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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, 2007.
[ ] 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 (I.R.S. Employer
of incorporation or organization) Identification No.)
9450 Seward Road, Fairfield, Ohio 45014
(Address of principal executive offices) (Zip Code)
(513) 603-2400
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15 (d) of the Securities Exchange Act
of 1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to
such filing requirements for the past 90 days.
Yes X No
-----
Indicate by check mark whether the registrant is a large accelerated
filer, an accelerated filer, or a non-accelerated filer. See definition of
"accelerated filer and large accelerated filer" in Rule 12b-2 of the
Exchange Act.
Large accelerated filer X Accelerated filer Non-accelerated filer
-----
Indicate by check mark whether the registrant is a shell company (as
defined in Rule 12b-2 of the Exchange Act).
Yes No X
-----
On July 27, 2007, there were 60,041,453 shares of common stock
outstanding.
Page 1 of 31
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INDEX
Page
----
PART I FINANCIAL INFORMATION
Item 1. Financial Statements 3
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations 15
Item 3. Quantitative and Qualitative Disclosures about
Market Risk 29
Item 4. Controls and Procedures 29
PART II OTHER INFORMATION
Item 1. Legal Proceedings 29
Item 4. Submission of Matters to a Vote of Security Holders 30
Item 6. Exhibits 30
Signature 31
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) 2007 2006
- -------------------------------------------------------------------------------------------
(Unaudited)
Assets
Investments:
Fixed income securities:
Available-for-sale, at fair value
(amortized cost: $3,494.3 and $3,451.0) $ 3,500.3 $ 3,512.3
Held-to-maturity, at amortized cost
(fair value: $219.2 and $230.8) 226.7 235.8
Equity securities, at fair value
(cost: $256.8 and $232.1) 486.6 458.5
- -------------------------------------------------------------------------------------------
Total investments 4,213.6 4,206.6
Cash and cash equivalents 39.0 45.6
Premiums and other receivables, net of allowance 331.0 316.0
Deferred policy acquisition costs 154.9 150.2
Property and equipment, net of accumulated depreciation 82.8 80.5
Reinsurance recoverable, net of allowance 619.0 633.8
Agent relationships, net of accumulated amortization 91.9 96.9
Interest and dividends due or accrued 50.6 51.2
Deferred tax asset, net 22.3 -
Other assets 99.9 117.8
- -------------------------------------------------------------------------------------------
Total assets $ 5,705.0 $ 5,698.6
===========================================================================================
Liabilities
Insurance reserves:
Losses $ 2,385.3 $ 2,390.4
Loss adjustment expenses 520.4 521.9
Unearned premiums 673.7 663.0
Debt 199.4 199.6
Reinsuance treaty funds held 106.2 117.6
Deferred tax liability, net - 7.2
Other liabilities 199.5 243.2
- -------------------------------------------------------------------------------------------
Total liabilities 4,084.5 4,142.9
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 32.2 25.4
Accumulated other comprehensive income 159.5 194.1
Retained earnings 1,663.6 1,559.5
Treasury stock, at cost:
(Shares: 12,387,526; 12,095,652) (243.8) (232.3)
- -------------------------------------------------------------------------------------------
Total shareholders' equity 1,620.5 1,555.7
- -------------------------------------------------------------------------------------------
Total liabilities and shareholders' equity $ 5,705.0 $ 5,698.6
===========================================================================================
Accompanying notes are an integral part of these consolidated financial
statements. For complete disclosures see Notes to Consolidated Financial
Statements on pages 71-89 of the Corporation's 2006 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) 2007 2006
- -------------------------------------------------------------------------------------------
Premiums and finance charges earned $ 339.3 $ 355.5
Investment income, less expenses 51.9 51.9
Investment gains realized, net 6.6 5.3
- -------------------------------------------------------------------------------------------
Total revenues 397.8 412.7
Losses and benefits for policyholders 157.7 199.3
Loss adjustment expenses 35.9 42.7
General operating expenses 123.7 116.7
Write-down and amortization of agent relationships 1.5 4.5
Amortization of deferred policy acquisition costs 82.6 82.7
Deferral of policy acquisition costs (85.7) (84.6)
Depreciation and amortization expense 3.4 2.6
- -------------------------------------------------------------------------------------------
Total expenses 319.1 363.9
- -------------------------------------------------------------------------------------------
Income before income taxes 78.7 48.8
Income tax expense/(benefit):
Current 22.4 14.9
Deferred (0.3) (1.7)
- -------------------------------------------------------------------------------------------
Total income tax expense 22.1 13.2
- -------------------------------------------------------------------------------------------
Net income $ 56.6 $ 35.6
===========================================================================================
Average shares outstanding - basic 59,890,873 62,815,872
===========================================================================================
Earnings per share - basic:
Net income, per share $ 0.95 $ 0.57
===========================================================================================
Average shares outstanding - diluted 61,625,551 64,351,335
===========================================================================================
Earnings per share - diluted:
Net income, per share $ 0.92 $ 0.55
===========================================================================================
Accompanying notes are an integral part of these consolidated financial
statements. For complete disclosures see Notes to Consolidated Financial
Statements on pages 71-89 of the Corporation's 2006 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) 2007 2006
- -------------------------------------------------------------------------------------------
Premiums and finance charges earned $ 688.9 $ 713.2
Investment income, less expenses 103.6 102.8
Investment gains realized, net 14.6 19.5
- -------------------------------------------------------------------------------------------
Total revenues 807.1 835.5
Losses and benefits for policyholders 319.6 388.3
Loss adjustment expenses 74.5 79.4
General operating expenses 241.1 233.4
Write-down and amortization of agent relationships 5.0 7.4
Amortization of deferred policy acquisition costs 164.1 165.6
Deferral of policy acquisition costs (168.7) (165.7)
Depreciation and amortization expense 6.6 5.1
- -------------------------------------------------------------------------------------------
Total expenses 642.2 713.5
- -------------------------------------------------------------------------------------------
Income before income taxes 164.9 122.0
Income tax expense/(benefit):
Current 54.7 23.1
Deferred (9.5) 11.4
- -------------------------------------------------------------------------------------------
Total income tax expense 45.2 34.5
- -------------------------------------------------------------------------------------------
Net income $ 119.7 $ 87.5
===========================================================================================
Average shares outstanding - basic 59,867,660 63,024,617
===========================================================================================
Earnings per share - basic:
Net income, per share $ 2.00 $ 1.39
===========================================================================================
Average shares outstanding - diluted 61,519,908 64,591,888
===========================================================================================
Earnings per share - diluted:
Net income, per share $ 1.95 $ 1.35
===========================================================================================
Accompanying notes are an integral part of these consolidated financial
statements. For complete disclosures see Notes to Consolidated Financial
Statements on pages 71-89 of the Corporation's 2006 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, 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
of $38.7 (71.9) (71.9)
---------
Comprehensive income 15.6
Unearned stock compensation (2.9) 2.9 -
Stock based compensation, including
income tax of $1.6 4.9 4.9
Net issuance of treasury
stock (375,048 shares) (0.2) 5.6 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
==============================================================================================================
Balance
January 1, 2007 $ 9.0 $ 25.4 $194.1 $1,559.5 $(232.3) $1,555.7
Net income 119.7 119.7
Change in unrealized gain,
net of deferred income tax
of $19.0 (32.9) (32.9)
Change in prior service credit, net of
deferred income tax of $1.5 (2.7) (2.7)
Change in actuarial loss, net of
deferred tax of $0.5 1.0 1.0
---------
Comprehensive income 85.1
Stock based compensation, including
income tax of $1.6 7.7 7.7
Net issuance of treasury
stock (286,730 shares) (0.9) 5.6 4.7
Repurchase of treasury stock
(578,604 shares) (17.1) (17.1)
Cash dividends paid ($0.26 per share) (15.6) (15.6)
- --------------------------------------------------------------------------------------------------------------
Balance,
June 30, 2007 $ 9.0 $ 32.2 $159.5 $1,663.6 $(243.8) $1,620.5
==============================================================================================================
Accompanying notes are an integral part of these consolidated financial
statements. For complete disclosures see Notes to Consolidated Financial
Statements on pages 71-89 of the Corporation's 2006 Form 10-K.
6
ITEM 1. Continued
Ohio Casualty Corporation & Subsidiaries
CONSOLIDATED STATEMENTS OF CASH FLOWS
Six Months
Ended June 30,
(in millions) (Unaudited) 2007 2006
- -------------------------------------------------------------------------------------------------
Cash Flows from Operating Activities:
Operating Activities
Net income $ 119.7 $ 87.5
Adjustments to reconcile net income to cash
provided by operations:
Changes in:
Insurance reserves 4.1 47.1
Reinsurance treaty funds held (11.4) (7.6)
Income taxes (21.9) (6.1)
Premiums and other receivables (15.0) (29.3)
Deferred policy acquisition costs (4.7) -
Reinsurance recoverable 14.9 6.7
Other assets 9.3 (15.7)
Other liabilities (19.5) (36.2)
Stock-based compensation expense 6.1 3.3
Write-down and amortization of agent relationships 5.0 7.4
Depreciation and amortization 6.6 5.1
Investment gains realized, net (14.6) (19.5)
- -------------------------------------------------------------------------------------------------
Net cash provided by operating activities 78.6 42.7
- -------------------------------------------------------------------------------------------------
Cash Flows from Investing Activities:
Purchase of securities:
Fixed income, available-for-sale (472.0) (489.6)
Fixed income, held-to-maturity - (0.5)
Equity (36.7) (51.1)
Proceeds from sales of securities:
Fixed income, available-for-sale 302.2 435.6
Equity 29.7 49.8
Proceeds from maturities and calls of securities:
Fixed income, available-for-sale 122.4 60.3
Fixed income, held-to-maturity 8.2 8.5
Property and equipment
Purchases (9.3) (5.0)
Sales 0.2 0.3
- -------------------------------------------------------------------------------------------------
Net cash (used in) provided by investing activities (55.3) 8.3
- -------------------------------------------------------------------------------------------------
Cash Flows from Financing Activities:
Debt:
Repayments (0.3) (0.3)
Payments for deferred financing costs - (0.3)
Proceeds from exercise of stock options 4.0 4.3
Repurchase of treasury stock (19.3) (60.5)
Income tax benefit from stock option exercises 1.3 1.3
Dividends paid to shareholders (15.6) (11.3)
- -------------------------------------------------------------------------------------------------
Net cash used in financing activities (29.9) (66.8)
- -------------------------------------------------------------------------------------------------
Net (decrease) in cash and cash equivalents (6.6) (15.8)
Cash and cash equivalents, beginning of period 45.6 54.5
- -------------------------------------------------------------------------------------------------
Cash and cash equivalents, end of period $ 39.0 $ 38.7
=================================================================================================
Accompanying notes are an integral part of these consolidated financial
statements. For complete disclosures see Notes to Consolidated Financial
Statements on pages 71-89 of the Corporation's 2006 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, 2007 and the
Consolidated Statements of Income, Shareholders' Equity and Cash Flows for
the three and six months ended June 30, 2007 and 2006, 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,
2007 and for each period presented have been made.
We prepared the accompanying unaudited Consolidated Financial Statements in
accordance with U.S. generally accepted accounting principles (GAAP) 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 GAAP 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 2006 Annual Report on Form 10-K. The results of operations
for the period ended June 30, 2007 are not necessarily indicative of the
results of operations for the full year.
The preparation of financial statements in conformity with GAAP 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 $1.3 at June 30, 2007 and $ 1.5 at December 31,
2006, respectively. Property and equipment are carried at cost less
accumulated depreciation of $180.0 and $183.0 at June 30, 2007 and December
31, 2006, respectively. Amounts recoverable from reinsurers are calculated
in a manner consistent with the reinsurance contract and are reported net
of allowance of $3.7 at both June 30, 2007 and December 31, 2006.
NOTE II - EARNINGS PER SHARE
Three Months Ended Six Months Ended
June 30, June 30,
2007 2006 2007 2006
- ----------------------------------------------------------------------------
Net income $56.6 $35.6 $119.7 $87.5
Weighted average common shares
outstanding - basic (thousands) 59,891 62,816 59,868 63,025
Basic net income per weighted
average share $0.95 $0.57 $2.00 $1.39
============================================================================
Net income $56.6 $35.6 $119.7 $87.5
Weighted average common shares
outstanding - basic (thousands) 59,891 62,816 59,868 63,025
Effect of dilutive securities from
stock compensation plans (thousands) 1,735 1,535 1,652 1,567
- ----------------------------------------------------------------------------
Weighted average common shares
outstanding - diluted (thousands) 61,626 64,351 61,520 64,592
Diluted net income per weighted
average share $0.92 $0.55 $1.95 $1.35
============================================================================
8
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.
Three Months Ended June 30,
Commercial Lines Segment 2007 2006
- -----------------------------------------------------------------
Net premiums written $217.5 $223.9
% Change (2.9)% 0.9%
Net premiums earned 200.5 206.5
% Change (2.9)% (0.1)%
Underwriting gain/(loss) (before tax) 20.1 (4.9)
Specialty Lines Segment 2007 2006
- -----------------------------------------------------------------
Net premiums written $ 34.3 $ 37.3
% Change (8.0)% (6.0)%
Net premiums earned 34.3 35.9
% Change (4.5)% (1.4)%
Underwriting gain/(loss) (before tax) 1.5 (0.6)
Personal Lines Segment 2007 2006
- -----------------------------------------------------------------
Net premiums written $105.6 $111.6
% Change (5.4)% (9.6)%
Net premiums earned 104.5 113.1
% Change (7.6)% (7.5)%
Underwriting gain (before tax) 7.6 8.3
Total Property & Casualty 2007 2006
- -----------------------------------------------------------------
Net premiums written $357.4 $372.8
% Change (4.1)% (3.1)%
Net premiums earned 339.3 355.5
% Change (4.6)% (2.7)%
Underwriting gain (before tax) 29.2 2.8
All Other Segment 2007 2006
- -----------------------------------------------------------------
Revenues $ 5.1 $ 3.7
Write-down and amortization of
agent relationships (1.5) (4.5)
Other expenses (7.5) (6.7)
- -----------------------------------------------------------------
Loss before income tax $(3.9) $(7.5)
Reconciliation of Revenues 2007 2006
- -----------------------------------------------------------------
Net premiums earned for reportable
segments $339.3 $355.5
Net investment income 46.8 47.5
Realized gains, net 6.6 6.0
- -----------------------------------------------------------------
Total property and casualty revenues 392.7 409.0
All other segment revenues 5.1 3.7
- -----------------------------------------------------------------
Total revenues $397.8 $412.7
=================================================================
9
Reconciliation of Underwriting Gain
(before tax) 2007 2006
- -----------------------------------------------------------------
Property and casualty underwriting
gain (before tax) $ 29.2 $ 2.8
Net investment income 51.9 51.9
Realized gains, net 6.6 5.3
Write-down and amortization of
agent relationships (1.5) (4.5)
Other expenses (7.5) (6.7)
- -----------------------------------------------------------------
Income before income tax 78.7 48.8
Income tax expense (22.1) (13.2)
- -----------------------------------------------------------------
Net income $ 56.6 $ 35.6
=================================================================
Six Months Ended June 30,
Commercial Lines Segment 2007 2006
- -----------------------------------------------------------------
Net premiums written $426.9 $436.3
% Change (2.2)% 2.1%
Net premiums earned 405.8 411.1
% Change (1.3)% (0.3)%
Underwriting gain/(loss) (before tax) 31.4 (8.5)
Specialty Lines Segment 2007 2006
- -----------------------------------------------------------------
Net premiums written $68.9 $73.1
% Change (5.7)% (7.2)%
Net premiums earned 71.0 73.2
% Change (3.0)% 2.4%
Underwriting gain (before tax) 14.9 8.6
Personal Lines Segment 2007 2006
- -----------------------------------------------------------------
Net premiums written $206.9 $217.5
% Change (4.9)% (8.3)%
Net premiums earned 212.1 228.9
% Change (7.3)% (6.2)%
Underwriting gain (before tax) 20.5 20.9
Total Property & Casualty 2007 2006
- -----------------------------------------------------------------
Net premiums written $702.7 $726.9
% Change (3.3)% (2.2)%
Net premiums earned 688.9 713.2
% Change (3.4)% (2.0)%
Underwriting gain (before tax) 66.8 21.0
All Other Segment 2007 2006
- -----------------------------------------------------------------
Revenues $ 8.7 $ 7.3
Write-down and amortization of
agent relationships (5.0) (7.4)
Other expenses (15.1) (13.9)
- -----------------------------------------------------------------
Loss before income tax $(11.4) $(14.0)
Reconciliation of Revenues 2007 2006
- -----------------------------------------------------------------
Net premiums earned for reportable
segments $688.9 $713.2
Net investment income 94.0 94.7
Realized gains, net 15.5 20.3
- -----------------------------------------------------------------
Total property and casualty revenues 798.4 828.2
All other segment revenues 8.7 7.3
- -----------------------------------------------------------------
Total revenues $807.1 $835.5
=================================================================
Reconciliation of Underwriting Gain
(before tax) 2007 2006
- -----------------------------------------------------------------
Property and casualty underwriting
gain (before tax) $ 66.8 $ 21.0
Net investment income 103.6 102.8
Realized gains, net 14.6 19.5
Write-down and amortization of
agent relationships (5.0) (7.4)
Other expenses (15.1) (13.9)
- -----------------------------------------------------------------
Income before income tax 164.9 122.0
Income tax expense (45.2) (34.5)
- -----------------------------------------------------------------
Net income $119.7 $ 87.5
=================================================================
10
Management of the Consolidated Corporation believes the significant
volatility of realized investment gains and losses limits the usefulness
of net income as a measure of current operating performance. Accordingly,
management uses the non-GAAP financial measure of operating income to
further evaluate current operating performance. Operating income is
reconciled to net income in the table below:
Three Months Ended Six Months Ended
June 30, June 30,
2007 2006 2007 2006
- ---------------------------------------------------------------------------
Net income $56.6 $35.6 $119.7 $87.5
After-tax net realized gains 4.2 3.4 9.4 12.6
- ---------------------------------------------------------------------------
Operating income $52.4 $32.2 $110.3 $74.9
===========================================================================
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) 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. For a 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, 2006.
Following is a summary of stock based compensation expense recognized by
the Consolidated Corporation:
Three Months Ended Six Months Ended
June 30, June 30,
2007 2006 2007 2006
- ---------------------------------------------------------------------------
2005 Incentive Plan
Stock Options $0.4 $0.7 $0.9 $1.4
Stock Appreciation Rights 0.3 0.3 0.6 0.6
Restricted Stock 0.2 0.3 0.4 0.7
Long Term Incentive Plan 2.2 0.6 4.1 0.3
Employee Stock Purchase Plan - - 0.1 0.3
- ---------------------------------------------------------------------------
Total Stock-Based Compensation $3.1 $1.9 $6.1 $3.3
===========================================================================
NOTE V - INCOME TAXES
Effective January 1, 2007, the Consolidated Corporation adopted the
recognition and disclosure provisions of SFAS Interpretation No. 48,
"Accounting for Uncertainties in Income Taxes, an Interpretation of SFAS
109, Accounting for Income Taxes" (FIN 48). FIN 48 requires the
Consolidated Corporation to account for and disclose uncertainty in tax
positions, along with related interest and penalties, that meet a minimum
recognition threshold. As of June 30, 2007 and December 31, 2006, the
total amount of unrecognized tax benefits was $1.5. If recognized, the
entire amount of unrecognized tax benefits would affect the Consolidated
Corporation's effective tax rate. For the periods presented, there were no
interest or penalties recognized in the Consolidated Corporation's
consolidated statements of income and consolidated balance sheets. It is
reasonably possible that none of the unrecognized tax benefits will
significantly increase or decrease within twelve months. In February 2007,
the Internal Revenue Service (IRS) issued the final report on its
examination of the Consolidated Corporation for tax years 2002 and 2003.
There is one matter for which the Consolidated Corporation has filed a
written protest with the IRS Appeals Office. The ultimate settlement of
this matter is not expected to have a significant adverse impact on the
Consolidated Corporation's financial position or results of operations.
During the second quarter of 2007, the IRS commenced its examination of the
Consolidated Corporation's tax years 2004 and 2005.
The Consolidated Corporation's policy under FIN 48 with respect to interest
and penalties related to tax uncertainties is to classify such amounts in
its statement of income as income tax expense, consistent with its policy
prior to the adoption of FIN 48.
11
NOTE VI - 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 primarily to agent relationships. Agent relationships are
evaluated quarterly as events or circumstances indicate a possible
inability to recover their carrying amount. As a result of this evaluation
conducted for the second quarter of 2007, there was no write down of this
asset at June 30, 2007. In the second quarter of 2006, the asset was
written down by $3.0. For the six months ended June 30, 2007 and 2006, the
asset was written down before tax by $2.1 and $4.3, 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 17 years. For the three and six month period ended
June 30, 2007, the Consolidated Corporation recorded amortization expense
of $1.5 and $2.9, respectively, which compares to $1.5 and $3.1,
respectively, for the same periods of the prior year. At June 30, 2007 and
December 31, 2006, the unamortized carrying value of the agent
relationships asset was $91.9 and $96.9, respectively. The agent
relationships asset is recorded net of accumulated amortization of $50.2
and $48.4 at June 30, 2007 and December 31, 2006, 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 reasonably possible to cause further
impairment losses beyond the quarterly amortization of the remaining asset
value over the remaining useful lives.
NOTE VII - DEBT
The following table represents outstanding debt and deferred financing
costs of the Consolidated Corporation at June 30, 2007 and December 31,
2006:
June 30, December 31,
2007 2006
- ---------------------------------------------------------------------
Senior Debt (net of discount and
issuance costs of $2.0) $198.0 $198.0
Ohio Loan 1.7 2.0
Deferred Financing Costs (0.3) (0.4)
- ---------------------------------------------------------------------
Total Debt $199.4 $199.6
=====================================================================
On June 29, 2004, the Corporation issued $200.0 of 7.3% Senior Notes due
June 15, 2014 (Senior Notes) and received net proceeds after related fees
and discount of $198.0. The Corporation used a substantial majority of the
net proceeds to repurchase and redeem the Convertible Notes. See Note 15
included in the Notes to Consolidated Financial Statements in the
Corporation's Annual Report on Form 10-K for the year ended December 31,
2006 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 $2.0 at June 30,
2007 and December 31, 2006. 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. In March 2007, the
Corporation extended the expiration by one year to March 16, 2012. 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
12
ended December 31, 2006 for a detailed discussion regarding the terms and
provisions of the new revolving credit agreement. At June 30, 2007, 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, 2007 or December 31, 2006.
Interest expense incurred for the six month periods ended June 30, 2007 and
2006 was $7.3. Interest expense incurred for the three month periods ended
June 30, 2007 and 2006 was $3.6.
NOTE VIII - CONTINGENCIES
A proceeding entitled Carol Lazarus v. the Group was brought against West
American Insurance Company (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 Court granted preliminary
approval to a settlement agreement between Carol Lazarus, individually and
on behalf of a class, with West American, its parent and affiliates, on May
31, 2007. A final settlement hearing is scheduled for November 19, 2007.
A proceeding entitled Douglas and Carla Scott v. the Company, West
American, American Fire Insurance Company (American Fire), and Ohio
Security Insurance Company (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.
A proceeding entitled Georgia Hensley, et al. v. Computer Sciences
Corporation, et al. was brought against several defendants, including the
Company, American Fire, Ohio Casualty of New Jersey (OCNJ), Ohio Security,
and West American in the Circuit Court of Miller County, Arkansas in May,
2005. The proceeding alleged the defendants (involving approximately 400
different entities) improperly reduced uninsured/underinsured motorist
coverage payments to persons insured under private passenger automobile
insurance policies by consulting a computer software program in determining
the amount of damages payable to the insured for bodily injury claims. The
Corporation has been dismissed without prejudice from the Hensley
proceeding. A separate class action complaint entitled Dusty Easley, et
al. v. the Company, American Fire, Avomark Insurance Company (Avomark), the
Corporation, Ohio Security, and West American was filed in the Circuit
Court of Miller County, Arkansas in March, 2007. The Easley proceeding
alleges substantially the same counts alleged in the Hensley proceeding and
includes the same putative class. Plaintiffs and defendants in the Easley
proceeding have filed a Stipulation of Settlement and Motion for
Preliminary Approval seeking approval of a settlement of the case. If the
proposed settlement is approved in the Easley matter then plaintiffs in the
Hensley action will also seek to amend the dismissal of the Corporation
with prejudice.
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.
13
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,
2007 2006 2007 2006
- ---------------------------------------------------------------------------------
Service cost earned during the period $ 2.1 $ 2.1 $ 4.2 $ 4.2
Interest cost on projected benefit
obligation 4.6 4.3 9.3 8.6
Expected return on plan assets (7.0) (6.5) (14.0) (13.0)
Amortization of accumulated losses 0.7 1.0 1.5 2.0
Amortization of prior service credit (0.5) (0.5) (1.2) (1.1)
Settlement - 1.0 - 1.0
- ---------------------------------------------------------------------------------
Net periodic pension (benefit)/cost $(0.1) $ 1.4 $ (0.2) $ 1.7
=================================================================================
The components of the Company's net periodic postretirement benefit as of
June 30:
Three Months Ended Six Months Ended
June 30, June 30,
2007 2006 2007 2006
- ---------------------------------------------------------------------------------
Service cost $ - $ 0.1 $ 0.1 $ 0.2
Interest cost 0.7 0.6 1.3 1.3
Amortization of prior service credit (1.5) (1.5) (3.0) (3.0)
- ---------------------------------------------------------------------------------
Net periodic postretirement benefit $(0.8) $(0.8) $(1.6) $(1.5)
=================================================================================
The Company adopted the recognition and disclosure provisions of SFAS 158,
"Employers' Accounting for Defined Benefit Pension and Other Postretirement
Plans as amendment of SFAS Statements No. 87, 88, 106, and 132(R)" as of
December 31, 2006. Please refer to Note 4 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, 2006 for a detailed discussion.
NOTE X - PENDING MERGER WITH LIBERTY MUTUAL INSURANCE COMPANY
On May 6, 2007, the Corporation entered into an Agreement and Plan of
Merger (the "Merger Agreement"), among Liberty Mutual Insurance Company
("Liberty") and Waterfall Merger Corp. a wholly owned direct subsidiary of
Liberty ("Waterfall").
The Merger Agreement provides for a business combination whereby Waterfall
will merge with and into the Corporation (the "Merger"). As a result of
the Merger, the separate corporate existence of Waterfall will cease and
the Corporation will continue as the surviving corporation in the Merger.
At the effective time of the Merger, each common share, par value $.125 per
share, of the Corporation (other than shares owned by the Corporation,
Liberty and Waterfall) will be converted into the right to receive $44.00
in cash, without interest. Each Corporation stock option and other share
acquisition and appreciation rights outstanding at the time of the closing
will be cancelled in the Merger and the holder thereof will be entitled to
an amount of cash, without interest, equal to the difference between $44.00
and the exercise price of such stock option or purchase right.
The Merger is subject to the approval of a majority of the Corporation's
outstanding shares. On June 18, 2007, the Board of Directors of the
Corporation declared a record date of June 28, 2007 for shareholders
eligible to vote at a special meeting of shareholders, to be held on August
8, 2007, concerning matters related to the Merger. In addition, the Merger
is subject to clearance under the Hart-Scott-Rodino Antitrust Improvements
Acts (HSR) and other regulatory laws applicable to the Merger, including
state insurance laws and regulation, as well as other customary closing
conditions. On June 11, 2007, the Corporation received clearance from the
Federal Trade Commission and Department of Justice of the waiting period
under HSR. The Merger Agreement contains certain termination rights for
both the Corporation and Liberty and further provides that upon termination
of the Merger Agreement under certain circumstances, the Corporation may be
obligated to pay Liberty a termination fee of $62.0. No such termination
fee has been accrued as of June 30, 2007.
14
Also, on May 6, 2007 the Corporation entered into a Second Amendment (the
"Second Amendment") to its Amended and Restated Rights Agreement, dated as
of February 19, 1998, between the Corporation and Computershare Trust
Company, N.A. (f/k/a Equiserve Trust Company, N.A.) as successor to First
Chicago Trust Company of New York, as amended on November 8, 2001 (the
"Rights Agreement") for the purpose of amending the Rights Agreement to
render it inapplicable to the Merger Agreement, the Merger and the
transactions contemplated thereby.
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 $56.6, or $0.92 per
share and $35.6, or $0.55 per share for the three months ended June 30,
2007 and 2006, respectively, which included after-tax realized investment
gains of $4.2 ($0.07 per share) and $3.4 ($0.05 per share) for the three
months ended June 30, 2007 and 2006, respectively. For the six months
ended June 30, 2007 and 2006, net income was $119.7, or $1.95 per share and
$87.5, or $1.35 per share, respectively, which included after-tax realized
investment gains of $9.4 ($0.16 per share) and $12.6 ($0.19 per share) for
the six months ended June 30, 2007 and 2006, respectively.
On May 6, 2007, the Corporation entered into an Agreement and Plan of
Merger (the "Merger Agreement"), among Liberty Mutual Insurance Company
("Liberty") and Waterfall Merger Corp., a wholly owned direct subsidiary of
Liberty. For a discussion of this pending merger, see Note X - Pending
Merger with Liberty Mutual Insurance Company, in the Notes to the
Consolidated Financial Statements.
All Lines Discussion
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 GAAP is
included in Item 15, page 87 of the Corporation's 2006 Annual Report on
Form 10-K.
At June 30, 2007 and December 31, 2006, statutory surplus, a financial
measure that is required by insurance regulators and used to monitor
financial strength, was $1,111.4 and $1,082.7, respectively. The ratio of
twelve months ended net premiums written to statutory surplus as of both
June 30, 2007 and December 31, 2006 was 1.3 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.
15
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,
2007 2006 % Chg 2007 2006 % Chg
---- ---- ----- ---- ---- -----
Gross Premiums Written
- ----------------------
Commercial Lines $226.5 $230.0 (1.5)% $441.7 $448.0 (1.4)%
Specialty Lines 47.4 51.1 (7.2)% 93.0 98.6 (5.7)%
Personal Lines 109.2 113.0 (3.4)% 211.8 220.2 (3.8)%
------ ------ ------ ------
All Lines $383.1 $394.1 (2.8)% $746.5 $766.8 (2.6)%
====== ====== ====== ======
Three Months Ended June 30, Six Months Ended June 30,
2007 2006 % Chg 2007 2006 % Chg
---- ---- ----- ---- ---- -----
Net Premiums Written
- --------------------
Commercial Lines $217.5 $223.9 (2.9)% $426.9 $436.3 (2.2)%
Specialty Lines 34.3 37.3 (8.0)% 68.9 73.1 (5.7)%
Personal Lines 105.6 111.6 (5.4)% 206.9 217.5 (4.9)%
------ ------ ------ ------
All Lines $357.4 $372.8 (4.1)% $702.7 $726.9 (3.3)%
====== ====== ====== ======
All Lines gross and net premiums written declined for the three and six
month periods ended June 30, 2007, when compared with the same periods of
the prior year, due primarily to a decline in new business premium
production across all three business segments, a decline in premium rates
for both Personal and Commercial Lines, lower Commercial Lines assumed
premiums from mandatory workers' compensation and commercial auto pools as
well as lower in-force policy counts in the Personal Lines segment and
commercial umbrella/other product line. Net premiums written were also
reduced by a $7.0 increase in ceded premium on experience based reinsurance
contracts during the second quarter of 2007. The experience rated
reinsurance contracts are for a funded layer of casualty excess of loss
reinsurance coverage. This decline was partially offset by continued
growth in the fidelity and surety bond product line.
The table below summarizes supplemental information which is useful to
understand the Company's premium trends:
Three Months Ended Six Months Ended
June 30, June 30,
2007 2006 2007 2006
---- ---- ---- ----
New Business Gross Premiums Written
- -----------------------------------
Commercial Lines $43.9 $44.8 $80.7 $87.3
Commercial umbrella/other 4.8 7.4 11.0 14.8
Personal Lines 9.4 10.2 18.8 19.1
Average Renewal Price Increase/(Decrease)1
- -----------------------------------------
Commercial Lines -1.3% 3.1% -1.0% 1.7%
Commercial umbrella/other 2.1% 0.2% 2.6% 0.8%
Policy Retention Ratio2
- -----------------------
Commercial Lines - - 78.0% 78.9%
Commercial umbrella/other - - 71.2% 72.9%
Personal Lines - - 85.4% 84.0%
1 When used in this Quarterly Report on Form 10-Q, renewal price
increase/(decrease) means the average increase in premium for policies
renewed by the Group. The Group revised its methodology for calculating
the average renewal price change for the Commercial Lines segment in 2006.
Previously the Company calculated this amount by comparing the total
expiring premium for the policy with the total renewal premium for the same
policy, including endorsement and audit premium on those policies
subsequent to the renewal date. The revised methodology is calculated by
comparing the total expiring premium for the policy with the total renewal
premium for the same policy at the renewal date. Endorsements and audit
premium subsequent to the renewal date are excluded from the calculation.
The amounts presented in the table above have been restated for all periods
to present the percentage using the revised methodology. Renewal price
increases include, among other things, the effects of rate increases and
changes in the underlying insured exposures of the policy. Only policies
issued by the Group in the previous policy term with the same policy
identification codes are included. Therefore, renewal price increases do
not include changes in premiums for newly issued policies and business
assumed through reinsurance agreements. Renewal price increases also do
not reflect the cost of any reinsurance purchased on the policies issued.
2 When used in this Quarterly Report on Form 10-Q, policy retention ratio
is calculated by dividing policies in force as of June 30 of the current
year that were also in force as of June 30 of the prior year by policies in
force as of June 30 of the prior year.
16
For Commercial Lines, the decline in gross and net premiums written for
both the three and six month periods ended June 30, 2007, is the result of
a decline in average renewal prices , the decrease in new business premium
production, and a reduction in assumed premiums from mandatory workers'
compensation and commercial auto policies. The decline in average renewal
prices is a result of a broad market trend of increased price competition.
Net premiums written were further reduced $3.4 during the second quarter of
2007 related to the increase in ceded premium on experience based
reinsurance contracts, as previously discussed.
For Specialty Lines gross and net premiums written declined for the three
and six month periods ended June 30, 2007, primarily the result of declines
in the commercial umbrella/other product line as both new business premium
production and in-force policy counts were lower than the same periods of
2006. This decline is primarily in the unsupported lead umbrella and
excess capacity product lines, resulting from our efforts to improve the
overall profitability of the commercial umbrella/other product line. These
declines were partially offset by a modest increase in average renewal
prices and by growth of 6.2% and 5.9% for the three month and six month
periods ended June 30, 2007, respectively, in the fidelity and surety bond
product line. Net premiums written were further reduced $1.6 during the
second quarter of 2007 related to an increase in ceded premium on
experience based reinsurance contracts.
For Personal Lines, the decline in gross and net premiums written for the
three and six month periods ended June 30, 2007, is the result of the
continued effect of premium rate reductions, a decline in new business
premium and in-force policy counts, partially offset by policy retention
rates that are up modestly. Net premiums written were further reduced by
$2.0 during the second quarter of 2007 related to an increase in ceded
premium on experience based reinsurance contracts. During the second half
of 2006 and continuing into the first half of 2007, an effort has been
underway to write new personal auto policies on a 12 month basis rather
than a six month basis. This transition effort only impacts new policies
and does not include the renewal of currently existing six month policies.
The following table provides key financial measures for All Lines:
Three Months Ended Six Months Ended
June 30, June 30,
2007 2006 2007 2006
---- ---- ---- ----
All Lines
Loss ratio 46.5% 56.1% 46.4% 54.4%
Loss adjustment expense ratio 10.6% 12.0% 10.8% 11.1%
Underwriting expense ratio 34.3% 31.1% 33.1% 31.5%
----- ----- ----- -----
Combined ratio 91.4% 99.2% 90.3% 97.0%
===== ===== ===== =====
The improvement in the All Lines combined ratio for the second quarter was
primarily the result of a significant increase in favorable prior year loss
and loss adjustment expense reserve development and a reduction in
catastrophe losses. These favorable impacts were partially offset by the
negative impact of an increase in loss costs and a decline in premium
rates. In addition, the underwriting expense ratio increased as a result
of increased incentive compensation and commissions costs related to our
improved profitability, as well as the impact on the ratio of lower earned
premiums. The above ratios, for both three and six month periods ended
June 30, 2007, were also negatively impacted by the $7.0 increase in ceded
premium on experienced based reinsurance contracts recorded during the
second quarter of 2007. The impact on the combined ratio of this increase
in ceded premium was 1.9 points and 0.9 points for the three and six month
periods, respectively.
All Lines Loss Ratio Analysis
We monitor incurred losses by operating segment, product line, risk
classification, geographic region and agency addressing loss ratio issues
or trends as part of our ongoing business operations. We also track
current accident year large losses (losses over $250,000, excluding
catastrophe losses) to monitor severity trends. The following table
provides a reconciliation of significant changes to the All Lines loss and
LAE ratio for the three and six month periods ended June 30, 2007 and 2006,
respectively.
17
Three Months Ended Six Months Ended
June 30, June 30,
2007 2006 Pt Chg 2007 2006 Pt Chg
---- ---- ------ ---- ---- ------
Ratios as a % of premiums earned
- --------------------------------
Current accident year large losses,
as defined 4.7% 4.8% (0.1) 4.2% 4.3% (0.1)
Catastrophe losses -
calendar year basis 2.0% 4.5% (2.5) 1.8% 2.8% (1.0)
Loss and LAE development
from prior accident years (12.2)% (3.0)% (9.2) (11.5)% (3.3)% (8.2)
All other losses and LAE 62.6% 61.8% 0.8 62.7% 61.7% 1.0
------ ----- ------ ------ ----- -----
Total loss and LAE ratio 57.1% 68.1% (11.0) 57.2% 65.5% (8.3)
====== ===== ====== ====== ===== =====
An effect of a continuing soft Commercial and Personal Lines market is the
upward pressure placed upon the loss and LAE ratio, as reflected in "All
other losses and LAE" in the table above, which is the result of loss cost
trends increasing while premium rates are declining slightly (both new and
renewal).
Large loss activity can be volatile from year to year as indicated by the
Group's experience over the last five years. The current accident year
large loss impact on the loss ratio in each of these years, evaluated at
June 30 for each of the respective years, is as follows:
2007 4.2%
2006 4.3%
2005 3.4%
2004 2.6%
2003 4.0%
The following table summarizes reserve development, net of reinsurance, by
operating segment:
Three Months Ended Six Months Ended
June 30, June 30,
(Favorable)/Unfavorable 2007 2006 2007 2006
Operating Segment ---- ---- ---- ----
- -----------------------
Commercial Lines $(29.6) $ (2.3) $(45.9) $ (1.8)
Specialty Lines (2.3) (1.4) (14.8) (11.2)
Personal Lines (9.5) (7.1) (18.4) (10.7)
------- ------- ------- -------
Total Prior Accident
Years' Development $(41.4) $(10.8) $(79.1) $(23.7)
======= ======= ======= =======
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
favorable development was primarily attributable to actual severity being
lower than expected, much of which is occurring in the casualty product
lines, a result of our more disciplined underwriting and improved claims
handling practices which commenced in the 2000/2001 timeframe. The table
below summarizes the impact of changes in provision for all prior accident
year losses and LAE:
Three Months Six Months
Ended June 30, Ended June 30,
2007 2006 2007 2006
---- ---- ---- ----
Net liabilities, beginning of period $2,912.2 $2,951.8 $2,912.3 $2,946.8
(Decrease) in provision for prior
accident year claims $(41.4) $(10.8) $(79.1) $(23.7)
(Decrease) in provision for prior
accident year claims as % of premiums
earned (12.2)% (3.0)% (11.5)% (3.3)%
18
Catastrophe losses for the second quarter 2007 were $6.9 compared to $16.1
in the second quarter 2006. For the six months ended June 30, 2007,
catastrophe losses were $12.1 compared to $19.7 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 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 pages 84 and 85 of the
Corporation's 2006 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,
2007 2006 2007 2006
---- ---- ---- ----
Catastrophe Loss Ratio
- ----------------------
Commercial Lines 1.9% 3.7% 1.5% 2.3%
Specialty Lines 0.0% -0.2% 0.0% -0.1%
Personal Lines 3.0% 7.6% 2.9% 4.5%
Total All Lines 2.0% 4.5% 1.8% 2.8%
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 2007 2006 2007 2006
- --------------------------------------------------------------------------
Loss ratio 43.6% 56.2% 45.9% 56.7%
Loss adjustment expense ratio 10.9% 13.8% 12.1% 12.7%
Underwriting expense ratio 35.5% 32.4% 34.2% 32.7%
----- ------ ----- ------
Combined ratio 90.0% 102.4% 92.2% 102.1%
===== ====== ===== ======
The Commercial Lines combined ratio improved for both the three and six
month periods ended June 30, 2007, primarily the result of favorable prior
year loss and loss adjustment expense reserve development which decreased
the ratio by 14.8 points and 11.3 points for the three and six month
periods of 2007, respectively, compared to a decrease of 1.1 points and 0.5
points for the three and six month periods of 2006. Also contributing to
the improvement in the loss and LAE ratio was the decrease in catastrophe
losses for both the three and six month periods ended June 30, 2007. The
increase in the underwriting expense ratio was driven by lower earned
premiums and increased commission and incentive compensation costs related
to our improved profitability, partially offset by a decrease in premium
taxes and assessments. The above ratios for each period in 2007 were also
negatively impacted by the Commercial Lines portion ($3.4) of the increase
in ceded premium discussed earlier. This had a 1.5 point and 0.7 point
impact on the combined ratio for the three month and six month periods,
respectively.
Commercial Lines Loss Ratio Analysis
We monitor incurred losses by product line, risk classification, geographic
region and agency addressing loss ratio issues or trends as part of our
ongoing business operations. We also track current accident year large
losses, as defined, to monitor severity trends.
19
The following table provides a reconciliation of significant changes to the
Commercial Lines loss and LAE ratio for the three and six month periods
ended June 30, 2007 and 2006, respectively.
Three Months Ended Six Months Ended
June 30, June 30,
2007 2006 Pt Chg 2007 2006 Pt Chg
---- ---- ------ ---- ---- ------
Ratios as a % of premiums earned
- --------------------------------
Current accident year large losses,
as defined 5.8% 5.4% 0.4 5.0% 5.3% (0.3)
Catastrophe losses -
calendar year basis 1.9% 3.7% (1.8) 1.5% 2.3% (0.8)
Loss and LAE development
from prior accident years (14.8)% (1.1)% (13.7) (11.3)% (0.5)% (10.8)
All other losses and LAE 61.6% 62.0% (0.4) 62.8% 62.3% 0.5
------ ----- ------ ------ ----- ------
Total loss and LAE ratio 54.5% 70.0% (15.5) 58.0% 69.4% (11.4)
====== ===== ====== ====== ===== ======
As indicated in the All Lines section, current accident year large loss
activity can be volatile from year to year. The current accident year
large loss impact on the Commercial Lines loss ratio, evaluated at June 30
for each of the respective years, has been as follows:
2007 5.0%
2006 5.3%
2005 4.1%
2004 3.4%
2003 5.6%
The 2007 favorable reserve development described above was primarily
concentrated in the commercial multi peril (CMP), general liability and
commercial auto product lines partially offset by adverse development in
the workers' compensation product line. In 2006, the favorable development
was primarily concentrated in the commercial auto, general liability and
commercial property product lines partially offset by adverse development
in the CMP product line.
Specialty Lines Segment
Three Months Ended Six Months Ended
June 30, June 30,
Specialty Lines Segment 2007 2006 2007 2006
- --------------------------------------------------------------------------
Loss ratio 43.1% 49.3% 30.5% 40.2%
Loss adjustment expense ratio 8.5% 12.4% 6.8% 8.6%
Underwriting expense ratio 43.9% 40.3% 41.7% 39.5%
----- ------ ----- -----
Combined ratio 95.5% 102.0% 79.0% 88.3%
===== ====== ===== =====
The Specialty Lines combined ratio improved for the three and six month
periods ended June 30, 2007 driven primarily by an increase in favorable
prior year loss and loss adjustment expense reserve development (6.6 points
and 20.9 points for the three and six month periods ended June 30, 2007,
respectively, and 3.9 and 15.3 points for the respective periods of 2006).
The favorable prior year reserve development was primarily in the
commercial umbrella product line related to lower than expected severity
trends. The underwriting expense ratio increased due primarily to lower
earned premium and an increase in commission and incentive compensation
costs, partially offset by lower premium taxes and assessments. The above
ratios for each period in 2007 were also adversely impacted by the
Specialty Lines portion ($1.6) of the increase in ceded premium discussed
earlier. This had a 4.1 point and 1.9 point impact on the combined ratio
for the three month and six month periods, respectively.
Personal Lines Segment
Three Months Ended Six Months Ended
June 30, June 30,
Personal Lines Segment 2007 2006 2007 2006
- --------------------------------------------------------------------------
<C
Loss ratio 53.1% 57.9% 52.6% 54.9%
Loss adjustment expense ratio 10.8% 8.7% 9.7% 9.2%
Underwriting expense ratio 28.9% 25.9% 28.0% 26.8%
----- ----- ----- -----
Combined ratio 92.8% 92.5% 90.3% 90.9%
===== ===== ===== =====
20
The Personal Lines combined ratio increased modestly for the three month
period ended June 30, 2007 driven by an increase in the underwriting
expense ratio partially offset by an improving loss and LAE ratio. The
improvement in the loss and LAE ratio was due primarily to an increase in
favorable prior year reserve development and a significant decline in
catastrophe losses partially offset by an increase in large losses and
margin compression driven by increasing loss cost trends and declining
premium rates, as indicated in the All other losses and LAE line in the
table below. The Personal Lines combined ratio improved for the six month
period ended June 30, 2007, the result of 1.8 point improvement in the loss
and LAE ratio for the same reasons noted above partially offset by an
increase in the underwriting expense ratio. The underwriting expense ratio
increased for the three and six month periods of 2007 primarily due to a
decline in earned premium and increases in incentive compensation costs
partially offset by a reduction in premium taxes, assessments and
commissions. The above ratios for each period in 2007 were also adversely
impacted by the Personal Lines portion ($2.0) of the increase in ceded
premium discussed earlier. This had a 1.7 point and 0.8 point impact on
the combined ratio for the three month and six month periods, respectively.
The following table provides a reconciliation of significant changes to the
Personal Lines loss and LAE ratio for the three and six month periods ended
June 30, 2007 and 2006, respectively.
Three Months Ended Six Months Ended
June 30, June 30,
2007 2006 Pt Chg 2007 2006 Pt Chg
---- ---- ------ ---- ---- ------
Ratios as a % of premiums earned
- --------------------------------
Current accident year large losses,
as defined 4.4% 2.1% 2.3 3.6% 2.5% 1.0
Catastrophe losses -
calendar year basis 3.0% 7.6% (4.6) 2.9% 4.5% (1.6)
Loss and LAE development
from prior accident years (9.0)% (6.3)% (2.7) (8.7)% (4.7)% (3.9)
All other losses and LAE 65.5% 63.2% 2.3 64.5% 61.8% 2.7
----- ----- ----- ----- ----- -----
Total loss and LAE ratio 63.9% 66.6% (2.7) 62.3% 64.1% (1.8)
===== ===== ===== ===== ===== =====
As indicated in the All Lines section, current accident year large loss
activity can be volatile from year to year. The current accident year
large loss impact on the Personal Lines loss ratio, evaluated at June 30
for each of the respective years, has been as follows:
2007 3.6%
2006 2.5%
2005 3.0%
2004 1.5%
2003 2.3%
The table below presents the calendar year and accident year combined
ratios calculated on a statutory basis. The loss and LAE ratio components
of the accident year combined ratio measure losses and LAE arising from
insured events that occurred in the respective accident year. The current
accident year excludes losses and LAE for insured events that occurred in
prior accident years.
Earned Premium and Statutory Combined Ratios
Combined Ratios
Earned ------------------------------------------------
Premium Calendar Year Accident Year
Year to Date Year to Date Year to Date Calendar Accident
June 30, June 30, June 30, Year Year
(By operating segment) 2007 2007 2007(a) 2006 2006(a)
- --------------------------------------------------------------------------------------
Commercial Lines $405.8 92.2% 103.6% 98.7% 97.6%
Specialty Lines 71.0 81.5% 102.3% 78.2% 98.6%
Personal Lines 212.1 91.7% 100.4% 92.4% 93.8%
- --------------------------------------------------------------------------------------
Total All Lines $688.9 91.0% 102.5% 94.5% 96.5%
======================================================================================
(a) The measurement date for accident year data is June 30, 2007.
Partial and complete accident periods may not be comparable due to
seasonality, claim reporting and development patterns, claim settlement
rates and other factors.
21
Investment Results
For both the three months ended June 30, 2007 and 2006, consolidated pre-
tax investment income was $51.9. For the six months ended June 30, 2007
and 2006, consolidated pre-tax investment income was $103.6 and $102.8,
respectively. For the three and six months ended June 30, 2007, net
realized gains were $6.6 and $14.6 versus $5.3 and $19.5 for the comparable
period in 2006. The Consolidated Corporation realized $9.2 and $18.2 in
gross gains and $2.7 and $3.7 in gross losses for the three and six month
periods ended June 30, 2007, respectively. During the three and six month
periods ending June 30, 2006, the Consolidated Corporation realized $14.4
and $35.1 in gross gains and $9.1 and $15.6 in gross losses, respectively.
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 45 of the Corporation's 2006 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 then 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.
The following table summarizes, for all available-for-sale and held-to-
maturity securities, the total gross unrealized losses, excluding gross
unrealized gains, by investment category and length of time the securities
have continuously been in an unrealized loss position as of June 30, 2007.
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 $ - $ - $ 16.1 $(0.4) $ 16.1 $ (0.4)
States, municipalities and
political subdivisions 1,050.9 (13.5) 45.9 (1.1) 1,096.8 (14.6)
Corporate securities 314.3 (6.2) 140.5 (4.7) 454.8 (10.9)
Mortgage and asset-backed
securities 322.2 (2.8) 151.1 (2.4) 473.3 (5.2)
- -----------------------------------------------------------------------------------------------
Subtotal 1,687.4 (22.5) 353.6 (8.6) 2,041.0 (31.1)
Equity securities 56.8 (2.3) 11.4 (0.6) 68.2 (2.9)
- -----------------------------------------------------------------------------------------------
Total $1,744.2 $(24.8) $365.0 $(9.2) $2,109.2 $(34.0)
===============================================================================================
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 $5.2 $(0.1) $107.1 $(4.9) $112.3 $(5.0)
Mortgage-backed
securities - - 64.9 (2.5) 64.9 (2.5)
- -----------------------------------------------------------------------------------------------
Total $5.2 $(0.1) $172.0 $(7.4) $177.2 $(7.5)
===============================================================================================
22
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 $41.5 aggregate unrealized loss on
the investment portfolio at June 30, 2007, 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, 2007. In the tables above, there are approximately 661
securities represented. Of this total, 40 securities have unrealized loss
positions greater than 5% of their book values at June 30, 2007, with two
exceeding 20%. This group represents $9.1, or 21.9% of the total
unrealized loss position. Of this group, 20 securities, representing
approximately $4.7 in unrealized losses, have been in an unrealized loss
position for less than twelve months. The remaining 20 securities have
been in an unrealized loss position for longer than twelve months and total
$4.4 in unrealized losses. Management believes that it is probable that
all contract terms of the security will be satisfied. The unrealized loss
position is primarily due to increases in interest rates. As previously
stated above, management has the 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, 2007, 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 $ 27.1 $ 27.0 $ (0.1)
Due after one year through five years 165.4 163.6 (1.8)
Due after five years through ten years 810.8 798.6 (12.2)
Due after ten years 590.3 578.5 (11.8)
Mortgage and asset-backed securities 478.5 473.3 (5.2)
- ----------------------------------------------------------------------------
Total $2,072.1 $2,041.0 $(31.1)
============================================================================
Held-to-maturity: Amortized Estimated Unrealized
Cost Fair Value Loss
- ----------------------------------------------------------------------------
Due in one year or less $ 2.1 $ 2.1 $ -
Due after one year through five years 42.3 40.9 (1.4)
Due after five years through ten years 66.4 63.1 (3.3)
Due after ten years 6.5 6.2 (0.3)
Mortgage-backed securities 67.4 64.9 (2.5)
- ----------------------------------------------------------------------------
Total $184.7 $177.2 $(7.5)
============================================================================
For additional discussion relative to the Consolidated Corporation's
investment portfolio, see the "Investment Portfolio" section under
"Liquidity and Capital Resources" on the following two pages of this MD&A.
23
LIQUIDITY AND CAPITAL RESOURCES
Investment Portfolio
The following table sets forth the distribution and other data related to
investments at June 30, 2007 and December 31, 2006, respectively.
June 30, 2007 December 31, 2006
------------- -----------------
Average Amortized Carrying % of Amortized Carrying % of
Rating Cost Value Total Cost Value Total
--------------------------------------------------------------------
U.S. Government:
Available-for-sale AAA $ 25.0 $ 24.7 0.6 $ 25.2 $ 25.1 0.6
States,
municipalities, and
political
subdivisions:
Investment grade:
Available-for-sale AA+ 1,454.4 1,442.7 33.9 1,388.0 1,408.2 33.1
Corporate securities:
Investment grade:
Available-for-sale A 1,357.7 1,377.7 32.4 1,407.1 1,445.8 34.0
Held-to-maturity A+ 144.6 144.6 3.4 147.7 147.7 3.5
Below Investment grade:
Available-for-sale BB 64.7 66.7 1.6 75.6 77.9 1.8
----------------------------------------------------------
Total corporate
securities 1,567.0 1,589.0 37.4 1,630.4 1,671.4 39.3
----------------------------------------------------------
Mortgage and asset-backed
securities:
Investment grade:
Available-for-sale AAA 592.5 588.5 13.8 555.1 555.3 13.0
Held-to-maturity AAA 82.1 82.1 1.9 88.1 88.1 2.1
----------------------------------------------------------
Total mortgage and
asset-backed
securities 674.6 670.6 15.7 643.2 643.4 15.1
----------------------------------------------------------
Total fixed income
securities AA- 3,721.0 3,727.0 87.6 3,686.8 3,748.1 88.1
Equity securities 256.8 486.6 11.5 232.1 458.5 10.8
Cash and cash equivalents 39.0 39.0 0.9 45.6 45.6 1.1
----------------------------------------------------------
Total investment
portfolio, cash and
cash equivalents $4,016.8 $4,252.6 100.0 $3,964.5 $4,252.2 100.0
==========================================================
* Included in the available-for-sale category of the mortgage and asset-
backed securities allocation at June 30, 2007 are mortgage-backed
securities with a cost of $420.9 and carrying value of $417.9. Included in
the available-for-sale category of the mortgage and asset-backed securities
allocation at December 31, 2006 are mortgage-backed securities with a cost
of $397.3 and carrying value of $397.9. The remaining balance within this
category for both 2007 and 2006 are asset-backed securities. All of the
securities at both June 30, 2007 and December 31, 2006 within the held-to-
maturity category of this security allocation are mortgage-backed
securities.
** Included in equity securities as of June 30, 2007 are common stock with
a cost of $155.5 and carrying value of $384.4 and preferred stock with a
cost of $101.3 and carrying value of $102.2. Included in equity securities
as of December 31, 2006 are common stock with a cost of $135.8 and carrying
value of $360.4 and preferred stock with a cost of $96.3 and carrying value
of $98.1.
The fixed income portfolio is allocated between available-for-sale and held-
to-maturity as follows:
June 30, 2007 December 31, 2006
------------- -----------------
Amortized Carrying % of Amortized Carrying % of
Cost Value Fixed Cost Value Fixed
---------------------------------------------------------
Total available-for-sale
fixed income securities $3,494.3 $3,500.3 93.9 $3,451.0 $3,512.3 93.7
Total held-to-maturity
fixed income securities 226.7 226.7 6.1 235.8 235.8 6.3
The fixed income portfolio is allocated between investment grade and below
investment grade securities as follows:
June 30, 2007 December 31, 2006
------------- -----------------
Amortized Carrying % of Amortized Carrying % of
Cost Value Fixed Cost Value Fixed
---------------------------------------------------------
Total investment $3,656.3 $3,660.3 98.2 $3,611.2 $3,670.2 98.0
Total below investment
grade 64.7 66.7 1.8 75.6 77.9 2.0
24
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.
A primary return objective of the fixed income portfolio is to maximize
after tax investment income within approved risk criteria inclusive of
quality, duration, diversification and liquidity requirements within the
overall portfolio. The duration of the fixed income portfolio, which for
this purpose includes short-term securities, was approximately 4.9 years at
June 30, 2007 compared with 4.8 years at December 31, 2006. To mitigate
interest rate risk to the fixed income portfolio, maturities are laddered
across the yield curve. Additionally, the Consolidated Corporation remains
fully invested and does not attempt to time the markets.
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, 2007, the equity portfolio consisted of stocks in a total of 93
separate entities covering all ten major S&P industry sectors. Of this
total, 17.6% was invested in five companies and the largest single position
was 5.2% of the equity portfolio. At December 31, 2006, the equity
portfolio consisted of stocks in 83 separate entities in ten major S&P
industry sectors. Of this total, 19.0% were invested in five companies and
the largest single position was 4.9% of the equity portfolio.
In addition to fixed income and equity securities which have a readily
available market value, the investment portfolio also includes securities
that do not have a readily available market value such as private
placements, non-exchange traded equities and limited partnerships which are
carried at fair value. Fair values for these types of securities 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, 2007 was $242.0 compared to $229.3 at
December 31, 2006.
The excess of carrying value over cost of the available-for-sale investment
portfolio was $235.8 at June 30, 2007 compared with $287.7 at December 31,
2006. The decrease in unrealized gains in the second quarter 2007 is
primarily the result of the sale of certain highly appreciated equity
securities, and increases in the interest rate yield curve which adversely
impacted the fair value of fixed income securities held in the portfolio.
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 $2.9
billion at June 30, 2007 and December 31, 2006, respectively. As of June
30, 2007, the loss reserves by operating segment were as follows: $1,906.9
Commercial Lines, $629.5 Specialty Lines and $369.3 Personal Lines. The
Group purchases reinsurance to mitigate the impact of large losses and
catastrophic events. Loss reserves ceded to reinsurers amounted to $581.2
and $585.7 at June 30, 2007 and December 31, 2006, 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,
2006 and records its best estimate each quarter based on that review. In
the opinion of management, the reserves recorded at June 30, 2007 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.
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
25
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, 2006, 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, 2007 and December 31, 2006:
June 30, 2007
- -------------
Gross Total Total
Operating Segment Case IBNR LAE Total Ceded Net
- --------------------------------------------------------------------------------------
Commercial Lines $ 741.5 $ 795.5 $369.9 $1,906.9 $196.1 $1,710.8
Workers' compensation 420.9 370.3 73.1 864.3 163.8 700.5
Commercial auto 110.5 109.7 42.7 262.9 10.5 252.4
General liability 62.0 118.2 97.7 277.9 4.8 273.1
CMP, fire & inland marine 148.1 197.3 156.4 501.8 17.0 484.8
Specialty Lines 114.4 425.9 89.2 629.5 312.2 317.3
Commercial umbrella/other 105.6 425.4 83.7 614.7 308.9 305.8
Fidelity & surety 8.8 0.5 5.5 14.8 3.3 11.5
Personal Lines 189.5 118.5 61.3 369.3 72.9 296.4
Personal auto & umbrella 161.2 82.5 45.4 289.1 72.8 216.3
Personal property 28.3 36.0 15.9 80.2 0.1 80.1
Total All Lines $1,045.4 $1,339.9 $520.4 $2,905.7 $581.2 $2,324.5
- ---------------------------------------------------------------------------------------
26
December 31, 2006
- -----------------
Gross Total Total
Operating Segment Case IBNR LAE Total Ceded Net
- --------------------------------------------------------------------------------------
Commercial Lines $ 743.9 $ 784.6 $369.2 $1,897.7 $185.3 $1,712.4
Workers' compensation 413.7 352.1 70.8 836.6 149.3 687.3
Commercial auto 112.4 105.2 43.8 261.4 7.2 254.2
General liability 64.2 124.6 96.1 284.9 6.0 278.9
CMP, fire & inland marine 153.6 202.7 158.5 514.8 22.8 492.0
Specialty Lines 122.3 429.3 90.3 641.9 334.7 307.2
Commercial umbrella/other 112.3 428.6 84.8 625.7 330.2 295.5
Fidelity & surety 10.0 0.7 5.5 16.2 4.5 11.7
Personal Lines 191.0 119.3 62.4 372.7 65.7 307.0
Personal auto & umbrella 162.5 83.5 45.9 291.9 65.5 226.4
Personal property 28.5 35.8 16.5 80.8 0.2 80.6
Total All Lines $1,057.2 $1,333.2 $521.9 $2,912.3 $585.7 $2,326.6
- ---------------------------------------------------------------------------------------
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. However, substantial variability exists on a net
of reinsurance basis. The estimate of reinsurance recoverables is
considered a critical accounting estimate and is discussed on pages 45 and
46 of the Annual Report on Form 10-K for the year ended December 31, 2006.
Loss reserve uncertainty is illustrated by the variability in reserve
development presented in the Analysis of Development of Loss and LAE
Liabilities schedule which appears on pages 11 and 12 under Item 1 of the
Annual Report on Form 10-K for the year ended December 31, 2006.
To illustrate the uncertainty by operating segment, the table presented in
the All Lines discussion of this MD&A on page 18 provides the before-tax
amount of prior accident years' loss reserve development by operating
segment on a net of reinsurance basis for the three month and six month
periods ended June 30, 2007 and 2006. 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, 2007,
the workers' compensation product line had adverse development of $13.9
while the CMP product line had favorable development of $31.6.
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
2007 2006 2007 2006 2006
-------------- -------------- ----
(Favorable)/Unfavorable
- -----------------------
Accident Year 2006 $(19.2) $ - $(24.4) $ - $ -
Accident Year 2005 (18.3) (1.7) (30.4) (4.5) (21.2)
Accident Year 2004 and Prior (3.9) (9.1) (24.3) (19.2) (31.0)
------- ------- ------- ------- -------
Total Prior Accident
Years' Development $(41.4) $(10.8) $(79.1) $(23.7) $(52.2)
======= ======= ======= ======= =======
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. Please
refer to the Corporation's Annual Report on Form 10-K for the year ended
December 31, 2006, for a broader discussion of reserve variability and
uncertainty.
27
Cash Flow
Net cash provided by operating activities increased to $78.6 for the first
six months of 2007 compared with $42.7 for the same period in 2006, driven
primarily by improved operating results. Net cash used in investing
activities was $55.3 compared with net cash provided of $8.3 during the
first half of 2006. Cash used in financing activities was $29.9 in the
first six months of 2007 compared with $66.8 in the first six months of
2006. A decrease in repurchases of the Corporation's common stock
partially offset by an increase in the shareholder dividend were the
primary reasons for the decrease in cash used in financing activities
during 2007. Liquidity needs of the Group are expected to be met by net
cash generated from operations, maturities of investments, interest and
dividend receipts and current cash balances. For additional information
regarding Liquidity of the Corporation, please see below.
Debt
For a discussion regarding Debt of the Corporation, please refer to Note
VII in the Notes to the Consolidated Financial Statements on pages 12 and
13 of this Quarterly Report on Form 10-Q.
At June 30 2007, the Corporation had cash and marketable securities,
totaling $392.5, which compared to $326.6 at December 31, 2006. 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 2007, dividend payments from the Company to
the Corporation are limited to approximately $206.0 without prior approval
from the Ohio Department of Insurance. During the first six months of
2007, the Company paid dividends of $95.0 to the Corporation resulting in a
dividend payment limitation of $111.0 for the remainder of 2007.
Book Value Per Share
At June 30, 2007, the book value per share of the Consolidated Corporation
increased $1.21 per share from $25.79 per share to $27.00 per share when
compared to book value at December 31, 2006. This increase is principally
the result of improved profitability offset by declines in unrealized gains
on securities and the affects of the share repurchase and dividend
programs. At June 30, 2007 and December 31, 2006 there were 60,030,818 and
60,322,692 actual shares outstanding, respectively. Below is a table
reconciling the changes in book value per share from December 31, 2006 to
June 30, 2007.
December 31, 2006 $25.79
Activity year-to-date June 2007:
Net income 1.98
Change in unrealized gains (0.57)
Impact of share repurchase program (0.03)
Dividend to shareholders (0.26)
Other 0.09
-------
June 30, 2007 $27.00
=======
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. Following are the
Consolidated Corporation's current ratings and rating outlooks.
A.M. Best Fitch Moody's S&P
--------- ----- ------- ---
Financial strength rating (Group) A A A3 A-
Senior unsecured debt rating
(Corporation) bbb BBB Baa3 BBB-
Rating outlook/watch Stable Rating Review for Credit
watch possible watch
negative upgrade positive
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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 2006 Annual Report on Form 10-K for the
year ended December 31, 2006.
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; changes in government regulation; performance of financial
markets; fluctuations in interest rates; availability and pricing of
reinsurance; litigation and administrative proceedings; rating agency
actions; acts of war and terrorist activities; ability to appoint and
retain agents; ability to achieve premium targets and profitability goals;
failure to consummate the announced merger; 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 2006 Annual Report on Form 10-K.
ITEM 4. Controls and Procedures
(a) The Corporation's Chief Executive Officer and Chief Financial Officer
evaluated the disclosure controls and procedures (as defined under
Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934,
as amended) as of the end of the period covered by this report. Based
upon that evaluation, the Chief Executive Officer and Chief Financial
Officer have concluded that the Corporation's disclosure controls and
procedures are effective.
(b) There were no significant changes in the Corporation's internal
control over financial reporting identified in connection with the
foregoing evaluation that occurred during the Corporation's last fiscal
quarter that have affected, or are reasonably likely to materially
affect, the Corporation's internal control over financial reporting.
PART II Other Information
ITEM 1. Legal Proceedings
Reference is made to the fourth paragraph of Part I, Item 3 Legal
Proceedings to the Corporation's Form 10-K for the fiscal year ended
December 31, 2006 regarding the matter captioned Georgia Hensley, et al. v.
Computer Sciences Corporation, et al. The Hensley proceeding (involving
approximately 400 different entities) has been dismissed without prejudice
as to the Corporation. A separate class action complaint entitled Dusty
Easley, et al. v. The Ohio Casualty Insurance Company, American Fire and
Casualty Company, Avomark Insurance Company, Ohio Casualty Corporation,
Ohio Security Insurance Company, and West American Insurance Company was
filed in the Circuit Court of Miller County, Arkansas in March, 2007. The
Easley proceeding alleges substantially the same counts alleged in the
Hensley proceeding and includes the same putative class. Plaintiffs and
Defendants in the Easley proceeding have filed a Stipulation of Settlement
and Motion for Preliminary Approval seeking approval of a settlement of the
case. If the proposed settlement is approved in the Easley matter then
plaintiffs in the Hensley proceeding will also seek to amend the dismissal
of the Corporation with prejudice. The settlement, if approved and after
giving effect to 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.
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Reference is made to the second paragraph of Part I, Item 3 Legal
Proceedings to the Corporation's Form 10-K for the fiscal year ended
December 31, 2006 regarding the matter captioned Carol Lazarus v. West
American Insurance Company. The Court of Common Pleas Cuyahoga County,
Ohio granted preliminary approval to a settlement agreement between Carol
Lazarus, individually and on behalf of a class, with West American, its
parent and affiliates, on May 31, 2007. A final settlement hearing is
scheduled for November 19, 2007.
ITEM 4. Submission of Matters to a Vote of Security Holders
At the Annual Meeting of Shareholders (the Annual Meeting) held on May 16,
2007, shareholders voted on the re-election of three members of the Board
of Directors for terms expiring in 2010 as follows.
Terrence J. Baehr For 54,118,917; Withheld 594,339
Stanley N. Pontius For 53,371,750; Withheld 1,341,206
Ronald W. Tysoe For 54,080,603; Withheld 632,352
Other directors whose term of office continued after the meeting were:
Jack E. Brown, Dan R. Carmichael, Catherine E. Dolan, Philip G. Heasley,
Robert A. Oakley, Jan H. Suwinski, and Michael A. Wright.
The adoption of The Ohio Casualty Insurance Company Annual Incentive Plan
for Executive Officers was approved with a final vote of:
For 50,745,073; Against 3,142,045; Abstain 825,837
Also, at the Annual Meeting, shareholders ratified the appointment of Ernst
& Young, LLP as independent public accountants for the fiscal year 2007.
The proposal was approved with a final vote of:
For 54,343,649; Against 328,428; Abstain 40,877
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.
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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 30, 2007 /s/Michael A. Winner
-------------------------------------------
Michael A. Winner, Executive Vice President
and Chief Financial Officer
31