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UNITED STATES SECURITIES AND
EXCHANGE COMMISSION
Washington, D. C. 20549
FORM 10-Q
[x] Quarterly Report Pursuant to Section 13 or 15 (d) of the Securities
Exchange Act of 1934
For the quarterly period ended June 30, 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
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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
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On July 25, 2006, there were 61,432,539 shares of common stock
outstanding.
Page 1 of 33
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INDEX
Page
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PART I FINANCIAL INFORMATION
Item 1. Financial Statements 3
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations 19
Item 3. Quantitative and Qualitative Disclosures
about Market Risk 31
Item 4. Controls and Procedures 31
PART II OTHER INFORMATION
Item 2. Unregistered Sales of Equity Securities and
Use of Proceeds 31
Item 4. Submission of Matters to a Vote of Security Holders 32
Item 6. Exhibits 32
Signature 33
Exhibit 31.1 Certification of Chief Executive Officer of Ohio
Casualty Corporation in accordance with SEC
Rule 13(a)-14(a) and Rule 15(d)-14(a)
Exhibit 31.2 Certification of Chief Financial Officer of Ohio
Casualty Corporation in accordance with SEC
Rule 13(a)-14(a) and Rule 15(d)-14(a)
Exhibit 32.1 Certification of Chief Executive Officer of Ohio
Casualty Corporation in accordance with Section
1350 of the Sarbanes-Oxley Act of 2002
Exhibit 32.2 Certification of Chief Financial Officer of Ohio
Casualty Corporation in accordance with Section
1350 of the Sarbanes-Oxley Act of 2002
2
PART I FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
Ohio Casualty Corporation & Subsidiaries
CONSOLIDATED BALANCE SHEETS
June 30, December 31,
(in millions, except share data) (Unaudited) 2006 2005
=========================================================================================
Assets
Investments, at fair value:
Fixed maturities:
Available-for-sale, at fair value
(amortized cost: $3,434.8 and $3,453.5) $ 3,421.8 $ 3,527.7
Held-to-maturity, at amortized cost
(fair value: $244.7 and $260.5) 255.5 264.4
Equity securities, at fair value
(cost: $176.2 and $144.2) 385.2 375.1
- -----------------------------------------------------------------------------------------
Total investments 4,062.5 4,167.2
Cash and cash equivalents 38.7 54.5
Premiums and other receivables, net of allowance 338.5 309.2
Deferred policy acquisition costs 153.7 153.7
Property and equipment, net of accumulated depreciation 79.7 80.1
Reinsurance recoverable, net of allowance 735.1 741.8
Agent relationships, net of accumulated amortization 102.4 109.7
Interest and dividends due or accrued 52.6 55.0
Deferred tax asset, net 42.2 14.8
Other assets 74.4 77.1
- -----------------------------------------------------------------------------------------
Total assets $ 5,679.8 $ 5,763.1
=========================================================================================
Liabilities
Insurance reserves:
Losses $ 2,463.2 $ 2,435.0
Loss adjustment expenses 519.4 511.8
Unearned premiums 690.9 679.6
Debt 199.9 200.4
Reinsuance treaty funds held 142.8 150.4
Other liabilities 288.4 359.5
- -----------------------------------------------------------------------------------------
Total liabilities 4,304.6 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 20.6 18.8
Accumulated other comprehensive income 106.1 178.0
Retained earnings 1,439.7 1,360.6
Treasury stock, at cost:
(Shares: 10,996,869; 9,137,208) (200.2) (140.0)
- -----------------------------------------------------------------------------------------
Total shareholders' equity 1,375.2 1,426.4
- -----------------------------------------------------------------------------------------
Total liabilities and shareholders' equity $ 5,679.8 $ 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 June 30,
(in millions, except share and per share data) (Unaudited) 2006 2005
- ------------------------------------------------------------------------------------------
Premiums and finance charges earned $ 355.5 $ 365.5
Investment income, less expenses 51.9 48.6
Investment gains realized, net 5.3 13.8
- ------------------------------------------------------------------------------------------
Total revenues 412.7 427.9
Losses and benefits for policyholders 199.3 191.7
Loss adjustment expenses 42.7 40.4
General operating expenses 116.7 120.4
Write-down and amortization of agent relationships 4.5 3.3
Amortization of deferred policy acquisition costs 82.7 84.7
Deferral of policy acquisition costs (84.6) (83.4)
Depreciation and amortization expense 2.6 2.8
Loss on retirement of convertible debt, including
debt conversion expenses - 8.3
- ------------------------------------------------------------------------------------------
Total expenses 363.9 368.2
- ------------------------------------------------------------------------------------------
Income before income taxes 48.8 59.7
Income tax expense (benefit):
Current 14.9 15.4
Deferred (1.7) 2.2
- ------------------------------------------------------------------------------------------
Total income tax expense 13.2 17.6
- ------------------------------------------------------------------------------------------
Net income $ 35.6 $ 42.1
==========================================================================================
Weighted average shares outstanding - basic 62,815,872 63,679,352
==========================================================================================
Earnings per share - basic:
Net income, per share $ 0.57 $ 0.66
==========================================================================================
Weighted average shares outstanding - diluted 64,351,335 66,997,317
===========================================================================================
Earnings per share - diluted:
Net income, per share $ 0.55 $ 0.63
===========================================================================================
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 INCOME
Six Months
Ended June 30,
(in millions, except share and per share data) (Unaudited) 2006 2005
- ----------------------------------------------------------------------------------------
Premiums and finance charges earned $ 713.2 $ 727.8
Investment income, less expenses 102.8 97.0
Investment gains realized, net 19.5 13.8
- ----------------------------------------------------------------------------------------
Total revenues 835.5 838.6
Losses and benefits for policyholders 388.3 382.8
Loss adjustment expenses 79.4 83.3
General operating expenses 233.4 233.7
Write-down and amortization of agent relationships 7.4 7.7
Amortization of deferred policy acquisition costs 165.6 171.8
Deferral of policy acquisition costs (165.7) (164.8)
Depreciation and amortization expense 5.1 5.7
Loss on retirement of convertible debt, including
debt conversion expenses - 9.0
- ----------------------------------------------------------------------------------------
Total expenses 713.5 729.2
- ----------------------------------------------------------------------------------------
Income before income taxes 122.0 109.4
Income tax expense:
Current 23.1 21.0
Deferred 11.4 8.6
- ----------------------------------------------------------------------------------------
Total income tax expense 34.5 29.6
- ----------------------------------------------------------------------------------------
Net income $ 87.5 $ 79.8
========================================================================================
Average shares outstanding - basic 63,024,617 63,023,233
========================================================================================
Earnings per share - basic:
Net income, per share $ 1.39 $ 1.27
========================================================================================
Average shares outstanding - diluted 64,591,888 69,327,993
========================================================================================
Earnings per share - diluted:
Net income, per share $ 1.35 $ 1.18
========================================================================================
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 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 79.8 79.8
Change in unrealized gain,
net of deferred income tax
benefit of $2.4 (4.6) (4.6)
---------
Comprehensive income 75.2
Net issuance of restricted stock
(13,664 shares) 0.2 0.2
Net issuance of treasury
stock (926,806 shares) 4.0 (0.1) 11.8 15.7
Cash dividends paid ($0.06 per share) (3.8) (3.8)
Issuance of common stock pursuant
to Convertible Note transaction
(See Note VII) 11.2 17.3 28.5
- ----------------------------------------------------------------------------------------------------------
Balance,
June 30, 2005 $ 9.0 $ 15.2 $ 254.5 $ 1,237.4 $ (105.4) $ 1,410.7
==========================================================================================================
Balance
January 1, 2006 $ 9.0 $ 18.8 $ 178.0 $ 1,360.6 $ (140.0) $ 1,426.4
Net income 87.5 87.5
Change in unrealized gain,
net of deferred income tax
benefit of $38.7 (71.9) (71.9)
----------
Comprehensive income 15.6
Net issuance of restricted stock
(18,638 shares) 0.4 0.3 0.7
Unearned stock compensation (2.9) 2.9 -
Stock based compensation, net of
income tax benefit of $1.6 4.2 4.2
Net issuance of treasury
stock (356,410 shares) 0.1 5.3 5.4
Repurchase of treasury stock
(2,234,709 shares) (65.8) (65.8)
Cash dividends paid ($0.18 per share) (11.3) (11.3)
- ----------------------------------------------------------------------------------------------------------
Balance,
June 30, 2006 $ 9.0 $ 20.6 $ 106.1 $ 1,439.7 $ (200.2) $ 1,375.2
==========================================================================================================
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
ITEM 1. Continued
Ohio Casualty Corporation & Subsidiaries
CONSOLIDATED STATEMENTS OF CASH FLOWS
Six Months
Ended June 30,
(in millions) (Unaudited) 2006 2005
- ----------------------------------------------------------------------------------------
Cash Flows from Operating Activities:
Net income $ 87.5 $ 79.8
Adjustments to reconcile net income to cash
from operations:
Changes in:
Insurance reserves 47.1 93.3
Reinsurance treaty funds held (7.6) (23.4)
Income taxes (6.1) (5.4)
Premiums and other receivables (29.3) 16.6
Deferred policy acquisition costs - 6.9
Reinsurance recoverable 6.7 (37.3)
Other assets (15.7) (5.7)
Other liabilities (36.2) (43.2)
Loss on retirement of convertible debt, including
debt conversion expenses - 9.0
Stock-based compensation expense 3.3 0.3
Write-down and amortization of agent relationships 7.4 7.7
Depreciation and amortization 5.1 5.7
Investment gains realized, net (19.5) (13.8)
- ----------------------------------------------------------------------------------------
Net cash provided by operating activities 42.7 90.5
- ----------------------------------------------------------------------------------------
Cash Flows from Investing Activities:
Purchase of securities:
Fixed income, available-for-sale (489.8) (619.0)
Fixed income, held-to-maturity (0.5) (0.4)
Equity (51.3) (3.7)
Proceeds from sales of securities:
Fixed income, available-for-sale 435.4 416.7
Equity 49.6 7.9
Proceeds from maturities and calls of securities:
Fixed income, available-for-sale 60.1 29.6
Fixed income, held-to-maturity 8.5 17.4
Property and equipment
Purchases (5.0) (4.9)
Sales 0.3 0.1
- ----------------------------------------------------------------------------------------
Net cash provided by (used in) investing activities 7.3 (156.3)
- ----------------------------------------------------------------------------------------
Cash Flows from Financing Activities:
Debt:
Repayments (0.3) (160.0)
Payments for deferred financing costs (0.3) -
Loss on retirement of convertible debt,
including conversion expense - (3.6)
Proceeds from exercise of stock options 4.3 12.5
Repurchase of treasury stock (60.5) -
Income tax benefit from stock option exercises 2.3 2.8
Dividends paid to shareholders (11.3) (3.8)
- ----------------------------------------------------------------------------------------
Net cash used in financing activities (65.8) (152.1)
- ----------------------------------------------------------------------------------------
Net decrease in cash and cash equivalents (15.8) (217.9)
Cash and cash equivalents, beginning of period 54.5 252.6
- ----------------------------------------------------------------------------------------
Cash and cash equivalents, end of period $ 38.7 $ 34.7
========================================================================================
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.
7
Ohio Casualty Corporation & Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
Ohio Casualty Corporation (the Corporation) is the holding company of The
Ohio Casualty Insurance Company (the Company), which is one of six property-
casualty insurance companies that make up the Ohio Casualty Group (the
Group), 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 June 30, 2006 and the
Consolidated Statements of Income, Shareholders' Equity and Cash Flows for
the three and six months ended June 30, 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 June 30,
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 June 30, 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 $2.1 at June 30, 2006 and $4.2 at December 31,
2005. Property and equipment are carried at cost less accumulated
depreciation of $181.6 and $177.2 at June 30, 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 June 30, 2006 and December 31, 2005.
8
NOTE II - EARNINGS PER SHARE
Basic and diluted earnings per share are summarized as follows:
Three Months Ended Six Months Ended
June 30, June 30,
2006 2005 2006 2005
- ------------------------------------------------------------------------------------
Net income $35.6 $42.1 $87.5 $79.8
Weighted average common shares
outstanding - basic (thousands) 62,816 63,679 63,025 63,023
Basic net income per weighted
average share $0.57 $0.66 $1.39 $1.27
===================================================================================
Net income $35.6 $42.1 $87.5 $79.8
Effect of EITF 04-8 on net income
using "if-converted" method - 0.2 - 1.8
Adjusted net income using
"if-converted" method 35.6 42.3 87.5 81.6
Weighted average common shares
outstanding - basic (thousands) 62,816 63,679 63,025 63,023
Effect of dilutive securities from stock
compensation plans (thousands) 1,535 1,199 1,567 1,273
Effect of EITF 04-8 (thousands) - 2,119 - 5,032
- ------------------------------------------------------------------------------------
Weighted average common shares
outstanding - diluted (thousands) 64,351 66,997 64,592 69,328
Diluted net income per weighted
average share $0.55 $0.63 $1.35 $1.18
====================================================================================
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 2.1 and 5.0 million shares into its
diluted earnings per share calculation using the "if-converted" method for
the three and six months ended June 30, 2005. See Note VII for more
information regarding the convertible securities.
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.
9
Three Months Ended June 30,
Commercial Lines Segment 2006 2005
- ---------------------------------------------------------------------
Net premiums written $223.9 $221.8
% Change 0.9% 0.7%
Net premiums earned 206.5 206.8
% Change (0.1)% 2.2%
Underwriting loss (before tax) (4.9) (5.4)
Specialty Lines Segment 2006 2005
- ---------------------------------------------------------------------
Net premiums written $ 37.3 $ 39.7
% Change (6.0)% 1.5%
Net premiums earned 35.9 36.4
% Change (1.4)% (10.8)%
Underwriting (loss)/gain (before tax) (0.6) 1.7
Personal Lines Segment 2006 2005
- ---------------------------------------------------------------------
Net premiums written $111.6 $123.4
% Change (9.6)% (3.1)%
Net premiums earned 113.1 122.3
% Change (7.5)% (1.4)%
Underwriting gain (before tax) 8.3 19.8
Total Property & Casualty 2006 2005
- ---------------------------------------------------------------------
Net premiums written $372.8 $384.9
% Change (3.1)% (0.5)%
Net premiums earned 355.5 365.5
% Change (2.7)% (0.5)%
Underwriting gain (before tax) 2.8 16.1
All Other Segment 2006 2005
- ---------------------------------------------------------------------
Revenues $ 3.7 $ 8.8
Write-down and amortization of
agent relationships (4.5) (3.3)
Other expenses (6.7) (15.5)
- ---------------------------------------------------------------------
Loss before income tax $(7.5) $(10.0)
Reconciliation of Revenues 2006 2005
- ---------------------------------------------------------------------
Net premiums earned for reportable
segments $355.5 $365.5
Net investment income 47.5 44.7
Realized gains, net 6.0 8.9
- ---------------------------------------------------------------------
Total property and casualty revenues 409.0 419.1
All other segment revenues 3.7 8.8
- ---------------------------------------------------------------------
Total revenues $412.7 $427.9
=====================================================================
Reconciliation of Underwriting Gain
(before tax) 2006 2005
- ---------------------------------------------------------------------
Property and casualty underwriting gain
(before tax) $ 2.8 $ 16.1
Net investment income 51.9 48.6
Realized gains, net 5.3 13.8
Write-down and amortization of agent
relationships (4.5) (3.3)
Other expenses (6.7) (15.5)
- ---------------------------------------------------------------------
Income before income tax 48.8 59.7
Income tax expense 13.2 17.6
- ---------------------------------------------------------------------
Net income $ 35.6 $ 42.1
=====================================================================
10
Six Months Ended June 30,
Commercial Lines Segment 2006 2005
- ---------------------------------------------------------------------
Net premiums written $436.3 $427.4
% Change 2.1% (1.2)%
Net premiums earned 411.1 412.4
% Change (0.3)% 3.0%
Underwriting loss (before tax) (8.5) (18.3)
Specialty Lines Segment 2006 2005
- ---------------------------------------------------------------------
Net premiums written $73.1 $78.8
% Change (7.2)% 6.6%
Net premiums earned 73.2 71.5
% Change 2.4% (13.3)%
Underwriting gain (before tax) 8.6 3.0
Personal Lines Segment 2006 2005
- ---------------------------------------------------------------------
Net premiums written $217.5 $237.2
% Change (8.3)% (2.9)%
Net premiums earned 228.9 243.9
% Change (6.2)% (0.7)%
Underwriting gain (before tax) 20.9 47.5
Total Property & Casualty 2006 2005
- ---------------------------------------------------------------------
Net premiums written $726.9 $743.4
% Change (2.2)% (1.0)%
Net premiums earned 713.2 727.8
% Change (2.0)% (0.1)%
Underwriting gain (before tax) 21.0 32.2
All Other Segment 2006 2005
- ---------------------------------------------------------------------
Revenues $ 7.3 $ 12.1
Write-down and amortization of
agent relationships (7.4) (7.7)
Other expenses (13.9) (25.9)
- ---------------------------------------------------------------------
Loss before income tax $(14.0) $(21.5)
Reconciliation of Revenues 2006 2005
- ---------------------------------------------------------------------
Net premiums earned for reportable
segments $713.2 $727.8
Net investment income 94.7 89.8
Realized gains, net 20.3 8.9
- ---------------------------------------------------------------------
Total property and casualty revenues 828.2 826.5
All other segment revenues 7.3 12.1
- ---------------------------------------------------------------------
Total revenues $835.5 $838.6
=====================================================================
Reconciliation of Underwriting Gain
(before tax) 2006 2005
- ---------------------------------------------------------------------
Property and casualty underwriting gain
(before tax) $ 21.0 $ 32.2
Net investment income 102.8 97.0
Realized gains, net 19.5 13.8
Write-down and amortization of agent
relationships (7.4) (7.7)
Other expenses (13.9) (25.9)
- ---------------------------------------------------------------------
Income before income tax 122.0 109.4
Income tax expense 34.5 29.6
- ---------------------------------------------------------------------
Net income $ 87.5 $ 79.8
=====================================================================
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:
11
Three Months Ended Six Months Ended
June 30, June 30,
2006 2005 2006 2005
- -------------------------------------------------------------------------------
Net income $35.6 $42.1 $87.5 $79.8
After-tax net realized gains 3.4 8.9 12.6 8.9
- -------------------------------------------------------------------------------
Operating income $32.2 $33.2 $74.9 $70.9
===============================================================================
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 $0.5 and $0.8 for the three and six months ended June 30, 2006.
Basic and diluted earnings per share were reduced by $0.01 for both the
three and six months ended June 30, 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 $2.3 during the first six months of 2006.
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.
At June 30, 2006, there were 1,865,965 shares 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 second quarter of 2006, there were 27,000 stock options
granted from the 2005 Plan. Total options outstanding, excluding
forfeitures, were 103,750 at June 30, 2006.
The 2005 Plan also provides for the grant of freestanding and/or tandem
stock appreciation rights (SARs) and restricted stock. At June 30, 2006,
there were 350,000 outstanding freestanding SARs, none of which were
granted during the second quarter of 2006. There were no issued and
outstanding tandem SARs. The requisite service period for outstanding SARs
is three years.
12
During the six months ended June 30, 2006 and 2005, there were 19,750 and
18,500 restricted shares issued, excluding forfeitures, under either the
2005 Plan or a predecessor plan. At June 30, 2006, there are 128,250
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 when SFAS 123(R) was implemented.
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. There was no compensation expense recognized in the three
or six month periods 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 three 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 the stated discount, of the Corporation's common stock in
a calendar year. During the six months ended June 30, 2006, there were
67,759 shares purchased under the plan compared to 56,491 shares purchased
under the plan in the same period of 2005. At June 30, 2006, there were
1,752,836 shares available for future issuance under the plan.
Following is a summary of stock based compensation expense recognized by
the Consolidated Corporation:
Three Months Ended Six Months Ended
June 30, June 30,
2006 2005 2006 2005
- -------------------------------------------------------------------------------
2005 Incentive Plan
Stock Options $0.7 $ - $1.4 $ -
Stock Appreciation Rights 0.3 - 0.6 -
Restricted Stock 0.3 0.1 0.7 0.3
Long Term Incentive Plan 1.4 - 1.7 -
Employee Stock Purchase Plan - - 0.3 -
- -------------------------------------------------------------------------------
Total Stock-Based Compensation $2.7 $0.1 $4.7 $0.3
===============================================================================
The following table summarizes information about the stock-based
compensation plans (options and SARs) as of June 30, 2006:
Weighted- Weighted- Aggregate
Avg Avg Intrinsic
Shares Exercise Remaining Value
(000) Price Contract Life ($ in 000)
--------------------------------------------------
Outstanding at January 1, 2006 3,958 $15.68
Granted 135 $31.05
Exercised (317) $14.27
Forfeited (5) $20.61
-------
Outstanding at June 30, 2006 3,771 $16.41 6.2 $50,466
Exercisable at June 30, 2006 3,053 $14.26 5.7 $47,243
13
The total intrinsic value of stock options exercised was $1.1 and $3.9
during the three months ended June 30, 2006 and 2005, respectively, and
$5.2 and $9.2 for the six months ended June 30, 2006 and 2005,
respectively.
The total fair value of shares vested for restricted stock was $1.1 during
the three and six months ended June 30, 2006. During the same period in
2005, the total fair value of shares vested for restricted stock was less
than $0.1.
The following table summarizes information about the restricted stock
activity as of June 30, 2006:
Weighted-
Avg
Shares Grant Date
(000) Fair Value
-------------------------
Restricted stock awards at January 1, 2006 148 $25.49
Granted 20 30.32
Released (39) 19.27
Forfeited (1) 19.13
---- ------
Restricted stock awards at June 30, 2006 128 $28.17
==== ======
The per share weighted-average fair value of options and awards granted by
the Consolidated Corporation is as follows:
Three Months Ended Six Months Ended
June 30, June 30,
2006 2005 2006 2005
- -------------------------------------------------------------------------------
Stock options $ 9.31 $ 8.64 $ 9.45 $ 9.14
Restricted stock $29.16 $23.93 $30.32 $24.25
SARs N/A N/A $ 9.80 N/A
Employee Stock Purchase Plan $ 2.97 $ 7.62 $ 7.96 $ 5.67
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:
June 30,
2006 2005
- ------------------------------------------------------------------
Dividend yield 1.0% 1.8%
Expected volatility 32.0% 42.5%
Risk-free interest rate 5.1% 3.7%
Expected term 4.5 years 5.0 years
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 June 30, 2006, there was $7.7 of total unrecognized compensation cost
($5.0 relating to options and freestanding SARs and $2.7 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 1.2 years for options and freestanding SARs and 3.1 years
for restricted stock.
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:
14
Three Months Ended Six Months Ended
June 30, 2005 June 30,2005
- ----------------------------------------------------------------------------------
Net income
As reported $42.1 $79.8
Add: Stock-based employee
compensation reported in net
income, net of related tax effect 0.1 0.3
Deduct: Total stock-based employee
compensation, net of related tax effect 1.5 2.6
- ----------------------------------------------------------------------------------
Pro forma $40.7 $77.5
==================================================================================
Basic EPS
As reported $0.66 $1.27
Pro Forma $0.64 $1.23
Diluted EPS*
As reported $0.63 $1.18
Pro Forma $0.61 $1.14
==================================================================================
*Diluted EPS has been adjusted for the effect of EITF Issue No. 04-8 for
the three and six months of 2005. Also See Note II.
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 $3.0 and $1.7 in the second quarter of 2006 and 2005,
respectively. For the six months ended June 30, 2006 and 2005, the asset
was written down before tax by $4.3 and $4.5, 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 and six month period ended June 30,
2006, the Consolidated Corporation recorded amortization expense of $1.5
and $3.1 which compares to $1.6 and $3.2 for the same periods of the prior
year. At June 30, 2006 and December 31, 2005, the unamortized carrying
value of the agent relationships asset was $102.4 and $109.7, respectively.
The agent relationships asset is recorded net of accumulated amortization
of $46.7 and $45.5 at June 30, 2006 and December 31, 2005, respectively.
Future cancellation of agents included in the agent relationships
intangible asset or a diminution of certain former GAI 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 not exceeding 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 $61.0 and $18.0 at June 30, 2006 and
$58.5 and $15.9 at December 31, 2005, respectively.
15
NOTE VII - DEBT
The following table represents outstanding debt and deferred financing
costs of the Consolidated Corporation at June 30, 2006 and December 31,
2005:
June 30, 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 2.4 2.7
Deferred Financing Costs (0.3) -
- -----------------------------------------------------------------------------
Total Debt $199.9 $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 reference
to Note 15 below). As a result of the repurchase and redemption of the
Convertible Notes, the Corporation recorded a loss on retirement of $8.3
and $9.0 for the three and six month periods ended June 30, 2005,
principally comprised of the write-off of unamortized debt issuance cost
and premium paid on repurchases of the Convertible Notes during these
periods and issued 1,305,585 shares of its common stock. 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 June 30,
2006 and $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.
On February 16, 2006, the Corporation entered into a new revolving credit
agreement with an expiration date of March 16, 2011 and simultaneously
terminated its prior $80.0 revolving credit agreement. 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 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 June 30, 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 June 30, 2006 or December 31, 2005.
Interest expense incurred for the six month period ended June 30, 2006 and
2005 was $7.3 and $10.4, respectively. Interest expense incurred for the
three month period ended June 30, 2006 and 2005 was $3.6 and $4.4,
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 by $4.4 which left a remaining liability of $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. The total amount paid by
OCNJ pursuant to the surplus guarantee was $10.5, compared to the maximum
cumulative exposure of $15.6.
16
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
decision regarding class certification has been appealed by West American.
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 June 30, 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.
17
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 June 30
is determined as follows:
Three Months Ended Six Months Ended
June 30, June 30,
2006 2005 2006 2005
- -------------------------------------------------------------------------------
Service cost earned during the
period $ 2.1 $ 1.8 $ 4.2 $ 3.6
Interest cost on projected
benefit obligation 4.3 4.3 8.6 8.6
Expected return on plan assets (6.5) (5.4) (13.0) (10.8)
Amortization of accumulated losses 1.0 0.9 2.0 1.8
Amortization of unrecognized prior
service cost (0.5) (0.5) (1.1) (1.1)
Settlement 1.0 - 1.0 -
- -------------------------------------------------------------------------------
Net periodic pension cost $ 1.4 $ 1.1 $ 1.7 $ 2.1
===============================================================================
During the second quarter of 2006, the Company's former CEO made a lump sum
benefit plan payment election, pursuant to the terms of the Benefit
Equalization Plan which resulted in an increase to net periodic pension
cost of $1.0. This lump sum benefit plan payment is accounted for as a
"settlement" pursuant to the provisions of SFAS 88, "Employers' Accounting
for Settlements and Curtailments of Defined Benefit Pension Plans and
Termination Benefits."
The components of the Company's net periodic postretirement benefit cost as
of June 30:
Three Months Ended Six Months Ended
June 30, June 30,
2006 2005 2006 2005
- -------------------------------------------------------------------------------
Service cost $ 0.1 $ - $ 0.2 $ 0.1
Interest cost 0.6 0.8 1.3 1.5
Amortization of unrecognized
prior service cost (1.5) (1.5) (3.0) (3.0)
------------------------------------------------------------------------------
Net periodic postretirement
benefit cost $(0.8) $(0.7) $(1.5) $(1.4)
===============================================================================
NOTE X - RECENTLY ISSUED ACCOUNTING STANDARDS
In February 2006, the Financial Accounting Standards Board (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 Consolidated Corporation's
overall results of operations or financial position.
In July 2006, the FASB released FASB Interpretation No. (FIN) 48,
`Accounting for Uncertainty in Income Taxes, an interpretation of FASB
Statement No. 109.' This Interpretation clarifies the accounting for
uncertainty in income taxes recognized in the financial statements in
accordance with SFAS 109, `Accounting for Income Taxes.' This
Interpretation prescribes a recognition threshold and measurement attribute
for the financial statement recognition and measurement of a tax position
taken or expected to be taken in a tax return. This Interpretation also
provides guidance on derecognition, classification, interest and penalties,
accounting for interim periods, disclosure and transition. FIN 48 is
effective for fiscal years beginning after December 15, 2006. The
Consolidated Corporation currently is evaluating the impact of this
Interpretation.
18
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 $87.5, or $1.35 per
share and $79.8, or $1.18 per share for the six months ended June 30, 2006
and 2005, respectively, which included after-tax realized investment gains
of $12.6 ($0.19 per share) and $8.9 ($0.13 per share) for the six months
ended June 30, 2006 and 2005, respectively. For the second quarter, net
income was $35.6, or $0.55 per share and $42.1, or $0.63 per share for 2006
and 2005, respectively, which included after-tax realized investment gains
of $3.4 ($0.05 per share) and $8.9 ($0.13 per share) for the three months
ended June 30, 2006 and 2005, respectively.
The Consolidated Corporation adopted the provisions 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.
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 June 30, 2006 and December 31, 2005, statutory surplus, a financial
measure that is required by insurance regulators and used to monitor
financial strength, was $1,007.0 and $1,004.5, respectively. The ratio of
twelve months ended net premiums written to statutory surplus as of June
30, 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.
19
The table below summarizes property and casualty premium on a gross and net
basis compared with the same periods of the prior year:
Three Months Ended June 30, Six Months Ended June 30,
2006 2005 % Chg 2006 2005 % Chg
---- ---- ----- ---- ---- -----
Gross Premiums Written
- ----------------------
Commercial Lines $230.0 $223.9 2.7% $448.0 $435.1 3.0%
Specialty Lines 51.1 54.2 (5.7)% 98.6 107.4 (8.2)%
Personal Lines 113.0 123.2 (8.3)% 220.2 238.1 (7.5)%
------ ------ ------ ------
All Lines $394.1 $401.3 (1.8)% $766.8 $780.6 (1.8)%
Three Months Ended June 30, Six Months Ended June 30,
2006 2005 % Chg 2006 2005 % Chg
---- ---- ----- ---- ---- -----
Net Premiums Written
- --------------------
Commercial Lines $223.9 $221.8 0.9% $436.3 $427.4 2.1%
Specialty Lines 37.3 39.7 (6.0)% 73.1 78.8 (7.2)%
Personal Lines 111.6 123.4 (9.6)% 217.5 237.2 (8.3)%
------ ------ ------ ------
All Lines $372.8 $384.9 (3.1)% $726.9 $743.4 (2.2)%
All Lines gross premiums written declined slightly for the three and six
months periods ended June 30, 2006 when compared with the same periods of
the prior year, due primarily to lower in-force policy counts in both the
Personal and Specialty Lines. This decline was partially offset by an
increase in new business premium production and improving policy renewal
rates. Net premiums written for the three months ended June 30, 2005 were
favorably impacted by $5.5 return of ceded premium on experienced based
reinsurance contracts. The return of ceded premium benefited all three
operating segments in 2005. There was not a comparable return of ceded
premium during the periods presented in 2006.
For Commercial Lines, the increase in gross premiums written for both the
three month and six month periods ended June 30, 2006 is the result of an
increase in new business premium of 11.2% and 15.6% for the three and six
month periods ended June 30, 2006, respectively, coupled with slight
improvement in policy renewal rates for these same periods.
For Specialty Lines, the decline in gross premiums written for both the
three month and six month periods ended June 30, 2006 is primarily the
result of declines in the commercial umbrella product line of 13.1% and
15.5% respectively, as both in-force policies and new business premium
production are lower than the same periods of the prior year. This decline
is primarily in the unsupported lead umbrella and excess capacity products,
the result of our efforts to improve the overall profitability of the
commercial umbrella product line. This decline is partially offset by
strong growth (15.2% and 13.6% for the three month and six month periods
ended June 30, 2006, respectively) in the fidelity and surety bond product
line, as we continue to leverage our market knowledge and strong producer
base.
For Personal Lines, the decline in gross premiums written for both the
three month and six month periods ended June 30, 2006 is the result of rate
reductions previously taken in a number of states in both the personal auto
and homeowners product lines and lower in-force policy counts when compared
to the same periods of the prior year. However, the rate of decline in
policy count lessened in the second quarter of 2006 compared with the first
quarter of 2006. This decline is partially offset by a slight increase in
new business premium production of 3.6% (5.2% increase for the second
quarter only) and slightly improved policy renewal rates for both the three
and six month periods of 2006.
Commercial Lines average renewal prices have been essentially flat during
both the second quarter 2006 and year to date 2006, compared to an increase
of 1.6% in the second quarter 2005 and an increase of 1.9% for the year-to-
date period of 2005, while the commercial umbrella product line had an
average renewal price increase of 0.2% compared to 6.0% in second quarter
2005 and 0.8% compared with 5.5% for the year to date periods of both 2006
and 2005, respectively. 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.
20
All Lines Discussion
The following table provides key financial measures for All Lines:
Three Months Ended Six Months Ended
June 30, June 30,
2006 2005 2006 2005
---- ---- ---- ----
All Lines
- ---------
Loss ratio 56.1% 52.4% 54.4% 52.6%
Loss adjustment expense ratio 12.0% 11.0% 11.1% 11.4%
Underwriting expense ratio 31.1% 32.1% 31.5% 31.5%
----- ----- ----- -----
Combined ratio 99.2% 95.5% 97.0% 95.5%
The All Lines combined ratio for the second quarter, deteriorated by 3.7
points driven by a 4.7 point increase in the loss and LAE ratios offset by
a 1.0 point decrease in the underwriting expense ratio. The increase in
the loss and LAE ratios is the result of an increase of $10.4 (3.0 points)
in catastrophe losses, non-catastrophe weather related losses and one large
loss (over $4.0 net of reinsurance) impacting both the Commercial and
Specialty Lines segments. These increases were partially offset by
favorable prior year reserve development, net of reinsurance, as reflected
in the table below, which summarizes the reserve development by operating
segment.
Three Months Ended Six Months Ended
June 30, June 30,
2006 2005 2006 2005
(Favorable)/Unfavorable ---- ---- ---- ----
Operating Segment
- -----------------------
Commercial Lines $ (2.3) $ 5.0 $ (1.8) $ 17.2
Specialty Lines (1.4) (1.5) (11.2) (4.3)
Personal Lines (7.1) (6.4) (10.7) (19.6)
------- ------ ------- -------
Total Prior Accident
Years' Development $(10.8) $(2.9) $(23.7) $ (6.7)
======= ====== ======= =======
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 Six Months Ended
June 30, June 30,
2006 2005 2006 2005
---- ---- ---- ----
Statutory net liabilities,
beginning of period $2,269.4 $2,200.7 $2,258.5 $2,183.8
Decrease in provision for prior
accident year claims $(10.8) $(2.9) $(23.7) $(6.7)
Decrease in provision for prior
accident year claims as % of
premiums earned (3.0)% (0.8)% (3.3)% (0.9)%
</TABLE
The underwriting expense ratio improved 1.0 point for the three months
ended June 30, 2006, primarily due to decreased incentive accruals and a
reduction in the allowance for bad debt on premium receivables partially
offset by an increase in contingent commissions and the pension settlement
charge discussed in Note IX in the Notes to the Consolidated Financial
Statements on page 18 of this Quarterly Report on Form 10-Q. In addition,
the ratio continues to be favorably impacted by our on-going expense
management initiatives and lower staffing levels. The expense ratio for
the second quarter of 2005 included a $0.7 reduction to the surplus
guarantee accrual related to the final settlement with Proformance, which
decreased the underwriting expense ratio by 0.2 points.
Catastrophe losses for the second quarter 2006 were $16.1 compared to $5.7
in the second quarter 2005. For the six months ended June 30, 2006,
catastrophe losses were $19.7 compared to $8.1 in the same period of the
prior year. 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
21
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.
The table below summarizes the catastrophe loss ratios by operating
segment.
Three Months Ended Six Months Ended
June 30, June 30,
2006 2005 2006 2005
---- ---- ---- ----
Catastrophe Loss Ratio
- ----------------------
Commercial Lines 3.7% 1.4% 2.3% 1.0%
Specialty Lines -0.2% 0.0% -0.1% 0.0%
Personal Lines 7.6% 2.2% 4.5% 1.6%
Total All Lines 4.5% 1.5% 2.8% 1.1%
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 Six Months Ended
June 30, June 30,
Commercial Lines Segment 2006 2005 2006 2005
- -------------------------------------------------------------------------------
Net premiums earned $206.5 $206.8 $411.1 $412.4
Loss ratio 56.2% 55.7% 56.7% 56.5%
Loss adjustment expense ratio 13.8% 12.9% 12.7% 14.0%
Underwriting expense ratio 32.4% 34.0% 32.7% 33.9%
------ ------ ------ ------
Combined ratio 102.4% 102.6% 102.1% 104.4%
The Commercial Lines combined ratio improved for the three months ended
June 30, 2006, when compared to the same period in 2005 primarily due to a
1.6 point improvement in the underwriting expense ratio offset by a 1.4
point increase in the loss and LAE ratios. The decline in the underwriting
expense ratio is due to the reasons outlined under the All Lines discussion
on page 21 of this MD&A. The increase in the loss and LAE ratios is a
result of increased catastrophe losses, non-catastrophe weather-related
property losses and one large general liability loss, partially offset by
favorable development on prior years loss reserves. The favorable prior
year reserve development decreased the loss and LAE ratio by 1.1 points,
primarily in the commercial auto, general liability and commercial property
product lines offset by adverse development in the commercial multiple
peril (CMP) product line. The same period in 2005 experienced adverse
prior year reserve development which added 2.4 points to the loss and LAE
ratios, concentrated primarily in the workers compensation product line
partially offset by favorable development in the commercial auto and
commercial property product lines. For the six months of 2006, Commercial
Lines loss and LAE reserves were favorably impacted by prior year reserve
development of 0.5 points compared to adverse development of 4.2 points for
the same period in 2005. The adverse development in 2005 is concentrated
in the workers' compensation and general liability product lines, partially
offset by favorable development in the commercial auto and commercial
property product lines. The same period in 2005 included $2.8 return of
ceded premium on experienced based reinsurance contracts, which favorably
impacted all of the above ratios.
Specialty Lines Segment
Three Months Ended Six Months Ended
June 30, June 30,
Specialty Lines Segment 2006 2005 2006 2005
- -------------------------------------------------------------------------------
Net premiums earned $35.9 $36.4 $73.2 $71.5
Loss ratio 49.3% 41.6% 40.2% 42.3%
Loss adjustment expense ratio 12.4% 9.8% 8.6% 8.9%
Underwriting expense ratio 40.3% 43.9% 39.5% 44.6%
------ ----- ----- -----
Combined ratio 102.0% 95.3% 88.3% 95.8%
22
The Specialty Lines combined ratio increased 6.7 points for the three
months ended June 30, 2006, primarily the result of one large umbrella loss
(in excess of $3.0), which added 8.2 points to the loss and combined
ratios. For the six month period ended June 30, 2006 the combined ratio
improved 7.5 points primarily driven by 15.3 points of favorable prior year
loss and LAE development compared to 6.1 points for the same period in 2005
partially offset by the large umbrella loss discussed above. The three
month period ended June 30, 2005 included a $1.3 return of ceded premium on
experience based reinsurance contracts which favorably impacted all of the
above ratios. Underwriting expenses were favorably impacted by increased
ceding commissions on reinsurance contracts and lower incentive accruals
for both the three and six month periods of 2006.
Three Months Ended Six Months Ended
June 30, June 30,
Personal Lines Segment 2006 2005 2006 2005
- -------------------------------------------------------------------------------
Net premiums earned $113.1 $122.3 $228.9 $243.9
Loss ratio 57.9% 50.1% 54.9% 49.0%
Loss adjustment expense ratio 8.7% 8.2% 9.2% 7.8%
Underwriting expense ratio 25.9% 25.5% 26.8% 23.7%
----- ----- ----- -----
Combined ratio 92.5% 83.8% 90.9% 80.5%
The Personal Lines combined ratios deteriorated 8.7 and 10.4 points for the
three and six month periods ended June 30, 2006, respectively when compared
to the same periods of the prior year driven primarily by increased
catastrophe losses. Also impacting the three month period ended June 30,
2006 was an increase in non-catastrophe weather related property losses and
a decrease in net premiums earned for both the three month and six month
periods of 2006 when compared to the same periods in 2005, a result of rate
reductions taken in the last half of 2005 and a return of ceded premium on
experience based reinsurance contracts of $1.4 in 2005. A decrease in net
premiums earned puts upward pressure on the combined ratio. Partially
offsetting the impact of these items is favorable prior year reserve
development which decreased the loss and LAE ratios by 6.3 points compared
to 5.2 points for the three months ended June 30, 2006 and 2005,
respectively. For the six month period ended June 30, 2006 and 2005
favorable prior year reserve development decreased the loss and LAE ratio
by 4.7 points and 8.0 points, respectively. The underwriting expense ratio
deteriorated by 0.4 points and 3.1 points for the three and six month
period ended June 30, 2006, when compared to the same periods in 2005 due
primarily to the favorable Proformance surplus guarantee adjustments which
reduced the 2005 underwriting expense ratio by 0.6 points and 2.1 points,
respectively.
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
-------------------------------------------------
Earmed
Premium Calendar Year Accident Year
Year to Date Year to Date Year to Date Calendar Accident
June 30, June 30, June 30, Year Year
(By operating segment) 2006 2006 2006(a) 2005 2005(a)
- ----------------------------------------------------------------------------------------
Commercial Lines $411.1 101.8% 102.3% 102.3% 98.8%
Specialty Lines 73.2 88.5% 103.6% 89.9% 100.4%
Personal Lines 228.9 91.8% 96.4% 81.2% 87.7%
- ----------------------------------------------------------------------------------------
Total All Lines $713.2 97.2% 100.6% 94.2% 95.3%
========================================================================================
(a) The measurement date for accident year data is June 30, 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
For the three and six month periods ended June 30, 2006 and 2005,
consolidated pre-tax investment income was $51.9 and $48.6 and $102.8 and
$97.0, 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 and six months
ended June 30, 2006, net realized gains were $5.3 and $19.5 versus $13.8
for both the three and six month periods of 2005. The Consolidated
Corporation realized $14.4 and $35.1 in gross gains and $9.1 and $15.6 in
gross losses for the three month
23
and six month periods ended June 30, 2006, respectively. During both the
three month and six month periods ending June 30, 2005, the Consolidated
Corporation realized $17.5 in gross gains and $3.7 in gross losses.
Included in these realized losses are write downs of securities for other
than temporary decline in market value of $7.6 and $9.5 for the three month
and six month periods ended June 30, 2006 and no write downs were
recognized for the same periods of 2005.
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 (including the interest rate environment),
market value changes and developments specific to each issuer. The
difference between the cost/amortized cost and estimated fair value of
investments is continually evaluated to determine whether a decline in
value is temporary or other than temporary in nature. This determination
involves a degree of uncertainty. If a decline in the fair value of a
security is determined to be temporary, the decline is recorded as an
unrealized loss in shareholders' equity. If a decline in a security's fair
value is considered to be other than temporary, the security is written
down to the estimated fair value with a corresponding realized loss
recognized in the current consolidated statement of income. 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.
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 the security until recovery in value, even if a decision to
sell the security has not been made. The FSP applies to reporting periods
beginning after December 15, 2005.
The following table summarizes, for all available-for-sale securities and
held-to-maturity securities, the total gross unrealized losses, excluding
gross unrealized gains, by investment category and length of time the
securities have continuously been in an unrealized loss position as of June
30, 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 $ 17.2 $ (0.6) $ - $ - $ 17.2 $ (0.6)
States, municipalities and
political subdivisions 1,109.5 (20.4) 83.2 (2.7) 1,192.7 (23.1)
Corporate securities 471.2 (12.0) 52.9 (3.1) 524.1 (15.1)
Mortgage-backed
securities:
Government 4.6 (0.1) - - 4.6 (0.1)
Other 449.0 (8.1) 15.7 (0.4) 464.7 (8.5)
- ---------------------------------------------------------------------------------------------------
Total fixed income securities 2,051.5 (41.2) 151.8 (6.2) 2,203.3 (47.4)
Equity securities 65.9 (1.9) 6.7 (0.4) 72.6 (2.3)
- ---------------------------------------------------------------------------------------------------
Total temporarily impaired
securities $2,117.4 $(43.1) $158.5 $(6.6) $2,275.9 $(49.7)
===================================================================================================
24
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 $112.4 $ (6.9) $16.4 $(1.0) $128.8 $(7.9)
Mortgage-backed
securities 79.2 (3.1) 13.8 (0.6) 93.0 (3.7)
- ---------------------------------------------------------------------------------------------------
Total temporarily impaired
securities $191.6 $(10.0) $30.2 $(1.6) $221.8 $(11.6)
===================================================================================================
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 $61.3 aggregate unrealized loss on
the investment portfolio, management performed a more intensive review of
securities with a relatively higher degree of unrealized loss. Based on a
review of each security, management believes that unrealized losses on
these securities were temporary declines in value at June 30, 2006. In the
tables above, there are approximately 770 securities represented. Of this
total, 75 securities have unrealized loss positions greater than 5% of
their book values at June 30, 2006, with two exceeding 15%. This group
represents $18.8, or 30% of the total unrealized loss position. Of this
group, 70 securities, representing approximately $18.3 in unrealized
losses, have been in an unrealized loss position for less than twelve
months. The remaining five securities have been in an unrealized loss
position for longer than twelve months and total $0.5 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.
The amortized cost and estimated fair value of available-for-sale and held-
to-maturity fixed income securities in an unrealized loss position at June
30, 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 $ 12.1 $ 12.0 $ (0.1)
Due after one year through five years 228.1 224.5 (3.6)
Due after five years through ten years 852.7 833.7 (19.0)
Due after ten years 679.9 663.8 (16.1)
Mortgage-backed securities 477.9 469.3 (8.6)
- -----------------------------------------------------------------------------------
Total $2,250.7 $2,203.3 $(47.4)
===================================================================================
Held-to-maturity: Amortized Estimated Unrealized
Cost Fair Value Loss
- -----------------------------------------------------------------------------------
Due in one year or less $ 2.4 $ 2.4 $ -
Due after one year through five years 36.0 34.5 (1.5)
Due after five years through ten years 91.8 85.8 (6.0)
Due after ten years 6.5 6.1 (0.4)
Mortgage-backed securities 96.7 93.0 (3.7)
- -----------------------------------------------------------------------------------
Total $233.4 $221.8 $(11.6)
===================================================================================
For additional discussion relative to the Consolidated Corporation's
investment portfolio, see the "Investment Portfolio" section under
"Liquidity and Capital Resources" on pages 26 and 27 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. For information regarding agent
relationships asset, please
25
refer to Note V in the Notes to the Consolidated Financial Statements on
page 15 in this Quarterly Report on Form 10-Q and the Corporation's Annual
Report on Form 10-K for the year ended December 31, 2005 - Critical
Accounting Policies.
LIQUIDITY AND CAPITAL RESOURCES
Investment Portfolio
The following table sets forth the distribution and other data of
investments at June 30, 2006 and December 31, 2005, respectively.
June 30, 2006 December 31, 2005
------------- -----------------
Average Amortized Carry % of Amortized Carrying % of
Rating Cost Value Total Cost Value Total
--------------------------------------------------------------------
U.S Government:
Available-for-sale AAA $ 25.5 $ 25.0 0.6 $ 25.8 $ 25.9 0.6
States,
municipalities, and
political
subdivisions:
Investment grade:
Available-for-sale AA+ 1,362.2 1,340.3 32.8 1,269.7 1,277.4 30.2
Corporate securities:
Investment grade:
Available-for-sale A 1,408.5 1,423.5 34.7 1,489.0 1,552.4 36.8
Held-to-maturity A+ 158.8 158.8 3.9 160.1 160.1 3.8
Below Investment
grade:
Available-for-sale BB 74.0 75.7 1.8 65.5 68.5 1.6
---------------------------------------------------------
Total corporate
securities 1,641.3 1,658.0 40.4 1,714.6 1,781.0 42.2
---------------------------------------------------------
Mortgage-backed
securities:
Investment grade:
Available-for-sale AAA 564.6 557.3 13.6 601.6 601.6 14.3
Held-to-maturity AAA 96.7 96.7 2.3 104.3 104.3 2.5
Below Investment
grade:
Available-for-sale B 1.9 1.9 -
---------------------------------------------------------
Total mortgage-
backed securities 661.3 654.0 15.9 707.8 707.8 16.8
---------------------------------------------------------
Total fixed income
securities 3,690.3 3,677.3 89.7 3,717.9 3,792.1 89.8
Equity securities* 176.2 385.2 9.4 144.2 375.1 8.9
Cash and cash equilavents 38.7 38.7 0.9 54.5 54.5 1.3
---------------------------------------------------------
Total investment
securities, cash and
cash equivalents $3,905.2 $4,101.2 100.0 $3,916.6 $4,221.7 100.0
=========================================================
* Included in equity securities as of June 30, 2006 are common stock with a
cost of $114.3 and carrying value of $324.6 and preferred stock with a cost
of $61.9 and carrying value of $60.6. 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:
June 30, 2006 December 31, 2005
------------- -----------------
Amortized Carrying % of Amortized Carrying % of
Cost Value Fixed Cost Value Fixed
---------------------------- ----------------------------
Total investment grade $3,616.3 $3,601.6 97.9 $3,650.5 $3,721.7 98.1
Total below investment
grade 74.0 75.7 2.1 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 $3,434.8 $3,421.8 93.1 $3,453.5 $3,527.7 93.0
Total held-to-
maturity fixed income
securities 255.5 255.5 6.9 264.4 264.4 7.0
26
The excess of carrying value over cost was $196.0 at June 30, 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.
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 5.0 and 5.2
years at June 30, 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 Standard
and Poor's (S&P) and Moody's Investor Service (Moody's). When a security
is not rated by either S&P or Moody's, the classification is based on other
rating services, including the Securities Valuation Office of the National
Association of Insurance Commissioners. The market value of available-for-
sale split-rated fixed 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 $28.4 and $35.2 at June 30, 2006 and
December 31, 2005, respectively.
Following is a table displaying available-for-sale non-investment grade and
non-rated securities in an unrealized loss position at June 30, 2006 and
December 31, 2005:
Amortized Fair Unrealized
Cost Value Loss
- -------------------------------------------------------------------
June 30, 2006 $16.9 $16.7 $(0.2)
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 June
30, 2006, the equity portfolio consisted of stocks in a total of 71
separate entities covering all ten major S&P industry sectors. Of this
total, 20.2% 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 June 30, 2006, was $244.0
compared to $285.3 at December 31, 2005.
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 June 30, 2006 and December 31, 2005,
respectively. As of June 30, 2006, the loss reserves by operating segment
were as follows: $1,868.7 Commercial Lines, $728.4 Specialty Lines and
$385.5 Personal Lines. The Group purchases reinsurance to mitigate the
impact of large losses and catastrophic events. Loss reserves ceded to
reinsurers amounted to $673.1 and $684.6 at June 30, 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 June 30, 2006 represent
the Group's best estimate of its ultimate liability for losses and LAE.
However, due to the inherent complexity of the estimation process and the
potential variability of the assumptions used, final claim settlements may
vary significantly from the amounts recorded. Furthermore, the timing,
frequency and extent of adjustments to the estimated liabilities cannot be
predicted 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.
27
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 June 30, 2006 and December 31, 2005:
June 30, 2006
- -------------
Gross Total Total
Operating Segment Case IBNR LAE Total Ceded Net
- -------------------------------------------------------------------------------------------
Commercial Lines $ 735.9 $ 772.9 $359.9 $1,868.7 $174.6 $1,694.1
Workers' compensation 403.1 341.2 71.5 815.8 135.2 680.6
Commercial auto 106.1 107.0 43.2 256.3 6.0 250.3
General liability 67.2 121.9 93.9 283.0 9.5 273.5
CMP, fire & inland marine 159.5 202.8 151.3 513.6 23.9 489.7
Specialty Lines 141.4 491.2 95.8 728.4 426.5 301.9
Commercial umbrella 128.7 491.7 89.8 710.2 419.3 290.9
Fidelity & surety 12.7 (0.5) 6.0 18.2 7.2 11.0
Personal Lines 196.8 124.9 63.8 385.5 72.0 313.5
Personal auto & umbrella 165.7 87.7 47.7 301.1 71.0 230.1
Personal property 31.1 37.2 16.1 84.4 1.0 83.4
Total All Lines $1,074.1 $1,389.0 $519.5 $2,982.6 $673.1 $2,309.5
- -------------------------------------------------------------------------------------------
28
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 table presented in
the All Lines discussion of this MD&A on page 21 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 June 30,
2006 and 2005, and year ended December 31, 2005. 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 six months ended June 30, 2006,
the workers' compensation product line had adverse development of $10.5
while the commercial auto product line had favorable development of $13.9.
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 Six Months
Ended June 30, Ended June 30, Year
2006 2005 2006 2005 2005
(Favorable)/Unfavorable -------------- -------------- ----
- -----------------------
Accident Year 2005 $ (1.7) $ - $ (4.5) $ - $ -
Accident Year 2004 (8.5) (6.6) (13.1) (15.9) (30.8)
Accident Year 2003 and Prior (0.6) 3.7 (6.1) 9.2 10.7
------- ------ ------- ------- -------
Total Prior Accident Years'
Development $(10.8) $(2.9) $(23.7) $ (6.7) $(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 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 is undertaking 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.
29
Cash Flow
Net cash provided by operations was $42.7 for the first six months of 2006,
compared with $90.5 for the same period in 2005. The decline in cash
provided by operations is primarily the result of increased income tax
payments, incentive plan payments and contributions to the Company's
retirement plan. The net cash provided by investing was $7.3 compared with
net cash used of $156.3 during the first half of 2005. The decrease in
net cash used for investing is primarily related to a reduction in the
purchase of securities from 2005 to 2006, resulting from a portfolio
reallocation during 2005 into tax exempt securities. Cash used by
financing operations was $65.8 in the first six months of 2006 compared
with $152.1 in the first six months of 2005. The reinstatement of the
shareholder dividend and the repurchase of the Corporation's common stock
attributed to the cash used in financing activities during 2006. See Part
II, Item 2, for additional information regarding the share repurchase
program. For the same period in 2005, cash used in financing activities
was attributed to the repurchase and redemption of the Corporation's
Convertible Notes. 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 page 16 of
this Quarterly Report on Form 10-Q.
At June 30, 2006, the Corporation had cash and marketable securities,
totaling $258.5, 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
from the Ohio Department of Insurance. During the first six months of
2006, the Company paid dividends of $85.0 to the Corporation resulting in a
dividend payment limitation of $330.0 for the remainder of 2006.
Book Value Per Share
At June 30, 2006, the book value per share of the Consolidated Corporation
decreased $0.15 per share from $22.54 per share to $22.39 per share when
compared to book value at December 31, 2005. This decrease is principally
the result of improved profitability offset by a decline in unrealized
gains. At June 30, 2006 and December 31, 2005 there were 61,421,475 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
June 30, 2006.
December 31, 2005 $22.54
Activity year-to-date June 2006:
Net income 1.38
Change in unrealized gains (1.12)
Impact of share repurchase program (0.25)
Dividend to shareholders (0.18)
Other 0.02
------
June 30, 2006 $22.39
======
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 and S&P. These agencies assign
ratings and rating outlooks reflecting the agencies' opinions of the
Group's financial strength and the ability of the Corporation to meet its
financial obligations to its debt security holders. On July 26, 2006, S&P
announced that it has upgraded the senior unsecured debt rating of Ohio
Casualty Corporation to BBB- and the insurance financial strength rating
of its operating subsidiaries to A-. In this same action, S&P changed
the outlook on the ratings to stable. Following are the Consolidated
Corporation's current ratings and rating outlooks.
30
A.M. Best Fitch Moody's S&P
--------- ----- ------- ---
Financial strength rating (Group) A- A- A3 A-
Senior unsecured debt rating
(Corporation) bbb- BBB- Baa3 BBB-
Rating outlook Positive Positive Positive Stable
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 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
second quarter ended June 30, 2006.
31
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
- ---------------------------------------------------------------------------------
April 1 - 30, 2006 17,302 $29.30 17,302 2,429,813
May 1 - 31, 2006 937,927 29.62 937,927 1,491,886
June 1 - 30, 2006 1,242,700 29.37 1,242,700 249,186
--------- ---------
Total 2,197,929 $29.48 2,197,929 249,186
ITEM 4. Submission of Matters to a Vote of Security Holders
At the Annual Meeting of Shareholders (the Annual Meeting) held on
May 17, 2006, shareholders voted on the re-election of three members
of the Board of Directors for terms expiring in 2009 as follows.
Jack E. Brown For 59,341,708; Withheld 945,428
Robert A. Oakley For 60,050,010; Withheld 237,126
Jan H. Suwinski For 60,041,213; Withheld 245,923
Other directors whose term of office continued after the meeting
were: Terrence J. Baehr, Dan R. Carmichael, Catherine E. Dolan,
Philip G. Heasley, Stanley N. Pontius, Ronald W. Tysoe and Michael
A. Wright.
Also, at the Annual Meeting, shareholders ratified the appointment
of Ernst & Young, LLP as independent public accountants for the
fiscal year 2006. The proposal was approved with a final vote of:
For 60,098,634; Against 93,212; Abstain 95,290
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
32
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
OHIO CASUALTY CORPORATION
-------------------------------
(Registrant)
July 26, 2006 /s/ Michael A. Winner
-------------------------------------------
Michael A. Winner, Executive Vice President
and Chief Financial Officer
33