10-Q 1 f10q6-07.txt OHIO CASUALTY CORP FORM 10-Q JUNE 30, 2007 ============================================================================== 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 ============================================================================== 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 -------------------------------------------------------------------------- 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
28 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. 29 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. 30 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