=============================================================================
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 March 31, 2006.
[ ] 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 a large accelerated
filer, an accelerated filer, or a non-accelerated filer. See definition of
"accelerated filer and large accelerated filer" in Rule 12b-2 of the
Exchange Act.
Large accelerated filer X Accelerated filer
-----
Non-accelerated filer
Indicate by check mark whether the registrant is a shell company (as
defined in Rule 12b-2 of the Exchange Act).
Yes No X
-----
On April 25, 2006, there were 63,581,815 shares of common stock
outstanding.
Page 1 of 29
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INDEX
Page
----
PART I FINANCIAL INFORMATION
Item 1. Financial Statements 3
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations 16
Item 3. Quantitative and Qualitative Disclosures about
Market Risk 28
Item 4. Controls and Procedures 28
PART II OTHER INFORMATION
Item 1. Legal Proceedings 28
Item 2. Unregistered Sales of Equity Securities
and Use of Proceeds 29
Item 6. Exhibits 29
Signature 29
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
March 31, December 31,
(in millions, except share data) 2006 2005
===========================================================================================
Assets (Unaudited)
Investments:
Fixed income securities:
Available-for-sale, at fair value
(amortized cost: $3,480.0 and $3,453.5) $ 3,502.6 $ 3,527.7
Held-to-maturity, at amortized cost
(fair value: $250.8 and $260.5) 259.4 264.4
Equity securities, at fair value
(cost: $150.3 and $144.2) 377.8 375.1
- -------------------------------------------------------------------------------------------
Total investments 4,139.8 4,167.2
Cash and cash equivalents 53.1 54.5
Premiums and other receivables, net of allowance 304.5 309.2
Deferred policy acquisition costs 151.9 153.7
Property and equipment, net of accumulated depreciation 79.4 80.1
Reinsurance recoverable, net of allowance 732.3 741.8
Agent relationships, net of accumulated amortization 106.9 109.7
Interest and dividends due or accrued 48.0 55.0
Deferred tax asset, net 20.8 14.8
Other assets 123.2 77.1
- -------------------------------------------------------------------------------------------
Total assets $ 5,759.9 $ 5,763.1
===========================================================================================
Liabilities
Insurance reserves:
Losses $ 2,441.4 $ 2,435.0
Loss adjustment expenses 510.4 511.8
Unearned premiums 673.9 679.6
Debt 200.0 200.4
Reinsuance treaty funds held 146.6 150.4
Other liabilities 345.8 359.5
- -------------------------------------------------------------------------------------------
Total liabilities 4,318.1 4,336.7
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 18.0 18.8
Accumulated other comprehensive income 142.3 178.0
Retained earnings 1,409.7 1,360.6
Treasury stock, at cost:
(Shares: 8,924,679; 9,137,208) (137.2) (140.0)
- -------------------------------------------------------------------------------------------
Total shareholders' equity 1,441.8 1,426.4
- -------------------------------------------------------------------------------------------
Total liabilities and shareholders' equity $ 5,759.9 $ 5,763.1
===========================================================================================
Accompanying notes are an integral part of these consolidated financial
statements. For complete disclosures see Notes to Consolidated Financial
Statements on pages 67-84 of the Corporation's 2005 Form 10-K.
3
ITEM 1. Continued
Ohio Casualty Corporation & Subsidiaries
CONSOLIDATED STATEMENTS OF INCOME
Three Months
Ended March 31,
(in millions, except share and per share data) (Unaudited) 2006 2005
- -------------------------------------------------------------------------------------------
Premiums and finance charges earned $ 357.7 $ 362.3
Investment income, less expenses 50.9 48.4
Investment gains realized, net 14.2 -
- -------------------------------------------------------------------------------------------
Total revenues 422.8 410.7
Losses and benefits for policyholders 189.0 191.1
Loss adjustment expenses 36.7 42.9
General operating expenses 116.7 113.3
Write-down and amortization of agent relationships 2.9 4.4
Amortization of deferred policy acquisition costs 82.9 87.1
Deferral of policy acquisition costs (81.1) (81.4)
Depreciation and amortization expense 2.5 2.9
Loss on retirement of convertible debt, including
debt conversion expenses - 0.7
- -------------------------------------------------------------------------------------------
Total expenses 349.6 361.0
- -------------------------------------------------------------------------------------------
Income before income taxes 73.2 49.7
Income tax expense:
Current 8.2 5.6
Deferred 13.1 6.4
- -------------------------------------------------------------------------------------------
Total income tax expense 21.3 12.0
- -------------------------------------------------------------------------------------------
Net income $ 51.9 $ 37.7
===========================================================================================
Weighted average shares outstanding - basic 63,235,681 62,359,823
===========================================================================================
Earnings per share - basic:
Net income, per share $ 0.82 $ 0.60
===========================================================================================
Weighted average shares outstanding - diluted 64,836,502 71,675,055
===========================================================================================
Earnings per share - diluted:
Net income, per share $ 0.80 $ 0.55
===========================================================================================
Accompanying notes are an integral part of these consolidated financial
statements. For complete disclosures see Notes to Consolidated Financial
Statements on pages 67-84 of the Corporation's 2005 Form 10-K.
4
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, 2005 $ 9.0 $ - $ 259.1 $1,161.5 $(134.7) $1,294.9
Net income 37.7 37.7
Change in unrealized gain,
net of deferred income tax
expense of $24.6 (45.6) (45.6)
------------
Comprehensive income (7.9)
Net issuance of restricted stock
(8,664 shares) (0.1) 0.1 -
Net issuance of treasury
stock (414,573 shares) (0.5) 5.1 4.6
- -----------------------------------------------------------------------------------------------------------------
Balance,
March 31, 2005 $ 9.0 $ - $ 213.5 $1,198.6 $(129.5) $1,291.6
=================================================================================================================
Balance
January 1, 2006 $ 9.0 $ 18.8 $ 178.0 $1,360.6 $(140.0) $1,426.4
Net income 51.9 51.9
Change in unrealized gain,
net of deferred income tax
expense of $19.1 (35.7) (35.7)
------------
Comprehensive income 16.2
Net issuance of restricted stock
(10,474 shares) 0.2 0.1 0.3
Unearned stock compensation (2.9) 2.9 -
Stock based compensation, net of
income tax benefit of $1.2 2.2 2.2
Net issuance of treasury
stock (238,835 shares) (0.3) 3.7 3.4
Repurchase of treasury stock
(36,780 shares) (1.0) (1.0)
Cash dividend paid ($0.09 per share) (5.7) (5.7)
- -----------------------------------------------------------------------------------------------------------------
Balance,
March 31, 2006 $ 9.0 $ 18.0 $ 142.3 $1,409.7 $(137.2) $1,441.8
=================================================================================================================
Accompanying notes are an integral part of these consolidated financial
statements. For complete disclosures see Notes to Consolidated Financial
Statements on pages 67-84 of the Corporation's 2005 Form 10-K.
5
ITEM 1. Continued
Ohio Casualty Corporation & Subsidiaries
CONSOLIDATED STATEMENTS OF CASH FLOWS
Three Months
Ended March 31,
(in millions) (Unaudited) 2006 2005
- -------------------------------------------------------------------------------------------------
Cash Flows from Operating Activities:
Operating Activities
Net income $ 51.9 $ 37.7
Adjustments to reconcile net income to net cash
provided by operations:
Changes in:
Insurance reserves (0.7) 37.4
Reinsurance treaty funds held (3.8) 1.1
Income taxes 11.2 2.0
Premiums and other receivables 4.7 23.1
Deferred policy acquisition costs 1.8 5.6
Reinsurance recoverable 9.5 (34.9)
Other assets (11.7) 1.1
Other liabilities (27.0) (24.9)
Loss on retirement of convertible debt, including
debt conversion expenses - 0.7
Stock-based compensation expense 1.4 -
Amortization and write-down of agent relationships 2.9 4.4
Depreciation and amortization 2.5 2.9
Investment gains realized, net (14.2) -
- -------------------------------------------------------------------------------------------------
Net cash provided by operating activities 28.5 56.2
- -------------------------------------------------------------------------------------------------
Cash Flows from Investing Activities:
Purchase of securities:
Fixed income, available-for-sale (272.9) (221.5)
Fixed income, held-to-maturity (0.2) (0.2)
Equity (13.2) -
Proceeds from sales of securities:
Fixed income, available-for-sale 187.2 177.7
Equity 22.8 0.6
Proceeds from maturities and calls of securities:
Fixed income, available-for-sale 45.7 15.1
Fixed income, held-to-maturity 4.8 6.6
Property and equipment
Purchases (2.0) (2.4)
Sales 0.1 -
- -------------------------------------------------------------------------------------------------
Net cash used in investing activities (27.7) (24.1)
- -------------------------------------------------------------------------------------------------
Cash Flows from Financing Activities:
Debt:
Repayments (0.2) (4.7)
Payment for deferred financing costs (0.3) -
Proceeds from exercise of stock options 3.3 4.5
Repurchase of treasury stock (1.0) -
Income tax benefit from stock option exercises 1.7 -
Dividends paid to shareholders (5.7) -
- -------------------------------------------------------------------------------------------------
Net cash used in financing activities (2.2) (0.2)
- -------------------------------------------------------------------------------------------------
Net increase (decrease) in cash and cash equivalents (1.4) 31.9
Cash and cash equivalents, beginning of period 54.5 252.6
- -------------------------------------------------------------------------------------------------
Cash and cash equivalents, end of period $ 53.1 $ 284.5
=================================================================================================
Accompanying notes are an integral part of these consolidated financial
statements. For complete disclosures see Notes to Consolidated Financial
Statements on pages 67-84 of the Corporation's 2005 Form 10-K.
6
Ohio Casualty Corporation & Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
Ohio Casualty Corporation (the Corporation) is the holding company of The
Ohio Casualty Insurance Company (the Company), which is one of six property-
casualty insurance companies that make up the Ohio Casualty Group (the
Group), collectively the "Consolidated Corporation". 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 March 31, 2006 and the
Consolidated Statements of Income, Shareholders' Equity and Cash Flows for
the three months ended March 31, 2006 and 2005, without an audit. In the
opinion of management, all adjustments necessary to fairly present the
financial position, results of operations and cash flows at March 31, 2006
and for each period 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 2005 Annual Report on Form 10-K. The results of operations
for the period ended March 31, 2006 are not necessarily indicative of the
results of operations for the full year.
The preparation of financial statements in conformity with accounting
principles generally accepted in the United States requires management to
make estimates and assumptions that affect the reported amounts of assets
and liabilities, the disclosure of contingent assets and liabilities at the
date of the financial statements and the reported amounts of revenues and
expenses during the reporting period. Actual results could differ from
those estimates.
The premiums receivable balance is presented net of bad debt allowances
determined by management of $4.0 at March 31, 2006 and $4.2 at December 31,
2005. Property and equipment are carried at cost less accumulated
depreciation of $179.4 and $177.2 at March 31, 2006 and December 31, 2005,
respectively. Amounts recoverable from reinsurers are calculated in a
manner consistent with the reinsurance contract and are reported net of
allowance of $3.7 at both March 31, 2006 and December 31, 2005.
7
NOTE II - EARNINGS PER SHARE
Basic and diluted earnings per share are summarized as follows:
Three Months Ended March 31,
2006 2005
- ----------------------------------------------------------------------------
Net income $51.9 $37.7
Weighted average common shares
outstanding - basic (thousands) 63,236 62,360
Basic net income per weighted average share $0.82 $0.60
============================================================================
Net income $51.9 $37.7
Effect of EITF 04-8 on net income using
"if-converted" method $ - $ 1.6
Adjusted net income using
"if-converted" method $51.9 $39.3
Weighted average common shares
Outstanding - basic (thousands) 63,236 62,360
Effect of dilutive securities from stock
compensation plans (thousands) 1,601 1,346
Effect of EITF 04-8 (thousands) - 7,969
- ----------------------------------------------------------------------------
Weighted average common shares
outstanding - diluted (thousands) 64,837 71,675
Diluted net income per weighted average share $0.80 $0.55
============================================================================
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.
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. As a result of this EITF, the
Consolidated Corporation has included 8.0 million shares into its diluted
earnings per share calculation using the "if-converted" method for the
first quarter of 2005.
NOTE III -- SEGMENT INFORMATION
The Consolidated 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 Consolidated
Corporation also has an All Other segment which derives its revenues from
investment income of the Corporation. The other expenses included in this
segment consist primarily of interest expense.
Each of the segments of the Consolidated 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 Consolidated Corporation does not produce such
information internally.
8
Three Months Ended March 31,
Commercial Lines Segment 2006 2005
- ----------------------------------------------------------------------
Net premiums written $212.4 $205.6
% Change 3.3% (3.1)%
Net premiums earned 204.6 205.6
% Change (0.5)% 3.9%
Underwriting loss (before tax) (3.6) (12.9)
Specialty Lines Segment 2006 2005
- ----------------------------------------------------------------------
Net premiums written $35.8 $39.1
% Change (8.4)% 12.4%
Net premiums earned 37.3 35.1
% Change 6.3% (15.8)%
Underwriting gain (before tax) 9.2 1.3
Personal Lines Segment 2006 2005
- ----------------------------------------------------------------------
Net premiums written $105.9 $113.8
% Change (6.9)% (2.7)%
Net premiums earned 115.8 121.6
% Change (4.8)% -
Underwriting gain (before tax) 12.6 27.7
Total Property & Casualty 2006 2005
- ----------------------------------------------------------------------
Net premiums written $354.1 $358.5
% Change (1.2)% (1.5)%
Net premiums earned 357.7 362.3
% Change (1.3)% 0.3%
Underwriting gain (before tax) 18.2 16.1
All Other Segment 2006 2005
- ----------------------------------------------------------------------
Revenues $ 3.6 $ 3.3
Write-down and amortization of
agent relationships (2.9) (4.4)
Other expenses (7.2) (10.4)
- ----------------------------------------------------------------------
Net loss before income tax $(6.5) $(11.5)
Reconciliation of Revenues 2006 2005
- ----------------------------------------------------------------------
Net premiums earned for
reportable segments $357.7 $362.3
Net investment income 47.2 45.1
Realized gains, net 14.3 -
- ----------------------------------------------------------------------
Total property and casualty revenues 419.2 407.4
All other segment revenues 3.6 3.3
- ----------------------------------------------------------------------
Total revenues $422.8 $410.7
======================================================================
Reconciliation of Underwriting
Gain (before tax) 2006 2005
- ----------------------------------------------------------------------
Property and casualty underwriting
gain (before tax) $ 18.2 $ 16.1
Net investment income 50.9 48.4
Realized gains, net 14.2 -
Write-down and amortization of
agent relationships (2.9) (4.4)
Other expenses (7.2) (10.4)
- ----------------------------------------------------------------------
Income before income tax 73.2 49.7
Income tax expense (21.3) (12.0)
- ----------------------------------------------------------------------
Net income $ 51.9 $ 37.7
======================================================================
Management of the Consolidated Corporation believes the significant
volatility of realized investment gains and losses limits the usefulness
of net income as a measure of current operating performance. Accordingly,
management uses the non-GAAP financial measure of operating income to
further evaluate current operating performance. Operating income is
reconciled to net income in the table below:
Three Months Ended March 31,
2006 2005
- -----------------------------------------------------------------------
Net income $51.9 $37.7
After-tax net realized gains 9.2 -
- -----------------------------------------------------------------------
Operating income $42.7 $37.7
=======================================================================
9
NOTE IV - STOCK BASED COMPENSATION
The Consolidated Corporation has several stock based incentive programs
that are utilized to facilitate the Consolidated Corporation's long-term
financial success. Effective January 1, 2006, the Consolidated Corporation
began accounting for stock based incentive programs under Statement of
Financial Accounting Standard (SFAS) 123(R), "Share-Based Payment." SFAS
123(R) superseded Accounting Principles Board (APB) Opinion No. 25,
"Accounting for Stock Issued to Employees," and amends SFAS No. 95,
"Statement of Cash Flows." SFAS 123(R) requires all share-based payments
to employees, including grants of employee stock options, be recognized as
compensation expense in the income statement at fair value. Pro forma
disclosure is no longer an alternative. The Consolidated Corporation
adopted the provisions of SFAS 123(R) using the modified prospective method
in which compensation expense is recognized (a) based on the requirements
of SFAS 123(R) for all share-based payments granted after January 1, 2006
and (b) based on the requirements of SFAS 123 for all awards granted to
employees prior to January 1, 2006 that remain unvested on January 1, 2006.
The adoption of SFAS 123(R) decreased the Consolidated Corporation's net
income by $0.3. Basic and diluted earnings per share were not impacted in
the first three months of 2006 by the adoption of SFAS 123(R). The
Consolidated Corporation uses the straight-line method of recording
compensation expense relative to share-based payments. SFAS 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 SFAS 95 prior to its amendment.
This requirement reduced net operating cash flows and increased net
financing cash flows by $1.7 in the first quarter of 2006.
In 2005, the Consolidated Corporation accounted for stock based
compensation issued to employees in accordance with APB 25, as was
permitted by SFAS 123. Under APB 25, the Consolidated Corporation
recognized compensation expense based on the intrinsic value of stock based
compensation. Had the Consolidated Corporation adopted the income
statement recognition requirements of SFAS 123 "Accounting for Stock Based
Compensation," the Consolidated Corporation's net income and earnings per
share would have been reduced to the pro forma amounts disclosed below:
Three Months Ended
March 31,
2005
- -------------------------------------------------------------------------
Net income
As reported $37.7
Add: Stock-based employee compensation
reported in net income, net of related tax effect 0.1
Deduct: Total stock-based employee
compensation, net of related tax effects 1.0
- -------------------------------------------------------------------------
Pro forma net income $36.8
=========================================================================
Basic EPS
As reported $0.60
Pro Forma $0.59
Average shares outstanding - basic 62,359,823
Diluted EPS*
As reported $0.55
Pro Forma $0.53
Average shares outstanding - diluted 71,675,055
=========================================================================
*Diluted EPS has been adjusted for the effect of EITF Issue No. 04-8 for
the three months 2005. Also See Note II.
The Consolidated Corporation has several share-based incentive programs
which are briefly described below. For a more detailed discussion of each
of these share-based incentive programs, see Note 5 in the Notes to the
Consolidated Financial Statements in the Annual Report on Form 10-K for the
year ended December 31, 2005.
2005 Incentive Plan
On May 18, 2005, the shareholders of the Corporation approved the
Consolidated Corporation's 2005 Incentive Plan (2005 Plan) which provides
for stock based compensation to employees and non-employee directors.
Approval of the 2005 plan resulted in the termination of the then existing
stock incentive plans of the Consolidated Corporation.
10
At March 31, 2006, 1,901,965 shares were available for issuance under the
2005 Plan. Equity-based awards that may be granted under the 2005 Plan
include stock options (incentive and non-qualified), restricted stock,
restricted stock units, stock appreciation rights and shares of the
Corporation's common stock as defined in the 2005 Plan document. In
addition to equity-based compensation, the 2005 Plan also authorizes grants
of performance based awards in the form of restricted stock, restricted
stock units, stock units and cash awards. The 2005 Plan limits the number
of shares of stock with respect to which awards may be issued to any
participant in a calendar year to 400,000.
Options granted under the plan may be exercised at any time after the
vesting requirements are met, which ranges from immediate vesting to three
years. During the first quarter of 2006, there were 7,750 stock options
granted from the 2005 Plan. Total options outstanding, excluding
forfeitures, were 76,750 at March 31, 2006. Total compensation expense
recorded in the first quarter of 2006 related to stock options was $0.7.
The 2005 Plan also provides for the grant of freestanding and/or tandem
stock appreciation rights (SAR) and restricted stock. At March 31, 2006,
there were 350,000 outstanding freestanding SARs, with 100,000 granted
during the first quarter of 2006 and there were no issued and outstanding
tandem SARs. The requisite service period for outstanding SARs is three
years. The Consolidated Corporation recognized $0.3 of compensation
expense in the first quarter of 2006 related to the freestanding SARs.
During the three months ended March 31, 2006 and 2005, there were 10,750
and 9,500 restricted shares issued, excluding forfeitures, under either the
2005 Plan or a predecessor plan. At March 31, 2006, there are 158,206
restricted shares which are under the restriction period. SFAS 123(R)
eliminated the presentation of the contra-equity account, unearned
compensation, on the face of the consolidated balance sheets. As a result,
$2.9 was reclassified to additional paid-in capital during the first
quarter of 2006. The Corporation has recognized compensation expense on
the grants of restricted shares of $0.4 and $0.2 in the three months ended
March 31, 2006 and 2005, respectively.
Long-term Incentive Plan
In July 2005, the Consolidated Corporation adopted a Long-Term Incentive
Plan (LTIP) award to better align officer interests with shareholders for
performance that promotes the long-term success of the Consolidated
Corporation. The 2005 LTIP award is a performance based award covering a
thirty-month period beginning July 1, 2005 and ending December 31, 2007
(the "performance period"). The 2006 LTIP award is a performance based
award with the final payout modified based upon achievement of a market
condition, comprised of total shareholder returns generated by the
Consolidated Corporation over the performance period relative to total
shareholder returns generated by a selected peer group over this same
performance period. The performance period began on January 1, 2006 and
will end on December 31, 2008. At the end of both performance periods,
payout, if any, will be made 50% in the form of Corporation common shares
and 50% in cash. There is no provision to pay the share portion of the
payout in cash. The Consolidated Corporation recognized compensation
expense related to the LTIP of $0.3 in the first quarter of 2006 ($1.3
representing normal quarterly expense accrual and $(1.0) as a result of
implementing 123(R)). There was no corresponding amount recognized in the
first quarter of 2005 as the performance period did not begin until July
2005.
Employee Stock Purchase Plan
The Consolidated Corporation has an employee stock purchase plan that is
available to eligible employees as defined in the plan. Under the plan,
shares of the Corporation's common stock may be purchased at a discount of
up to 15% of the lesser of the closing price of the Corporation's common
stock on the first trading day or the last trading day of the offering
period. The offering period (currently six months) and the offering price
are subject to change. Effective with the first offering period in 2006,
shares of the Corporation's common stock will be purchased at a discount of
10% and the offering period changed from six months to three months.
Participants may purchase no more than twenty-five thousand dollars, prior
to stated discount, of the Corporation's common stock in a calendar year.
During the three months ended March 31, 2006, 57,770 shares were purchased
under the plan compared to 56,491 shares purchased under the plan in the
same period of 2005. At March 31, 2006, there were 1,762,825 shares
available for future issuance under the plan. The Consolidated Corporation
recognized compensation expense related to the employee stock purchase plan
of $0.3 during the first quarter of 2006.
11
Following is a summary of stock based compensation expense recognized by
the Consolidated Corporation:
Three Months Ended March 31,
2006 2005
- --------------------------------------------------------------------------
2005 Incentive Plan
Stock Options $0.7 $ -
Stock Appreciation Rights 0.3 -
Restricted Stock 0.4 0.2
Long Term Incentive Plan 0.3 -
Employee Stock Purchase Plan 0.3 -
- --------------------------------------------------------------------------
Total Stock-Based Compensation $2.0 $0.2
==========================================================================
The following table summarizes information about the stock-based
compensation plans (options and SARs) as of March 31, 2006:
Weighted- Weighted- Aggregate
Avg Avg Intrinsic
Shares Exercise Remaining Value
(000) Price Contract Life ($ in 000)
--------------------------------------------------
Outstanding at January 1, 2006 3,958 $15.68
Granted 107 $31.52
Exercised (242) $14.03
Forfeited (3) $20.98
------
Outstanding at March 31, 2006 3,820 $16.29 6.5 $58,867
Exercisable at March 31, 2006 2,890 $13.93 5.8 $51,361
The total intrinsic value of stock options exercised was $4.1 and $5.3
during the first quarter of 2006 and 2005, respectively.
The following table summarizes information about the restricted stock
activity as of March 31, 2006:
Weighted-
Avg
Shares Grant Date
(000) Fair Value
-----------------------
Restricted stock awards at January 1, 2006 148 $25.49
Granted 11 31.30
Released (1) 19.13
Forfeited - -
---- ------
Restricted stock awards at March 31, 2006 158 $25.92
=== ======
The per share weighted-average fair value of options and awards granted
during the first quarter of 2006 and 2005 is as follows:
2006 2005
---------------------
Stock options $ 9.96 $ 9.30
Restricted stock $31.30 $24.55
SARs $ 9.80 N/A
Employee Stock Purchase Plan $ 8.83 $ 4.82
Under the provisions of SFAS 123(R), the Consolidated Corporation is
required to estimate on the date of grant the fair value of each option and
freestanding SAR using an option-pricing model. Accordingly, the Black-
Scholes option pricing model is used with the following weighted-average
assumptions:
Three Months Ended March 31,
2006 2005
---- ----
Dividend yield 1.0% 1.8%
Expected volatility 32.0% 44.2%
Risk-free interest rate 4.8% 4.2%
Expected term 4.5 years 5.0 years
12
The dividend yield is determined by using the expected per share dividend
during 2006. In 2005, the dividend yield was based upon the average of
selected peer companies. The expected volatility is based on the
Corporation's stock price over a historical period which approximates the
expected term. The risk free interest rate is the implied yield currently
available on U.S. Treasury issues with a remaining term approximating the
expected term. The expected term is calculated as the historic weighted
average life of similar awards.
As of March 31, 2006, there was $8.5 of total unrecognized compensation
cost ($5.7 relating to options and freestanding SARs and $2.8 relating to
restricted stock) related to non-vested share-based compensation
arrangements granted under the Consolidated Corporation's share-based
payment plans. That cost is expected to be recognized over a weighted-
average period of 1.1 years for options and freestanding SARs and 2.8 years
for restricted stock.
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 Consolidated 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 $1.3 and $2.8 in the first quarter of 2006 and 2005,
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 18 years. For the three month
period ended March 31, 2006 and 2005, the Consolidated Corporation recorded
amortization expense of $1.6. At March 31, 2006 and December 31, 2005, the
unamortized carrying value of the agent relationships asset was $106.9 and
$109.7, respectively. The agent relationships asset is recorded net of
accumulated amortization of $46.5 and $45.5 at March 31, 2006 and December
31, 2005, 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 Consolidated
Corporation capitalizes costs incurred during the application development
stage for the development of internal-use software. These costs primarily
relate to payroll and payroll-related costs for employees along with costs
incurred for external consultants who are directly associated with the
internal-use software project. Costs such as maintenance, training, data
conversion, overhead and general and administrative are expensed as
incurred. Management believes the expected future value of the asset
exceeds the carrying value. Management evaluates the asset on an annual
basis for impairment. The costs associated with the software are amortized
on a straight-line basis over an estimated useful life of 10 years
commencing when the software is substantially complete and ready for its
intended use.
Capitalized software costs and accumulated amortization amounts included in
the consolidated balance sheets were $58.8 and $16.9 at March 31, 2006 and
$58.5 and $15.9 at December 31, 2005, respectively.
NOTE VII - DEBT
The following table represents outstanding debt and deferred financing
costs of the Consolidated Corporation at March 31, 2006 and December 31,
2005:
13
March 31, December 31,
2006 2005
- ---------------------------------------------------------------------------
Senior Debt (net of discount and issuance
costs of $2.2 and $2.3, respectively) $197.8 $197.7
Ohio Loan 2.5 2.7
Deferred Financing Costs (0.3) -
- ---------------------------------------------------------------------------
Total Debt $200.0 $200.4
===========================================================================
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 a substantial majority of the
net proceeds to repurchase and redeem the Convertible Notes. See Note 15
included in the Notes to Consolidated Financial Statements in the
Corporation's Annual Report on Form 10-K for the year ended December 31,
2005 for a detailed discussion regarding the repurchase and redemption of
the Convertible Notes. Interest is payable on the Senior Notes on June 15
and December 15.
The Senior Notes are reported on the consolidated balance sheets net of
unamortized issuance-related costs and discount totaling $2.2 at March 31,
2006. The Convertible Notes and Senior Notes were reported on the
consolidated balance sheets net of unamortized issuance-related costs and
discount totaling $2.3 at December 31, 2005. The Corporation uses the
effective interest rate method to record interest expense, amortization of
issuance-related costs and amortization of the discount.
In February 2006, the Corporation terminated the $80.0 revolving credit
agreement which was entered into on July 31, 2002 and renewed in February
2005 with an expiration date of March 15, 2006. On February 16, 2006, the
Corporation entered into a new revolving credit agreement with an
expiration date of March 16, 2011. Under the terms of the new revolving
credit agreement, the lenders agreed to make loans to the Corporation in an
aggregate amount up to $125.0 for general corporate purposes. Additionally,
the new revolving credit agreement contains a $50.0 "accordion feature"
and provision for the issuance of letters of credit up to the amount of the
total facility. The accordion feature permits the Corporation to increase
the facility commitment from $125.0 to $175.0 subject only to a successful
syndication of the requested increase. Please refer to Note 15 included in
the Notes to the Consolidated Financial Statements in the Corporation's
Annual Report on Form 10-K for the year ended December 31, 2005 for a
detailed discussion regarding the terms and provisions of the new revolving
credit agreement. At March 31, 2006, the Corporation was in compliance with
all financial covenants and other provisions of this agreement. There were
no borrowings outstanding under the revolving line of credit at either
March 31, 2006 or December 31, 2005.
In connection with the repurchase and redemption of the Convertible Notes,
referenced above, during the quarter ended March 31, 2005, the Corporation
recognized $0.7 as loss on retirement, principally comprised of the write-
off of unamortized debt issuance cost and premium paid on repurchases of
the Convertible Notes during this period.
Interest expense incurred for the three month period ending March 31, 2006
and 2005 was $3.7 and $6.0, respectively.
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). Please refer to Note 7 in the Notes to the Consolidated
Financial Statements in the Corporation's Annual Report on Form 10-K for
the year ended December 31, 2005 for a detailed discussion regarding this
agreement. Late in the first quarter of 2005, OCNJ, based on revised
information provided by Proformance subsequent to the Consolidated
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, OCNJ 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 from any and all future obligations related to
this surplus guarantee. Accordingly, at March 31, 2006, no additional
amounts are recorded on the consolidated balance sheets pursuant to this
surplus guarantee. The total amount paid by OCNJ pursuant to the surplus
guarantee was $10.5, compared to the maximum cumulative exposure of $15.6.
14
A proceeding entitled Carol Murray v. the Corporation, the Company, Avomark
Insurance Company (Avomark), Ohio Security Insurance Company (Ohio
Security), West American Insurance Company (West American), American Fire
and Casualty Insurance Company (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 also filed motions to expand the definition to include claim
specialists, representative trainees, and representatives performing claims
adjusting services. The complaint sought overtime compensation for the
plaintiff and the class of persons plaintiff sought to represent. The U.S.
District Court dismissed the complaint against Avomark, Ohio Security, West
American, American Fire, and OCNJ on September 27, 2005. The U.S. District
Court also granted the motion for summary judgment of the Corporation and
the Company on September 27, 2005. The proceeding was ordered closed with
judgment in favor of the defendants. The decision has been appealed by
plaintiff to the U.S. Sixth Circuit Court of Appeals.
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. The Court
on April 13, 2006 granted a motion for class certification requested by
Carol Lazarus and denied West American's motion for summary judgment. The
matter is scheduled for trial in 2006 and is subject to appeal.
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.
In 2001, the Company, American Fire, West American, Ohio Security and OCNJ
sought refunds of retaliatory taxes paid to New Jersey in prior years on
the basis that New Jersey's calculation of premium and retaliatory taxes
deprived the Company, American Fire, West American, Ohio Security and OCNJ
of some or all of the benefit of New Jersey's premium tax cap. After the
refund requests were denied in a final determination issued by the New
Jersey Division of Taxation in July 2001, American Fire appealed to the New
Jersey Tax Court and in December 2003, the court affirmed the
determination. American Fire appealed to the Superior Court of New Jersey;
in March 2005, the court reversed the Tax Court, and the Director of the
Division of Taxation was ordered to recalculate the retaliatory tax as
proposed by American Fire. The New Jersey Division of Taxation appealed
the Superior Court decision to the New Jersey Supreme Court and the case
was argued in November 2005. No decision in the Supreme Court case has
been reached at this time. If American Fire is successful in this matter,
American Fire, as well as the Company, West American, Ohio Security and
OCNJ would expect to receive a refund of taxes previously paid. At this
time, American Fire is not able to reasonably predict the outcome of this
case and, therefore, no amounts have been recorded in the Consolidated
Financial Statements as of March 31, 2006 or December 31, 2005.
The proceedings described above and various other legal and regulatory
proceedings are currently pending that involve the Consolidated 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 Consolidated
Corporation.
NOTE IX - EMPLOYEE BENEFITS
The Company has a non-contributory defined benefit retirement plan and a
contributory health care plan. The net periodic pension cost as of March 31
is determined as follows:
15
Three Months Ended March 31,
2006 2005
- ---------------------------------------------------------------------------
Service cost earned during the period $ 2.1 $ 1.8
Interest cost on projected benefit obligation 4.3 4.3
Expected return on plan assets (6.5) (5.4)
Amortization of accumulated losses 1.0 0.9
Amortization of unrecognized prior service cost (0.6) (0.6)
- ---------------------------------------------------------------------------
Net periodic pension cost $ 0.3 $ 1.0
===========================================================================
The Company contributed $19.0 in the first quarter of 2006 to the defined
benefit retirement plan and is currently evaluating whether additional
contributions will be made during the balance of the fiscal year 2006.
The components of the Company's net periodic postretirement benefit cost as
of March 31:
Three Months Ended March 31,
2006 2005
- ---------------------------------------------------------------------------
Service cost $ 0.1 $ 0.1
Interest cost 0.7 0.7
Amortization of unrecognized prior service cost (1.5) (1.5)
- ---------------------------------------------------------------------------
Net periodic postretirement benefit cost $(0.7) $(0.7)
===========================================================================
NOTE X - RECENTLY ISSUED ACCOUNTING STANDARDS
In February 2006, the FASB issued SFAS 155, "Accounting for Certain Hybrid
Financial Instruments - An Amendment of SFAS 133 and 140." This Statement
permits fair value remeasurement for any hybrid financial instrument that
contains an embedded derivative that otherwise would require bifurcation
and clarifies which interest-only strips and principal-only strips are not
subject to the requirements of SFAS 133, "Accounting for Derivative
Instruments and Hedging Activities." Additionally, the Standard
establishes a requirement to evaluate interest in securitized financial
assets to identify interests that are freestanding derivatives or that are
hybrid financial instruments that contain an embedded derivative requiring
bifurcation. This Statement amends SFAS 140, "Accounting for Transfers and
Servicing of Financial Assets and Extinguishments of Liabilities," to
eliminate the prohibition on qualifying special purpose entities from
holding a derivative financial instrument that pertains to a beneficial
interest other than another derivative financial instrument. This
Statement is effective for all financial instruments acquired, issued, or
subject to a remeasurment event occurring after the beginning of the first
fiscal year that begins after September 15, 2006. For the Consolidated
Corporation, this would mean January 1, 2007. The Consolidated Corporation
does not believe the impact of the Standard will be significant to the
Corporation's overall results of operations or financial position.
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), collectively the "Consolidated Corporation". All dollar amounts in
this Management Discussion and Analysis (MD&A) are in millions unless
otherwise noted.
RESULTS OF OPERATIONS
Net Income
The Consolidated Corporation reported net income of $51.9, or $0.80 per
share for the three months ended March 31, 2006, compared with $37.7, or
$0.55 per share in the same period of 2005, which included after-tax
realized investment gains of $9.2 ($0.14 per share) for the period ending
March 31, 2006 and no after-tax realized gains for the period ending March
31, 2005.
The Consolidated Corporation adopted the provision of SFAS 123(R) as of
January 1, 2006. For further information on the impact of the adoption of
SFAS 123(R) in 2006, see Note IV to the unaudited interim consolidated
financial statements included in Item 1. "Financial Statements" of this
Quarterly Report on Form 10-Q.
16
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 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 82 of the Corporation's 2005 Annual Report on Form 10-K.
At March 31, 2006 and December 31, 2005, statutory surplus, a financial
measure that is required by insurance regulators and used to monitor
financial strength, was $1,038.2 and $1,004.5, respectively. The ratio of
twelve months ended net premiums written to statutory surplus as of March
31, 2006 and December 31, 2005, was 1.4 to 1.0.
Premium Revenue Results
Gross premium written differs from net premiums written by the amount of
premiums ceded to reinsurers. Management analyzes premium revenues
primarily by premiums written in the current period, which is a better
indicator of current production levels. Net premiums written are
recognized into revenue on a monthly pro rata basis over the coverage term
of the policy which is reflected in the consolidated income statements as
earned premium.
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 March 31,
2006 2005 % Chg
Gross Premiums Written ---- ---- -----
- ----------------------
Commercial Lines $218.0 $211.2 3.2%
Specialty Lines 47.5 53.2 (10.7)%
Personal Lines 107.2 114.9 (6.7)%
------ ------
All Lines $372.7 $379.3 (1.7)%
====== ======
Three Months Ended March 31,
2006 2005 % Chg
Net Premiums Written ---- ---- -----
- --------------------
Commercial Lines $212.4 $205.6 3.3%
Specialty Lines 35.8 39.1 (8.4)%
Personal Lines 105.9 113.8 (6.9)%
------ ------
All Lines $354.1 $358.5 (1.2)%
====== ======
All Lines gross premiums written declined slightly for the three month
period ended March 31, 2006, due primarily to lower in-force policy counts
across all three segments the result of declines in premium production
throughout 2005. This decline was partially offset by an increase in new
business premium production and improved policy renewal rates in the first
quarter 2006. The relatively small difference in percentage change between
gross and net premiums is due to the renewal of the majority of our
reinsurance programs on January 1, 2006 with no significant changes in
coverage or retentions and with an overall cost increase of less than 2%.
For Commercial Lines, gross premiums written increased 3.2% when compared
to the same period of 2005, a result of a 19.8% increase in new business
premium production and a slight increase in policy renewal rates, partially
offset by a decline in in-force policies for the three months ended March
31, 2006.
17
For Specialty Lines, the decline in gross premiums written is a result of a
17.8% decline in the commercial umbrella product line as both in-force
policies and new business premium production are lower than the same period
in the prior year. The decline in the commercial umbrella product line is
partially offset by strong growth of almost 12% in the fidelity and surety
bonds product line as we continue to leverage our market knowledge and
strong producer base.
The decline in Personal Lines gross premiums written is a result of rate
reductions taken in a number of states in both the personal auto and
homeowners product lines and lower in-force policy counts. This decline is
partially offset by a small increase of 1.9% in new business premium
production and slightly improved retention rates.
Commercial Lines average renewal prices were flat during the first quarter
2006 compared to an increase of 2.0% in the first quarter 2005, while the
commercial umbrella product line had an average renewal price increase of
1.5% compared to 6.8% in first quarter 2005. 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 any effects of reinsurance.
All Lines Discussion
The following table provides key financial measures for All Lines:
Three Months Ended March 31,
2006 2005
All Lines ---- ----
- ---------
Loss ratio 52.8% 52.8%
Loss adjustment expense ratio 10.3% 11.9%
Underwriting expense ratio 31.8% 30.9%
----- -----
Combined ratio 94.9% 95.6%
===== =====
The All Lines combined ratio for the three months ended March 31, 2006
improved 0.7 points. The loss and LAE ratios were positively impacted by
lower claim frequency trends and favorable prior year reserve development
of $12.9 for the quarter compared to $3.8 for first quarter 2005, which
decreased the combined ratio by 2.6 points quarter over quarter. This
decline was partially offset by an increase in large claim activity, losses
over $250,000, which increased the loss and LAE ratio by approximately 1.4
points and slightly higher catastrophe losses quarter over quarter.
The underwriting expense ratio increased 0.9 points to 31.8%. In first
quarter 2005, the underwriting expense ratio benefited from a reduction in
the Proformance surplus guarantee accrual, which decreased the underwriting
expense ratio by 1.2 points. Without this one time reduction, the 2005
underwriting ratio would have been 32.1%. For 2006, underwriting expenses
continue to be favorably impacted by our on-going expense management
initiatives and lower employee count.
The loss and LAE ratio components of the accident year combined ratio
measure losses and LAE arising from insured events that occurred in the
respective accident year. The current accident year excludes losses and
LAE for insured events that occurred in prior accident years. The table
below summarizes the impact of changes in provision for all prior accident
year losses and LAE:
Three Months Ended March 31,
2006 2005
- --------------------------------------------------------------------------
Statutory net liabilities,
beginning of period $2,258.5 $2,183.8
Decrease in provision for prior
accident year claims $(12.9) $(3.8)
Decrease in provision for prior accident
year claims as % of premiums earned (3.6)% (1.0)%
18
Catastrophe losses for the first quarter 2006 were $3.6 or 1.0 point
compared to $2.5 or 0.7 points in the first quarter 2005, an increase of
0.3 points. The effect of future catastrophes on the Group'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 Group's results of operations, future reinsurance pricing and
availability of reinsurance. For additional disclosure of catastrophe
losses, please refer to Item 15, Losses and LAE Reserves in the Notes to
the Consolidated Financial Statements on page 79 of the Corporation's 2005
Annual Report on Form 10-K.
Segment Discussion
The Consolidated Corporation's organizational structure consists of three
reportable segments: Commercial, Specialty and Personal Lines. These
reportable segments represent the Consolidated Corporation's operating
segments. The Consolidated Corporation also has an all other segment,
which derives its revenue from investment income of the Corporation. The
following tables provide key financial measures for each of the property
and casualty reportable segments:
Commercial Lines Segment
Three Months Ended March 31,
Commercial Lines Segment 2006 2005
- ----------------------------------------------------------------------
Net premiums written $212.4 $205.6
Net premiums earned 204.6 205.6
Loss ratio 57.2% 57.2%
Loss adjustment expense ratio 11.6% 15.2%
Underwriting expense ratio 33.0% 33.9%
Combined Ratio 101.8% 106.3%
The Commercial Lines combined ratio improved 4.5 points compared to the
same period last year primarily due to improvement in both the LAE and
underwriting expense ratios. The improvement in the LAE ratio is primarily
the result of favorable prior year LAE reserve development of 1.1 points
compared to 2.3 points of adverse prior year LAE reserve development in the
same period of 2005. The underwriting expense ratio improvement is
primarily the result of the lower incentive and contingent commission costs
previously discussed.
The Commercial Lines loss ratio, which was flat quarter over quarter was
impacted by adverse prior year loss reserve development which added 1.4
points to the first quarter 2006 combined ratio compared to 3.7 points in
the first quarter 2005. The adverse development occurring in the first
quarter of 2006 was primarily in the workers compensation and general
liability product lines, partially offset by favorable development in the
commercial auto and commercial multi-peril (CMP) product lines. The
adverse development in the first quarter of 2005 was primarily in the
workers compensation and CMP product lines again offset by favorable
development in the commercial auto product line. The 2005 adverse
development in workers' compensation is primarily related to higher medical
costs and longer life expectancy identified in a review of lifetime and
other severe cases. The 2006 adverse development was the result of higher
medical costs impacting the non-lifetime cases. The 2006 loss ratio was
also impacted by a $5.7 increase in large losses, which added 2.8 points to
the loss ratio quarter over quarter. Also impacting the loss and LAE
ratios for these periods were slightly higher catastrophe losses and
increased assessments for the National Workers' Compensation Pool (NWCP).
Offsetting these adverse impacts is a lower claim frequency trend for
Commercial Lines.
Specialty Lines Segment
Three Months Ended March 31,
Specialty Lines Segment 2006 2005
- ----------------------------------------------------------------------
Net premiums written $35.8 $39.1
Net premiums earned 37.3 35.1
Loss ratio 31.4% 43.0%
Loss adjustment expense ratio 5.1% 8.0%
Underwriting expense ratio 38.7% 45.3%
Combined Ratio 75.2% 96.3%
19
The Specialty Lines combined ratio improved 21.1 points for the three month
period ended March 31, 2006 compared to the same period last year. The
improvement was primarily the result of favorable prior year loss and LAE
reserve development, which lowered the combined ratio by 26.3 points in the
current year quarter versus 8.0 points of favorable prior year reserve
development in the first quarter of 2005. For the quarter ended March 31,
2005, Specialty Lines had one relatively large bond loss which served to
increase the combined ratio when compared to the current period.
Underwriting expenses were favorably impacted by lower incentive and
commission costs.
Personal Lines Segment
Three Months Ended March 31,
Personal Lines Segment 2006 2005
- ----------------------------------------------------------------------
Net premiums written $105.9 $113.8
Net premiums earned 115.8 121.6
Loss ratio 52.0% 48.0%
Loss adjustment expense ratio 9.6% 7.4%
Underwriting expense ratio 27.6% 21.8%
Combined Ratio 89.2% 77.2%
The Personal Lines combined ratio for the three months ended March 31, 2006
increased 12.0 points when compared to the same period of the prior year.
The loss and LAE ratio increased 6.2 points as a result of favorable
reserve development being 7.8 points lower in first quarter 2006 compared
to 2005 and slightly higher catastrophe losses which added a half point
compared to the same period last year. These declines were partially
offset by continued favorable claim frequency trends. The 5.8 point
increase in the underwriting expense ratio was due to the first quarter of
2005 benefit from a reduction in the Proformance surplus guarantee accrual,
which reduced the 2005 ratio by 3.6 points and an increase in premium taxes
and assessments, direct sales and legal expenses during the current quarter.
The table below presents the calendar year and accident year combined
ratios calculated on a statutory basis. The loss and LAE ratio components
of the accident year combined ratio measure losses and LAE arising from
insured events that occurred in the respective accident year. The current
accident year excludes losses and LAE for insured events that occurred in
prior accident years.
Earned Premium and Statutory Combined Ratios
Combined Ratios
------------------------------------------------
Earned
Premium Calendar Year Accident Year
Year to Date Year to Date Year to Date Calendar Accident
March 31, March 31, March 31, Year Year
(By operating segment) 2006 2006 2006(a) 2005 2005(a)
- ----------------------------------------------------------------------------------------
Commercial Lines $204.6 101.3% 101.1% 102.3% 98.8%
Specialty Lines 37.3 75.5% 101.8% 89.9% 99.0%
Personal Lines 115.8 88.3% 91.4% 81.2% 88.5%
- ----------------------------------------------------------------------------------------
Total All Lines $357.7 94.5% 98.1% 94.2% 95.4%
========================================================================================
(a) The measurement date for accident year data is March 31, 2006.
Partial and complete accident periods may not be comparable due to
seasonality, claim reporting and development patterns, claim settlement
rates and other factors.
Investment Results
Three months ended March 31, 2006 and 2005 consolidated pre-tax investment
income was $50.9 and $48.4, respectively. This increase was the result of
positive operating cash flows and a modest improvement in reinvestment
yields resulting from the recent upward movement in interest rates. For
the three months ended March 31, 2006, net realized gains were $14.2 versus
none for the three months ended March 31, 2005. The Consolidated
Corporation realized $20.7 in gross gains and $6.5 in gross losses on
securities sold during the first quarter of 2006.
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 page 41 of the Corporation's 2005 Annual
Report on Form 10-K. Investments are continually evaluated based on
current economic conditions, market value changes and developments specific
to each issuer. The difference between the cost/amortized cost and
estimated fair
20
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.
On November 3, 2005, the FASB released Financial Statement Position (FSP)
SFAS 115-1 and SFAS 124-1 replacing Emerging Issues Task Force (EITF) 03-1.
The final language on FSP SFAS 115-1 / SFAS 124-1 requires investors to
recognize an impairment loss when the impairment is deemed other-than-
temporary, and when the investor no longer has the positive intent and
ability to hold until recovery in value, even if a decision to sell has not
been made. The FSP applies to reporting periods beginning after December
15, 2005. The Consolidated Corporation recorded a pre-tax impairment
charge of $1.9 recorded in the first three months ended March 31, 2006.
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
March 31, 2006:
Available-for-sale securities 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 income securities:
U.S. government $ 17.4 $ (0.5) $ - $ - $ 17.4 $ (0.5)
States, municipalities and
political subdivisions 885.5 (9.8) 68.1 (1.0) 953.6 (10.8)
Corporate securities 401.7 (9.3) 51.7 (2.5) 453.4 (11.8)
Mortgage-backed
securities:
Government 21.5 (0.6) 1.3 - 22.8 (0.6)
Other 444.5 (7.1) 20.2 (0.6) 464.7 (7.7)
- ---------------------------------------------------------------------------------------------------
Total fixed income securities 1,770.6 (27.3) 141.3 (4.1) 1,911.9 (31.4)
Equity securities 25.8 (1.3) 1.0 (0.1) 26.8 (1.4)
- ---------------------------------------------------------------------------------------------------
Total temporarily impaired
securities $1,796.4 $(28.6) $142.3 $(4.2) $1,938.7 $(32.8)
===================================================================================================
Held-to-maturity securities 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 income securities:
Corporate securities $ 118.7 $(5.7) $16.9 $(0.9) $135.6 $(6.6)
Mortgage-backed
securities 81.7 (2.5) 14.9 (0.5) 96.6 (3.0)
- ---------------------------------------------------------------------------------------------------
Total temporarily impaired
securities $200.4 $(8.2) $31.8 $(1.4) $232.2 $(9.6)
===================================================================================================
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.
As part of the evaluation of the entire $42.4 aggregate unrealized loss on
the investment portfolio, management performed a more intensive review of
securities with a relatively higher degree of unrealized loss. Based on a
review of each security, management believes that unrealized losses on
these securities were temporary declines in value at March 31, 2006. In
the tables above, there are approximately 900 securities represented. Of
this total, 63 securities have unrealized loss positions greater than 5% of
their
21
book values at March 31, 2006, with none exceeding 15%. This group
represents $8.5, or 20% of the total unrealized loss position. Of this
group, 57 securities, representing approximately $6.7 in unrealized losses,
have been in an unrealized loss position for less than twelve months. The
remaining six securities have been in an unrealized loss position for
longer than twelve months and total $1.8 in unrealized losses. Management
believes that it is probable that all contract terms of the security will
be satisfied; the unrealized loss position is due to the changes in the
interest rate environment; and that it has positive intent and the ability
to hold the securities until they mature or recover in value.
All securities are monitored by portfolio managers who consider many
factors such as an issuer's financial and operating performance, degree of
financial flexibility 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.
The amortized cost and estimated fair value of available-for-sale and held-
to-maturity fixed income securities in an unrealized loss position at March
31, 2006, 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 $ 3.7 $ 3.7 $ -
Due after one year through five years 172.2 169.4 (2.8)
Due after five years through ten years 741.5 729.2 (12.3)
Due after ten years 530.1 522.1 (8.0)
Mortgage-backed securities 495.8 487.5 (8.3)
- -------------------------------------------------------------------------------
Total $1,943.3 $1,911.9 $(31.4)
===============================================================================
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 37.2 35.8 (1.4)
Due after five years through ten years 92.0 87.1 (4.9)
Due after ten years 11.0 10.7 (0.3)
Mortgage-backed securities 99.6 96.6 (3.0)
- -------------------------------------------------------------------------------
Total $241.8 $232.2 $(9.6)
===============================================================================
For additional discussion relative to the Consolidated Corporation's
investment portfolio, see the "Investment Portfolio" section under
"Liquidity and Capital Resources" on pages 23 and 24 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 Consolidated 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 approximately 18 years for this
asset. Overall, the estimated future cash flows for the remaining acquired
agents assigned an intangible
22
value exceed the remaining asset book value of $106.9 recorded at March 31,
2006. For additional information regarding agent relationships asset,
please refer to Note V in the Notes to the Consolidated Financial
Statements on page 13 in this Quarterly Report on Form 10-Q.
LIQUIDITY AND CAPITAL RESOURCES
Investment Portfolio
The following table sets forth the distribution and other data of
investments at March 31, 2006 and December 31, 2005, respectively.
March 31, 2006 December 31, 2005
-------------- -----------------
Average Amortized Carrying % of Amortized Carrying % of
Rating Cost Value Total Cost Value Total
---------------------------------------------------------------------
U.S Government:
Available-for-sale AAA $ 25.7 $ 25.4 0.6 $ 25.8 $ 25.9 0.6
States, municipalities,
and political
subdivisions:
Investment grade:
Available-for-sale AA+ 1,343.6 1,336.9 32.0 1,269.7 1,277.4 30.2
Corporate securities:
Investment grade:
Available-for-sale A 1,439.8 1,473.6 35.2 1,489.0 1,552.4 36.8
Held-to-maturity A+ 159.9 159.8 3.8 160.1 160.1 3.8
Below Investment grade:
Available-for-sale BB 74.7 76.9 1.8 65.5 68.5 1.6
-----------------------------------------------------------
Total corporate
securities 1,674.4 1,710.3 40.7 1,714.6 1,781.0 42.2
-----------------------------------------------------------
Mortgage-backed securities:
Investment grade:
Available-for-sale AAA 596.1 589.8 14.1 601.6 601.6 14.3
Held-to-maturity AAA 99.6 99.6 2.4 104.3 104.3 2.5
Below Investment grade:
Available-for-sale B - - - 1.9 1.9 -
-----------------------------------------------------------
Total mortgage-backed
securities 695.7 691.4 16.5 707.8 707.8 16.8
-----------------------------------------------------------
Total fixed income securites 3,739.4 3,762.0 89.9 3,717.9 3,792.1 89.8
Equity securities* 150.3 377.8 9.0 144.2 375.1 8.9
Cash and cash equivalents 53.1 53.1 1.1 54.5 54.5 1.3
-----------------------------------------------------------
Total investment
securities, cash
and cash equivalents $3,942.8 $4,192.9 100.0 $3,916.6 $4,221.7 100.0
===========================================================
* Included in equity securities as of March 31, 2006 are common stock with
a cost of $103.4 and carrying value of $330.7 and preferred stock with a
cost of $46.9 and carrying value of $47.1. Included in equity securities
as of December 31, 2005 are common stock with a cost of $97.3 and carrying
value of $327.9 and preferred stock with a cost of $46.9 and carrying value
of $47.2.
The fixed income portfolio is allocated between investment grade and
below investment grade securities as follows:
March 31, 2006 December 31, 2005
-------------- -----------------
Amortized Carrying % of Amortized Carrying % of
Cost Value Fixed Cost Value Fixed
------------------------------------------------------------
Total investment grade $3,664.7 $3,685.1 98.0 $3,650.5 $3,721.7 98.1
Total below investment grade 74.7 76.9 2.0 67.4 70.4 1.9
The fixed income portfolio is allocated between available-for-sale
and held-to-maturity securities as follows:
Total available-for-sale
fixed income securities $3,480.0 $3,502.6 93.1 $3,453.5 $3,527.7 93.0
Total held-to-maturity
fixed securities 259.4 259.4 6.9 264.4 264.4 7.0
The excess of carrying value over cost was $250.1 at March 31, 2006
compared with $305.1 at December 31, 2005. The decrease in unrealized
gains in 2006 was attributable to declining market values of fixed income
securities as a result of an increase in interest rates and the sale of
certain highly appreciated equity securities.
23
The consolidated fixed income portfolio, including short-term securities,
has an intermediate duration and a laddered maturity structure. The
duration of the fixed maturity portfolio was approximately 5.1 and 5.2
years at March 31, 2006 and December 31, 2005, respectively. The
Consolidated Corporation remains fully invested and does not time markets.
Fixed income securities are classified as investment grade or non-
investment grade based upon the higher of the ratings provided by S&P and
Moody's. When a security is not rated by either S&P or Moody's, the
classification is based on other rating services, including the Securities
Valuation Office of the National Association of Insurance Commissioners.
The market value of available-for-sale split-rated fixed income securities
(i.e., those having an investment grade rating from one rating agency and a
below investment grade rating from another rating agency) was $29.2 and
$35.2 at March 31, 2006 and December 31, 2005, 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 March 31, 2006 and
December 31, 2005:
Amortized Fair Unrealized
Cost Value Loss
- ------------------------------------------------------------------
March 31, 2006 $13.7 $13.2 $(0.5)
December 31, 2005 13.6 13.2 (0.4)
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 March
31, 2006, the equity portfolio consisted of stocks in a total of 59
separate entities covering all ten major S&P industry sectors. Of this
total, 22.5% was invested in five companies and the largest single position
was 4.7% of the equity portfolio. At December 31, 2005, the equity
portfolio consisted of stocks in 60 separate entities in ten different
industries. Of this total, 24.2% were invested in five companies and the
largest single position was 5.4% of the equity portfolio.
The investment portfolio also includes securities that do not have a
readily available market price 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 March 31, 2006, was $341.2
compared to $339.7 at December 31, 2005.
The Consolidated Corporation uses assumptions and estimates when valuing
certain investments and related income. These assumptions include
estimations of cash flows and interest rates. Although the Consolidated
Corporation believes the values of its investments represent fair value,
certain cash flow and interest rate estimates could change and lead to
changes in fair values.
Losses and Loss Adjustment Expenses
The Group's largest liabilities are reserves for losses and LAE. Loss and
LAE reserves (collectively "loss reserves") are established for all
incurred claims without discounting for the time value of money. Before
credit for reinsurance recoverables, these reserves amounted to $3.0
billion and $2.9 billion at March 31, 2006 and December 31, 2005,
respectively. As of March 31, 2006, the loss reserves by operating segment
were as follows: $1,838.5 Commercial Lines, $729.9 Specialty Lines and
$383.4 Personal Lines. The Group purchases reinsurance to mitigate the
impact of large losses and catastrophic events. Loss reserves ceded to
reinsurers amounted to $678.7 and $684.6 at March 31, 2006 and December 31,
2005, respectively.
The Group conducts a quarterly review of loss reserves using the methods
described in its Annual Report on Form 10-K for the year ended December 31,
2005, and records its best estimate each quarter based on that review. In
the opinion of management, the reserves recorded at March 31, 2006
represent the Group's best estimate of its ultimate liability for losses
and LAE. However, due to the inherent complexity of the
24
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 with certainty since conditions
and events which established historical loss reserve development and which
serve as the basis for estimating ultimate claim costs may not occur in
exactly the same manner, if at all.
Loss reserves are an estimate of ultimate unpaid costs of losses and LAE
for claims that have been reported and claims that have been incurred but
not yet reported. Loss reserves do not represent an exact calculation of
liability, but instead represent estimates, generally utilizing actuarial
expertise and reserving methods, at a given accounting date. These loss
reserve estimates are expectations of what the ultimate settlement and
administration of claims will cost upon final resolution in the future,
based on the Group's assessment of facts and circumstances then known. In
establishing reserves, the Group also takes into account estimated
recoveries for reinsurance, salvage and subrogation.
The process of estimating loss reserves involves a high degree of judgment
and is subject to a number of risk factors. These risk factors can be
related to both internal and external events, such as changes in claims
handling procedures, economic inflation, legal trends and legislative
changes, among others. Please refer to the Corporation's Annual Report on
Form 10-K for the year ended December 31, 2005, for a detailed discussion
of these risk factors. The impact of these items on ultimate costs for
loss and LAE is difficult to estimate. Loss reserve estimation differs by
product line due to differences in claim complexity, the volume of claims,
the potential severity of individual claims, the determination of
occurrence date for a claim and reporting lags (the time between the
occurrence of the policyholder loss event and when it is actually reported
to the insurer). Informed judgment is applied throughout the process. The
Group continually refines its loss reserve estimates in a regular ongoing
process as historical loss experience develops and additional claims are
reported and settled. The Group considers all significant facts and
circumstances known at the time loss reserves are established. Due to the
inherent uncertainty underlying loss reserve estimates, final resolution of
the estimated liability will be different from that anticipated at the
reporting date. Therefore, actual paid losses in the future may yield a
materially different amount than currently reserved--favorable or
unfavorable. The Group reflects adjustments to loss reserves in the
results of operations in the period the estimates are changed.
The following table displays case, IBNR and LAE reserves by product line
gross of reinsurance recoverables. Case reserves represent amounts
determined for each claim based on the known facts regarding the claim and
the parameters of the coverage that our policy provides. The IBNR reserves
include provisions for incurred but not reported claims, provisions for
losses in excess of the case reserves on previously reported claims, claims
to be reopened and a provision for uncertainty in recognition of the
variability and risk factors described below. The IBNR provision also
includes an offset for anticipated salvage and subrogation recoveries. LAE
reserves are an estimate of the expenses related to resolving and settling
claims. Reserves ceded to reinsurers and reserves net of reinsurance are
also shown.
Loss and LAE Reserves as of March 31, 2006 and December 31, 2005
March 31, 2006
- --------------
Gross Total Total
Operating Segment Case IBNR LAE Total Ceded Net
- ----------------------------------------------------------------------------------------------
Commercial Lines $ 721.3 $ 765.0 $352.2 $1,838.5 $174.2 $1,664.3
Workers' compensation 400.9 343.1 68.5 812.5 138.8 673.7
Commercial auto 104.7 108.4 44.3 257.4 7.1 250.3
General liability 63.1 120.4 93.9 277.4 7.0 270.4
CMP, fire & inland marine 152.6 193.1 145.5 491.2 21.3 469.9
Specialty Lines 133.4 502.4 94.1 729.9 437.3 292.6
Commercial umbrella 116.2 502.5 87.7 706.4 426.6 279.8
Fidelity & surety 17.2 (0.1) 6.4 23.5 10.7 12.8
Personal Lines 196.5 122.8 64.1 383.4 67.2 316.2
Personal auto & umbrella 165.8 87.3 48.0 301.1 66.3 234.8
Personal property 30.7 35.5 16.1 82.3 0.9 81.4
Total All Lines $1,051.2 $1,390.2 $510.4 $2,951.8 $678.7 $2,273.1
- ----------------------------------------------------------------------------------------------
25
December 31, 2005
- -----------------
Gross Total Total
Operating Segment Case IBNR LAE Total Ceded Net
- ----------------------------------------------------------------------------------------------
Commercial Lines $ 700.9 $ 762.2 $351.5 $1,814.6 $165.4 $1,649.2
Workers' compensation 387.1 344.0 69.2 800.3 131.4 668.9
Commercial auto 103.2 109.7 44.6 257.5 6.0 251.5
General liability 59.4 117.3 92.6 269.3 5.2 264.1
CMP, fire & inland marine 151.2 191.2 145.1 487.5 22.8 464.7
Specialty Lines 134.8 516.2 92.9 743.9 454.1 289.8
Commercial umbrella 116.4 516.1 85.9 718.4 442.4 276.0
Fidelity & surety 18.4 0.1 7.0 25.5 11.7 13.8
Personal Lines 194.8 126.1 67.4 388.3 65.1 332.2
Personal auto & umbrella 164.1 91.3 50.6 306.0 64.1 241.9
Personal property 30.7 34.8 16.8 82.3 1.0 81.3
Total All Lines $1,030.5 $1,404.5 $511.8 $2,946.8 $684.6 $2,262.2
- ----------------------------------------------------------------------------------------------
Reserve variability and uncertainty
- -----------------------------------
There is a great deal of uncertainty in the loss reserve estimates and
unforeseen events can have unfavorable impacts on the loss reserve
estimates. Reinsurance is purchased to mitigate the impact of large losses
and catastrophic events.
To illustrate the uncertainty by operating segment, the following table
provides the before-tax amount of prior accident years' loss reserve
development by operating segment on a net of reinsurance basis for the
three-months ended March 31, 2006 and 2005, and year ended December 31,
2005:
Three Months Ended
March 31 Year
2006 2005 2005
------------------ ----
Operating Segment
- -----------------
Commercial Lines $ 0.5 $ 12.2 $ 29.1
Specialty Lines (9.8) (2.8) (12.3)
Personal Lines (3.6) (13.2) (36.9)
------- ------- -------
Total Prior Accident Years'
Development $(12.9) $ (3.8) $(20.1)
======= ======= =======
This table illustrates the variability of reserves between operating
segments, and from period to period. Within each operating segment,
development can also be favorable or adverse by product line within the
same period. For example, for the Commercial Lines operating segment in
the three months ended March 31, 2006, the workers' compensation product
line had adverse development of $10.2 while the commercial auto product
line had favorable development of $7.9.
Reserve estimates are also uncertain by accident period. To illustrate
this, the following table provides the before-tax amount of prior accident
years' loss and LAE reserve development by accident year on a net of
reinsurance basis for all lines combined:
Three Months Ended
March 31 Year
2006 2005 2005
------------------ ----
(Favorable)/Unfavorable
- -----------------------
Accident Year 2005 $ (2.8) $ - $ -
Accident Year 2004 (4.6) (9.3) (30.8)
Accident Year 2003 and Prior (5.5) 5.5 10.7
------- ------ -------
Total Prior Accident Years'
Development $(12.9) $(3.8) $(20.1)
======= ====== =======
Please refer to the Corporation's Annual Report on Form 10-K for the year
ended December 31, 2005, for a broader discussion of reserve variability
and uncertainty. The Group does not prepare loss reserve ranges, nor does
it project future variability, when determining its best estimate, although
the above examples of
26
actual historical changes in loss reserve estimates provide a measure of
the uncertainty underlying the current loss reserve estimates. The Loss
Reserve process takes all risk factors into account, but no one risk factor
has been bifurcated to perform a sensitivity or variability analysis
because the risk factors were considered in the aggregate. As a result,
the Group is not in a position to quantify the impact of reasonably likely
changes to significant assumptions at this time. Nevertheless, the Group
plans to undertake an assessment to evaluate the sensitivity or variability
of changes in significant assumptions related to the Group's estimate of
loss reserves in the aggregate and/or by product line, to the extent
material. Upon completion of such sensitivity or variability assessment,
and to the extent that management believes the information to be reasonably
accurate and credible and would be beneficial, in the opinion of
management, to the understanding of the Group's financial statements, the
Corporation will include the outcome of this sensitivity/variability
analysis either in the aggregate or by product line, as appropriate, in the
first practicable periodic filing of the Corporation that follows the
completion of this assessment and continuing thereafter.
Cash Flow
Net cash provided by operations was $28.5 for the first three months of
2006, compared with $56.2 for the same period in 2005. The net cash from
operations fully funded the net cash used in investing of $27.7 which was
used for purchases of available-for-sale and equity securities. Cash used
by financing operations was $2.2 in the first three months of 2006 compared
with $0.2 in the first three months of 2005. The reinstatement of the
shareholder dividend and the repurchase of the Corporation's common stock
attributed to the increase in cash used in financing activities, see Part
II, Item 2, for additional information regarding the share repurchase
program. 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 March 31, 2006, the Corporation had cash and marketable securities,
totaling $279.8, which compared to $253.2 at December 31, 2005. 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 2006, dividend payments from the Company to
the Corporation are limited to approximately $415.0 without prior approval
of the Ohio Insurance Department. During the first three months of 2006,
the Company paid a dividend of $35.0 to the Corporation resulting in a
dividend payment limitation of $380.0 for the remainder of 2006.
Book Value Per Share
At March, 31, 2006, the book value per share of the Corporation increased
$0.17 per share from $22.54 per share to $22.71 per share when compared to
book value at December 31, 2005. This increase is principally the result
of improved profitability offset by a decline in unrealized gains. At
March 31, 2006 and December 31, 2005 there were 63,493,665 and 63,281,136
actual shares outstanding, respectively. Below is a table reconciling the
changes in book value per share from December 31, 2005 to March 31, 2006.
December 31, 2005 $22.54
Activity year-to-date March 2006:
Net income 0.82
Change in unrealized gains (0.56)
Dividend to shareholders (0.09)
-------
March 31, 2006 $22.71
=======
Rating Agencies
Regularly the financial condition of the Consolidated Corporation and the
Group is reviewed by four independent rating agencies, A. M. Best Company
(A.M. Best), Fitch, Inc. (Fitch), Moody's Investor Service (Moody's) and
Standards & Poor's (S&P). These agencies assign ratings and rating
outlooks reflecting the
27
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 Consolidated Corporation's current ratings and rating
outlooks.
A.M. Best Fitch Moody's S&P
--------- ----- ------- ---
Financial strength rating (Group) A- A- A3 BBB+
Senior unsecured debt rating
(Corporation) bbb- BBB- Baa3 BB+
Rating outlook Positive Positive Stable Positive
For more information on the rating agency actions, please refer to Item 7.
Management's Discussion and Analysis of Financial Condition and Results of
Operations in the Corporation's 2005 Annual Report on Form 10-K for the
year ended December 31, 2005.
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 Consolidated 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 Consolidated 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 2005 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.
PART II Other Information
ITEM 1. Legal Proceedings
Reference is made to the second paragraph of Part I, Item 3 Legal
Proceedings to the Corporation's Form 10-K for the fiscal year ended
December 31, 2005 regarding the matter captioned Carol Lazarus v. the
Group. The Court of Common Pleas Cuyahoga County, Ohio on April 13, 2006
granted plaintiff's motion for class certification and denied defendant's
motion for summary judgment.
28
ITEM 2.Unregistered Sales of Equity Securities and Use of Proceeds
On August 18, 2005, the Corporation's Board of Directors authorized the
repurchase of up to four million shares of the Corporation's common stock.
The repurchases may be made in the open market or in privately negotiated
transactions from time to time and are funded from available working
capital. The table below summarizes the status of this program during the
three months ended March 31, 2006.
ISSUER PURCHASES OF EQUITY SECURITIES
- --------------------------------------------------------------------------------
(c) Total (d) Maximum
Number Number of
of Shares Shares that
Purchased as May Yet Be
(a) Total Part of Publicly Purchased
Number of (b) Average Announced Under the
Shares Price Paid Plans or Plans or
Period Purchased per Share Programs Programs
- --------------------------------------------------------------------------------
January 1 - 31, 2006 36,780 $28.25 36,780 2,447,115
February 1 - 28, 2006 - - - 2,447,115
March 1-31, 2006 - - - 2,447,115
ITEM 6. Exhibits
Exhibits:
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
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)
April 26, 2006 /s/Michael A. Winner
-------------------------------------------
Michael A. Winner, Executive Vice President
and Chief Financial Officer
29