratios were favorably impacted by prior year reserve development of 4.1
points in second quarter 2005 compared to 5.1 points in second quarter 2004.
25
Personal Lines Segment
Three Months Ended Six Months Ended
June 30 June 30
Personal Lines Segment 2005 2004 2005 2004
- --------------------------------------------------------------------------------
Net premiums written $123.4 $127.3 $237.2 $244.3
Net premiums earned 122.3 124.0 243.9 245.6
Loss ratio 50.1% 61.6% 49.0% 61.6%
Loss adjustment expense ratio 8.2% 7.8% 7.8% 10.4%
Underwriting expense ratio 25.5% 26.4% 23.7% 30.9%
----- ----- ----- ------
Combined ratio 83.8% 95.8% 80.5% 102.9%
The combined ratio for the three months ended June 30, 2005 improved 12.0
points when compared to the same period of the prior year, primarily driven
by improvements to both the loss and underwriting expense ratios, partially
offset by an increase in the LAE ratio. The loss ratio for the second
quarter 2005 improved 11.5 points when compared to second quarter 2004, while
the LAE ratio deteriorated 0.4 points. The loss ratio improvement was driven
by lower catastrophe losses, favorable development on prior years' reserves,
increased pricing and favorable claims frequency trends. In the second
quarter 2005, favorable development on prior year reserves lowered the loss
and LAE ratio by 5.2 points compared to 4.8 points of favorable prior year
reserve development in 2004. The second quarter 2005 Personal Lines loss
ratio included 2.2 point of catastrophe losses, compared to 8.0 points in the
second quarter of 2004. During the first six months of 2005, the Personal
Lines loss ratio was impacted by 1.6 points related to catastrophe losses
compared to 4.7 points during the same period in 2004. The second quarter
2005 underwriting expense ratio includes a 0.6 point reduction pertaining to
the surplus guarantee related to the Proformance transaction compared to no
impact in the same period last year. The first six months of 2005
underwriting expense ratio included a 2.1 point reduction related to the
Proformance surplus guarantee, compared to a 3.7 point increase in the same
period last year. The remainder of the improvement in the underwriting
expense ratio is primarily related to the recognition of the full benefit of
the CSE initiative staff reductions implemented in the first half of 2004.
Statutory Earned Premium and Combined Ratios
Combined Ratios
Earned -----------------------------------------------------
Premium Calendar Year Accident Year
Year to Date Year to Date Year to Date Calendar Accident
June 30, June 30, June 30, Year Year
(By operating segment) 2005 2005 2005(a) 2004 2004(a)
- -------------------------------------------------------------------------------------------
Commercial Lines $412.4 103.3% 99.1% 99.3% 100.3%
Specialty Lines 71.5 87.6% 93.7% 97.2% 102.9%
Personal Lines 243.9 80.9% 89.0% 97.6% 95.5%
- -------------------------------------------------------------------------------------------
Total All Lines $727.8 94.4% 95.4% 98.4% 98.7%
===========================================================================================
(a) The loss and LAE ratio component of the accident year combined ratio
measures losses and LAE arising from insured events that occurred in the
respective accident year. The current accident year excludes losses and LAE
for insured events that occurred in prior accident years. The measurement
date for accident year data is June 30, 2005. Partial and complete accident
periods may not be comparable due to seasonality, claim reporting and
development patterns, claim settlement rates and other factors.
LIQUIDITY AND CAPITAL RESOURCES
Investment Portfolio
The following table sets forth the distribution and other data of investments
at June 30, 2005 and December 31, 2004, respectively.
26
June 30, 2005 December 31, 2004
------------- -----------------
Average Amortized Carrying % of Amortized Carrying % of
Rating Cost Value Total Cost Value Total
---------------------------------------------------------------------
U.S Government:
Available-for-sale AAA $ 35.5 $ 36.8 0.9 $ 31.9 $ 33.4 0.8
States, municipalities,
and political
subdivisions:
Investment grade:
Available-for-sale AA+ 1,168.7 1,195.4 28.6 1,018.4 1,034.6 24.4
Corporate securities:
Investment grade:
Available-for-sale A 1,583.9 1,697.3 40.5 1,562.8 1,686.4 39.7
Held-to-maturity A+ 163.2 163.2 3.9 164.7 164.7 3.9
Below Investment grade:
Available-for-sale BB 60.7 65.3 1.6 51.6 58.4 1.4
-------------------------------------------------------------
Total corporate
securities 1,807.8 1,925.8 46.0 1,779.1 1,909.5 45.0
-------------------------------------------------------------
Mortgage-backed securities:
Investment grade:
Available-for-sale AAA 503.9 525.1 12.5 505.2 524.7 12.4
Held-to-maturity AAA 120.0 120.0 2.9 136.7 136.7 3.2
Below Investment grade:
Available-for-sale B 1.9 1.9 - 6.9 8.6 0.2
-------------------------------------------------------------
Total mortgage-backed
securities 625.8 647.0 15.4 648.8 670.0 15.8
-------------------------------------------------------------
Total fixed maturities 3,637.8 3,805.0 90.9 3,478.2 3,647.5 86.0
Equity securities 102.2 356.8 8.5 98.9 357.4 8.4
Short-term investments 24.7 24.7 0.6 239.9 239.1 5.6
-------------------------------------------------------------
Total investment portfolio $3,764.7 $4,186.5 100.0 $3,817.0 $4,244.0 100.0
=============================================================
The fixed maturity portfolio is allocated between investment grade and below
investment grade as follows:
June 30, 2005 December 31, 2004
------------- -----------------
Amortized Carrying % of Amortized Carrying % of
Cost Value Fixed Cost Value Fixed
-------------------------------------------------------------
Total investment grade $3,575.2 $3,737.8 98.2 $3,419.7 $3,580.5 98.2
Total below investment grade 62.6 67.2 1.8 58.5 67.0 1.8
The fixed maturity portfolio is allocated between available-for-sale
and held-to-maturity as follows:
Total available-for-sale
fixed securities $3,354.5 $3,521.7 92.6 $3,176.8 $3,346.1 91.7
Total held-to-maturity fixed
securities 283.3 283.3 7.4 301.4 301.4 8.3
The excess of carrying value over cost was $421.8 at June 30, 2005, compared
with $427.0 at December 31, 2004. The decrease in 2005 was attributable to
an increase in interest rates for fixed maturity securities and the decline
in the market value of certain equity securities. This decline in the excess
of carrying value over cost during the six months ended June 30, 2005
decreased the Corporation's book value by $0.06 per share, which was
offset by the improved profitability of the Corporation. See page 30 for
reconciliation of book value per share from December 31, 2004 to June 30,
2005.
The consolidated fixed maturity portfolio, including short-term securities,
has an intermediate duration and a laddered maturity structure. The duration
of the fixed maturity portfolio was approximately 5.3 years at June 30, 2005
and 5.1 years at December 31, 2004. The increase in the duration is
principally the result of the reduction in short term investments used to
facilitate the redemption of the Convertible Notes. The Corporation and the
Group remain fully invested and do not time markets.
Fixed maturity securities are classified as investment grade or non-
investment grade based upon the higher of the ratings provided by S&P and
Moody's. When a security is not rated by either S&P or Moody's, the
classification is based on other rating services, including the Securities
Valuation Office of the National
27
Association of Insurance Commissioners. The market value of available-for-
sale split-rated fixed maturity securities (i.e., those having an investment
grade rating from one rating agency and a below investment grade rating from
another rating agency) was $29.1 and $31.5 at June 30, 2005 and December 31,
2004, respectively.
Investments in below investment grade securities have greater risks than
investments in investment grade securities. The risk of default by borrowers
that issue below investment grade securities is significantly greater because
these borrowers are often highly leveraged and more sensitive to adverse
economic conditions, including a recession or a sharp increase in interest
rates.
Following is a table displaying available-for-sale non-investment grade and
non-rated securities in an unrealized loss position at June 30, 2005 and
December 31, 2004:
Amortized Fair Unrealized
Cost Value Loss
- --------------------------------------------------------------------
June 30, 2005 $4.0 $4.0 $ -
December 31, 2004 1.5 1.4 (0.1)
Equity securities are carried at fair market value on the consolidated
balance sheets. As a result, shareholders' equity and statutory surplus
fluctuate with changes in the value of the equity portfolio. As of June 30,
2005, the equity portfolio consisted of stocks in a total of 51 separate
entities in nine different industries. Of this total, 32.6% were invested in
five companies and the largest single position was 10.4% of the equity
portfolio. At December 31, 2004, the equity portfolio consisted of stocks in
50 separate entities in nine different industries. Of this total, 31.2% were
invested in five companies and the largest single position was 7.3% of the
equity portfolio.
In June 2004, the Corporation invested the proceeds of the Senior Note
offering in short-term investments. Short-term investments are carried at
fair market value on the consolidated balance sheets and produce a lower
yield. In the second quarter of 2005, these investments were liquidated to
fund the redemption of the Company's 5.00% Convertible Notes, see Liquidity
and Capital Resources - Debt for additional information regarding this
transaction.
The investment portfolio also includes non-publicly traded securities such as
private placements, non-exchange traded equities and limited partnerships
which are carried at fair value. Fair values are based on valuations from
pricing services, brokers and other methods as determined by management to
provide the most accurate price. The carrying value of this portfolio at
June 30, 2005, was $296.0 compared to $310.8 at December 31, 2004.
The Corporation and Group use assumptions and estimates when valuing certain
investments and related income. These assumptions include estimations of
cash flows and interest rates. Although the Corporation and Group believe
the values of its investments represent fair value, certain estimates could
change and lead to changes in fair values due to the inherent uncertainties
and judgements involved with accounting measurements.
Losses and Loss Adjustment Expenses
The Group's largest liabilities are reserves for losses and LAE. Loss and
LAE reserves are established for all incurred claims without discounting for
the time value of money and before credit for reinsurance recoverable. Loss
and LAE reserves are adjusted upward or downward as new information is
received.
These reserves amounted to $2.9 billion at June 30, 2005 and $2.8 billion at
December 31, 2004. As of June 30, 2005, the reserves by operating segment
were as follows: $1.8 billion in Commercial Lines, $0.7 billion in Specialty
Lines and $0.4 billion in Personal Lines.
The Group's actuaries conduct a reserve study using generally accepted
actuarial methods each quarter from which point estimates of ultimate losses
and LAE by product line or coverage within product line are selected. In
selecting the point estimates, thousands of data points are reviewed and the
judgment of the
28
actuaries is applied broadly. Each quarter management records its best
estimate of the liability for loss and LAE reserves by considering the
actuaries' point estimates. Management's best estimate recognizes that there
is uncertainty underlying the actuarial point estimates.
Estimating the ultimate cost of claims is a complex process. This estimation
process is based largely on the assumption that actuarial reserving methods,
using historical loss experience applied by experienced reserving actuaries,
produces reasonable estimates of future losses on prior insured events.
Reserve estimates can change over time because of unexpected changes in the
internal and/or external environment. Assumptions internal to company
operations include: recording of premium and loss statistics in the
appropriate detail is accurate and consistent; claims handling, including the
recording of claims, payment and closure rates, and case reserving is
consistent; the quality of business written and the mix of business (e.g.
states, limits, coverages and deductibles) have been consistent; rate changes
and changes in policy provisions have been measured accurately; reinsurance
coverage has been consistent and reinsured losses are collectible.
Assumptions related to the external environment include: tort law and the
legal environment have been and remain consistent; coverage interpretation by
the courts has been and remains consistent; regulations regarding coverage
provisions have been consistent; and loss inflation is relatively stable. To
the extent any of the above factors have changed over time, attempts are made
to adjust for the changes.
Changes to losses and LAE for prior accident years favorably impacted results
of operations for the three months ended June 30, 2005 and 2004 by $2.9 and
$10.2, respectively. For the six months ended June 30, 2005 and 2004,
changes to losses and LAE for prior accident years favorably impacted the
results of operations by $6.7 and $12.7, respectively. These amounts and
those stated below are net of reinsurance, including the allowance for
uncollectible reinsurance recoverables. The following table provides the
before-tax amount of prior accident years' loss and LAE reserve development
by reportable segment:
Three Months Ended Six Months Ended
June 30 June 30 Year
2005 2004 2005 2004 2004
------------------ ---------------- ----
(Favorable)/Unfavorable
- -----------------------
Commercial Lines $ 5.0 $ (2.1) $ 17.2 $ (8.7) $(15.0)
Specialty Lines (1.5) (2.1) (4.3) (5.2) (9.4)
Personal Lines (6.4) (6.0) (19.6) 1.2 2.6
------ ------- ------- ------- ------
All Lines Prior
Accident Year
Development $(2.9) $(10.2) $ (6.7) $(12.7) $(21.8)
====== ======= ======= ======= =======
For the six months ended June 30, 2005, the principal reason for favorable
development is less severity than expected for automobile liability claims,
both personal and commercial, spread across accident years 2000 through 2004.
For Commercial Lines the favorable development in the commercial auto product
line was more than offset by adverse development from the workers'
compensation product line for accident years 2000 and prior. This adverse
workers' compensation development is mostly attributable to a review of
permanent cases to re-assess life expectancy and increased medical costs. A
substantial increase in losses for prior accident years reported by the
National Workers' Compensation Pool in the second quarter also contributed to
the adverse development in this product line.
The following table provides prior accident years' development for loss and
LAE by accident year:
Three Months Ended Six Months Ended
June 30 June 30 Year
2005 2004 2005 2004 2004
------------------ ---------------- ----
(Favorable)/Unfavorable
- -----------------------
Accident Year 2004 $(6.6) $ - $(15.9) $ - $ -
Accident Year 2003 (6.5) (8.1) (17.3) (22.2) (36.9)
Accident Year 2002
and Prior 10.2 (2.1) 26.5 9.5 15.1
------ ------- ------- ------- -------
Total Prior Accident
Years' Development $(2.9) $(10.2) $ (6.7) $(12.7) $(21.8)
====== ======= ======= ======= =======
29
In the opinion of management, the reserves recorded at June 30, 2005
represent the Group's best estimate of its ultimate liability for losses and
LAE. However, due to the complexity of the estimation process and the
potential variability of the assumptions used, final claim settlements may
vary significantly from the amounts recorded. Furthermore, the timing,
frequency and extent of adjustments to the estimated liabilities cannot be
predicted since conditions and events which established loss and LAE reserve
development and which serve as the basis for estimating ultimate claim costs
may not occur in exactly the same manner in the future, if at all.
Cash Flow
Net cash generated from operations was $93.3 for the first six months of
2005, compared with $97.2 for the same period in 2004. Net cash used in
investing was $156.3 in the first six months of 2005 compared with $92.3
during the first six months of 2004. The increase in net cash used for
investing is primarily related to a decrease in net proceeds from sales and
maturities of investments when compared to the same period in 2004. Cash
used in financing operations was $154.9 in the first six months of 2005
compared with cash provided by financing operations of $202.5 in the first
six months of 2004. Repurchases and the redemption of the convertible debt
attributed to the decline in cash used in financing activities. Liquidity
needs of the Group are expected to be met by net cash generated from
operations, maturities of investments, interest and dividend receipts and
current cash balances. For additional information regarding Liquidity of the
Corporation, please see below.
Debt
For a discussion regarding Debt of the Corporation, please refer to Note VII
in the Notes to the Consolidated Financial Statements on pages 13 and 14 of
this Quarterly Report on Form 10-Q.
At June 30, 2005, the Corporation had cash and marketable securities,
totaling $249.6, which compared to $327.5 at December 31, 2004. In addition
to investment income, the Corporation is dependent on dividend payments from
the Company for additional liquidity. Insurance regulatory authorities
impose various restrictions on the payment of dividends by insurance
companies. During 2005, dividend payments from the Company to the
Corporation are limited to approximately $138.3 without prior approval of the
Ohio Insurance Department. During the first half of 2005, the Company
declared dividends of $111.6 ($81.6 paid in the first half of 2005) to the
Corporation resulting in a dividend payment limitation of $26.7 for the
remainder of 2005.
Book Value Per Share
At June 30, 2005, the Corporation experienced an increase in book value of
$1.07 per share from $20.82 per share to $21.89 per share when compared to
book value at December 31, 2004. This increase is principally the result of
improved profitability. Below is a table reconciling the changes in book
value per share from December 31, 2004 to June 30, 2005.
Book
Value
-----
December 31, 2004 $20.82
Activity for the six months ended
June 30, 2005:
Net income 1.28
Change in unrealized gains (0.06)
Impact of convertible notes and other APIC
transactions 0.24
Dividend to shareholders (0.06)
Impact of increase in actual shares outstanding (0.33)
-------
June 30, 2005 $21.89
======
30
Rating Agencies
Regularly the financial condition of the Corporation and the Group is
reviewed by four independent rating agencies, A. M. Best Company (A.M. Best),
Fitch, Inc. (Fitch), Moody's and S&P. These agencies assign ratings and
rating outlooks reflecting the agencies' opinions of the Group's financial
strength and the ability of the Corporation to meet its financial obligations
to its debt security holders. Following are the Corporation's current
ratings and rating outlooks.
A.M. Best Fitch Moody's S&P
--------- ----- ------- ---
Financial strength rating A- A- A3 BBB
Senior unsecured debt rating bbb- BBB- Baa3 BB
Rating outlook Stable Stable Stable Positive
For more information on the most recent rating agency actions, please refer
to Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations in the Corporation's 2004 Annual Report on Form 10-K
for the year ended December 31, 2004.
Forward Looking Statements
Ohio Casualty Corporation publishes forward-looking statements relating to
such matters as anticipated financial performance, business prospects and
plans, regulatory developments and similar matters. The statements contained
in this Management's Discussion and Analysis that are not historical
information, are forward-looking statements within the meaning of The Private
Securities Litigation Reform Act of 1995. The operations, performance and
development of the Corporation's business are subject to risks and
uncertainties which may cause actual results to differ materially from those
contained in or supported by the forward looking statements. The risks
and uncertainties that may affect the operations, performance, development
and results of the Corporation's business include the following: changes in
property and casualty reserves; catastrophe losses; premium and investment
growth; product pricing environment; availability of credit; changes in
government regulation; performance of financial markets; fluctuations in
interest rates; availability and pricing of reinsurance; litigation and
administrative proceedings; rating agency actions; acts of war and terrorist
activities; ability to achieve targeted expense savings; ability to appoint
and retain agents; ability to achieve premium targets and profitability
goals; and general economic and market conditions.
ITEM 3. Quantitative and Qualitative Disclosures about Market Risk
There have been no material changes in the information about market risk set
forth in the Corporation's 2004 Annual Report on Form 10-K.
ITEM 4. Controls and Procedures
(a) The Corporation's Chief Executive Officer and Chief Financial
Officer evaluated the disclosure controls and procedures (as
defined under Rules 13a-15(e) and 15d-15(e) of the Securities
Exchange Act of 1934, as amended) as of the end of the period
covered by this report. Based upon that evaluation, the Chief
Executive Officer and Chief Financial Officer have concluded
that the Corporation's disclosure controls and procedures are
effective.
(b) There were no significant changes in the Corporation's internal
control over financial reporting identified in connection with
the foregoing evaluation that occurred during the Corporation's
last fiscal quarter that have affected, or are reasonably
likely to materially affect, the Corporation's internal control
over financial reporting.
31
PART II Other Information
ITEM 4. Submission of Matters to a Vote of Security Holders
At the Annual Meeting of Shareholders (the Annual Meeting) held on
May 18, 2005, shareholders voted on the re-election of four members
of the Board of Directors for terms expiring in 2008 as follows.
Dan R. Carmichael For 51,888,760; Withheld 5,025,828
Catherine E. Dolan For 49,958,687; Withheld 6,955,901
Philip G. Heasley For 51,054,689; Withheld 5,859,899
Michael L. Wright For 52,484,554; Withheld 4,430,034
Other directors whose term of office continued after the meeting
were: Terrence J. Baehr, Jack E. Brown, Ralph S. Michael III,
Robert A. Oakley, Stanley N. Pontius and Jan H. Suwinski. Ralph S.
Michael III resigned from the Board of Directors effective July 25,
2005.
Also, at the Annual Meeting, shareholders approved a proposal for
The Ohio Casualty Corporation 2005 Incentive Plan. The proposal
was approved with a final vote of:
For 43,096,208; Against 8,760,493; Abstain 246,349;
Broker Non-Vote 4,811,538
ITEM 6. Exhibits
Exhibits:
10 Ohio Casualty Corporation 2005 Incentive Plan
31.1 Certification of Chief Executive Officer of Ohio Casualty
Corporation in accordance with SEC Rule 13(a) and Rule 15(d)
31.2 Certification of Chief Financial Officer of Ohio Casualty
Corporation in accordance with SEC Rule 13(a) and Rule 15(d)
32.1 Certification of Chief Executive Officer of Ohio Casualty
Corporation in accordance with Section 1350 of the
Sarbanes-Oxley Act of 2002
32.2 Certification of Chief Financial Officer of Ohio Casualty
Corporation in accordance with Section 1350 of the
Sarbanes-Oxley Act of 2002
32
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
OHIO CASUALTY CORPORATION
-------------------------
(Registrant)
July 26, 2005 /s/Michael A. Winner
-------------------------------
Michael A. Winner, Executive
Vice President and Chief Financial
Officer
33