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SELECTIVE INSURANCE GROUP INC - Quarter Report: 2012 June (Form 10-Q)

Table of Contents

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
 
FORM 10-Q
(Mark One)
 
ý QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the quarterly period ended: June 30, 2012
or
 
¨ 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: 001-33067
 
SELECTIVE INSURANCE GROUP, INC.
(Exact Name of Registrant as Specified in Its Charter)
 
New Jersey
 
22-2168890
(State or Other Jurisdiction of Incorporation or Organization)
 
(I.R.S. Employer Identification No.)
 
 
 
40 Wantage Avenue
 
 
Branchville, New Jersey
 
07890
(Address of Principal Executive Offices)
 
(Zip Code)
 
(973) 948-3000
(Registrant’s Telephone Number, Including Area Code)
 
(Former Name, Former Address and Former Fiscal Year, if Changed Since Last Report)
 
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.
Yesx           No ¨
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
Yesx           No ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer x
 
Accelerated filer ¨
Non-accelerated filer ¨
 
Smaller reporting company ¨
(Do not check if a smaller reporting company)
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes ¨          No x 
As of June 30, 2012, there were 54,950,993 shares of common stock, par value $2.00 per share, outstanding. 


Table of Contents

 
SELECTIVE INSURANCE GROUP, INC.
 
 
Table of Contents
 
 
 
Page No.
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
58
 


Table of Contents

PART I. FINANCIAL INFORMATION
 
ITEM 1. FINANCIAL STATEMENTS
 
SELECTIVE INSURANCE GROUP, INC.
CONSOLIDATED BALANCE SHEETS
 
Unaudited
 
 
($ in thousands, except share amounts)
 
June 30,
2012
 
December 31,
2011
ASSETS
 
 

 
 

Investments:
 
 

 
 

Fixed maturity securities, held-to-maturity – at carrying value (fair value:  $687,981 – 2012; $758,043 – 2011)
 
$
643,501

 
712,348

Fixed maturity securities, available-for-sale – at fair value (amortized cost: $2,974,819 – 2012; $2,766,856 – 2011)
 
3,123,006

 
2,897,373

Equity securities, available-for-sale – at fair value (cost:  $130,257 – 2012; $143,826 – 2011)
 
148,117

 
157,355

Short-term investments (at cost which approximates fair value)
 
135,823

 
217,044

Other investments
 
125,540

 
128,301

Total investments
 
4,175,987

 
4,112,421

Cash
 
141

 
762

Interest and dividends due or accrued
 
36,110

 
35,842

Premiums receivable, net of allowance for uncollectible accounts of:  $3,470 – 2012; $3,768 – 2011
 
523,588

 
466,294

Reinsurance recoverables, net
 
441,492

 
561,855

Prepaid reinsurance premiums
 
136,808

 
147,686

Current federal income tax
 
1,230

 
731

Deferred federal income tax
 
113,925

 
120,094

Property and equipment – at cost, net of accumulated depreciation and amortization of:
$164,835 – 2012; $160,294 – 2011
 
45,689

 
43,947

Deferred policy acquisition costs
 
152,399

 
135,761

Goodwill
 
7,849

 
7,849

Other assets
 
52,190

 
52,227

Total assets
 
$
5,687,408

 
5,685,469

 
 
 
 
 
LIABILITIES AND STOCKHOLDERS’ EQUITY
 
 

 
 

Liabilities:
 
 

 
 

Reserve for losses and loss expenses
 
$
3,044,363

 
3,144,924

Unearned premiums
 
970,806

 
906,991

Notes payable
 
307,373

 
307,360

Accrued salaries and benefits
 
113,598

 
119,297

Other liabilities
 
166,222

 
148,569

Total liabilities
 
$
4,602,362

 
4,627,141

 
 
 
 
 
Stockholders’ Equity:
 
 

 
 

Preferred stock of $0 par value per share:
Authorized shares 5,000,000; no shares issued or outstanding
 
$

 

Common stock of $2 par value per share Authorized shares 360,000,000 Issued: 97,960,814 – 2012; 97,246,711 – 2011
 
195,921

 
194,494

Additional paid-in capital
 
265,729

 
257,370

Retained earnings
 
1,120,143

 
1,116,319

Accumulated other comprehensive income
 
58,504

 
42,294

Treasury stock – at cost
(shares:  43,009,821 – 2012; 42,836,201 – 2011)
 
(555,251
)
 
(552,149
)
Total stockholders’ equity
 
1,085,046

 
1,058,328

Commitments and contingencies
 


 


Total liabilities and stockholders’ equity
 
$
5,687,408

 
5,685,469


The accompanying notes are an integral part of these unaudited interim consolidated financial statements.

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Table of Contents

SELECTIVE INSURANCE GROUP, INC.
UNAUDITED CONSOLIDATED STATEMENTS OF INCOME
 
Quarter ended June 30,
 
Six Months ended
June 30,
($ in thousands, except per share amounts)
 
2012
 
2011
 
2012
 
2011
Revenues:
 
 

 
 

 
 

 
 

Net premiums earned
 
$
392,212

 
355,580

 
$
771,041

 
706,923

Net investment income earned
 
34,006

 
39,345

 
66,634

 
82,818

Net realized gains (losses):
 
 

 
 

 


 
 

Net realized investment gains
 
272

 
2,315

 
5,051

 
8,705

Other-than-temporary impairments
 
(40
)
 
163

 
(297
)
 
(369
)
Other-than-temporary impairments on fixed maturity securities recognized in other comprehensive income
 
(54
)
 
(332
)
 
(218
)
 
(430
)
Total net realized gains (losses)
 
178

 
2,146

 
4,536

 
7,906

Other income
 
2,511

 
2,499

 
6,044

 
5,379

Total revenues
 
428,907

 
399,570

 
848,255

 
803,026

 
 
 
 
 
 
 
 
 
Expenses:
 
 

 
 

 
 

 
 

Losses and loss expenses incurred
 
287,903

 
274,555

 
540,809

 
523,761

Policy acquisition costs
 
131,219

 
115,163

 
259,177

 
230,207

Interest expense
 
4,723

 
4,559

 
9,423

 
9,116

Other expenses
 
5,754

 
5,392

 
16,347

 
13,883

Total expenses
 
429,599

 
399,669

 
825,756

 
776,967

(Loss) income before federal income tax
 
(692
)
 
(99
)
 
22,499

 
26,059

Federal income tax expense (benefit):
 
 

 
 

 
 

 
 

Current
 
(500
)
 
3,111

 
6,678

 
7,387

Deferred
 
(480
)
 
(4,677
)
 
(2,560
)
 
(3,295
)
Total federal income tax expense (benefit)
 
(980
)
 
(1,566
)
 
4,118

 
4,092

Net income
 
$
288

 
1,467

 
$
18,381

 
21,967

 
 
 
 
 
 
 
 
 
Earnings per share:
 
 

 
 

 
 

 
 

Basic net income
 
$
0.01

 
0.03

 
$
0.34

 
0.41

Diluted net income
 
$
0.01

 
0.03

 
$
0.33

 
0.40

Dividends to stockholders
 
$
0.13

 
0.13

 
$
0.26

 
0.26

 
The accompanying notes are an integral part of these unaudited interim consolidated financial statements. 
 


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Table of Contents

SELECTIVE INSURANCE GROUP, INC.
UNAUDITED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
 
 
 
 
 
 
Quarter ended June 30,
 
Six Months ended
June 30,
($ in thousands)
 
2012
 
2011
 
2012
 
2011
Net income
 
$
288

 
1,467

 
$
18,381

 
21,967

 
 
 
 
 
 
 
 
 
Other comprehensive income, net of tax:
 
 

 
 

 
 
 
 
Unrealized gains on investment securities:
 
 

 
 

 
 
 
 
Unrealized holding gains arising during period
 
5,101

 
19,563

 
17,974

 
18,957

Non-credit portion of other-than-temporary impairments
recognized in other comprehensive income
 
75

 
272

 
313

 
389

Amortization of net unrealized gains on held-to-maturity securities
 
(443
)
 
(817
)
 
(959
)
 
(1,581
)
Less: reclassification adjustment for gains included in net income
 
(142
)
 
(1,393
)
 
(2,975
)
 
(5,130
)
Total unrealized gains on investment securities
 
4,591

 
17,625

 
14,353

 
12,635

 
 
 
 
 
 
 
 
 
Defined benefit pension plans:
 
 

 
 

 
 
 
 
Amortization of net actuarial loss included in net income
 
905

 
718

 
1,808

 
1,436

Amortization of prior service cost included in net income
 
24

 
25

 
49

 
49

Total defined benefit pension plans
 
929

 
743

 
1,857

 
1,485

Other comprehensive income
 
5,520

 
18,368

 
16,210

 
14,120

Comprehensive income
 
$
5,808

 
19,835

 
$
34,591

 
36,087

 
The accompanying notes are an integral part of these unaudited interim consolidated financial statements.
 


3

Table of Contents

SELECTIVE INSURANCE GROUP, INC.
UNAUDITED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
 
 
 
 
Six Months ended June 30,
($ in thousands)
 
2012
 
2011
Common stock:
 
 

 
 

Beginning of year
 
$
194,494

 
192,725

Dividend reinvestment plan (shares:  46,603 – 2012; 47,488 – 2011)
 
93

 
95

Stock purchase and compensation plans (shares:  667,500 – 2012; 577,745 – 2011)
 
1,334

 
1,156

End of period
 
195,921

 
193,976

 
 
 
 
 
Additional paid-in capital:
 
 

 
 

Beginning of year
 
257,370

 
244,613

Dividend reinvestment plan
 
712

 
716

Stock purchase and compensation plans
 
7,647

 
6,860

End of period
 
265,729

 
252,189

 
 
 
 
 
Retained earnings:
 
 

 
 

Beginning of year, as previously reported
 
1,116,319

 
1,176,155

Add: Adjustment for the cumulative effect on prior years of applying retroactively the new method of accounting for deferred policy acquisition costs (Note 4)
 

 
(53,068
)
Balance at beginning of year, as adjusted
 
1,116,319

 
1,123,087

Net income
 
18,381

 
21,967

Dividends to stockholders ($0.26 per share – 2012 and 2011)
 
(14,557
)
 
(14,370
)
End of period
 
1,120,143

 
1,130,684

 
 
 
 
 
Accumulated other comprehensive income:
 
 

 
 

Beginning of year
 
42,294

 
7,024

Other comprehensive income
 
16,210

 
14,120

End of period
 
58,504

 
21,144

 
 
 
 
 
Treasury stock:
 
 

 
 

Beginning of year
 
(552,149
)
 
(549,408
)
Acquisition of treasury stock (shares:  173,620 – 2012; 136,904 – 2011)
 
(3,102
)
 
(2,526
)
End of period
 
(555,251
)
 
(551,934
)
Total stockholders’ equity
 
$
1,085,046

 
1,046,059

 
Selective Insurance Group, Inc. also has authorized, but not issued, 5,000,000 shares of preferred stock, without par value, of which 300,000 shares have been
designated Series A junior preferred stock, without par value.
  
The accompanying notes are an integral part of these unaudited interim consolidated financial statements.
 


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SELECTIVE INSURANCE GROUP, INC.
UNAUDITED CONSOLIDATED STATEMENTS OF CASH FLOW
 
Six Months ended
June 30,
($ in thousands)
 
2012
 
2011
Operating Activities
 
 

 
 

Net income
 
$
18,381

 
21,967

 
 
 
 
 
Adjustments to reconcile net income to net cash provided by operating activities:
 
 

 
 

Depreciation and amortization
 
19,550

 
16,261

Stock-based compensation expense
 
5,160

 
5,286

Undistributed losses (income) of equity method investments
 
496

 
(726
)
Net realized gains
 
(4,536
)
 
(7,906
)
 
 
 
 
 
Changes in assets and liabilities:
 
 

 
 

Increase in reserves for losses and loss expenses, net of reinsurance recoverables
 
19,802

 
49,164

Increase in unearned premiums, net of prepaid reinsurance and advance premiums
 
75,172

 
30,183

(Decrease) increase in net federal income taxes
 
(3,058
)
 
601

Increase in premiums receivable
 
(57,294
)
 
(53,017
)
Increase in deferred policy acquisition costs
 
(16,638
)
 
(3,624
)
(Increase) decrease in interest and dividends due or accrued
 
(500
)
 
514

Decrease in accrued salaries and benefits
 
(5,699
)
 
(555
)
Decrease in accrued insurance expenses
 
(4,500
)
 
(7,045
)
Other-net
 
5,823

 
8,694

Net adjustments
 
33,778

 
37,830

Net cash provided by operating activities
 
52,159

 
59,797

 
 
 
 
 
Investing Activities
 
 

 
 

Purchase of fixed maturity securities, available-for-sale
 
(426,346
)
 
(252,529
)
Purchase of equity securities, available-for-sale
 
(40,430
)
 
(123,141
)
Purchase of other investments
 
(6,355
)
 
(7,715
)
Purchase of short-term investments
 
(795,707
)
 
(694,764
)
Purchase of subsidiary
 
255

 

Sale of subsidiary
 
445

 
670

Sale of fixed maturity securities, available-for-sale
 
37,699

 
64,104

Sale of short-term investments
 
876,928

 
713,111

Redemption and maturities of fixed maturity securities, held-to-maturity
 
57,152

 
99,560

Redemption and maturities of fixed maturity securities, available-for-sale
 
197,199

 
66,805

Sale of equity securities, available-for-sale
 
58,176

 
59,663

Distributions from other investments
 
8,442

 
14,046

Sale of other investments
 
1

 
16,357

Purchase of property and equipment
 
(6,793
)
 
(2,843
)
Net cash used in investing activities
 
(39,334
)
 
(46,676
)
 
 
 
 
 
Financing Activities
 
 

 
 

Dividends to stockholders
 
(13,442
)
 
(13,225
)
Acquisition of treasury stock
 
(3,102
)
 
(2,526
)
Net proceeds from stock purchase and compensation plans
 
2,225

 
2,355

Excess tax benefits from share-based payment arrangements
 
873

 
(185
)
Net cash used in financing activities
 
(13,446
)
 
(13,581
)
Net decrease in cash
 
(621
)
 
(460
)
Cash, beginning of year
 
762

 
645

Cash, end of period
 
$
141

 
185

 
The accompanying notes are an integral part of these unaudited interim consolidated financial statements.

5

Table of Contents

NOTES TO UNAUDITED INTERIM CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1. Organization
Selective Insurance Group, Inc., through its subsidiaries, (collectively referred to as “we,” “us,” or “our”) offers standard and excess and surplus lines (“E&S”) property and casualty insurance products. Selective Insurance Group, Inc. (referred to as the “Parent”) was incorporated in New Jersey in 1977 and its main offices are located in Branchville, New Jersey. The Parent’s common stock is publicly traded on the NASDAQ Global Select Market under the symbol “SIGI.”
 
We classify our business into two operating segments:
Insurance Operations, which sells property and casualty insurance products and services in both the standard and E&S markets; and
Investments, which invests the premiums collected by our insurance operations.

NOTE 2. Basis of Presentation
These interim unaudited consolidated financial statements (“Financial Statements”) include the accounts of the Parent and its subsidiaries, and have been prepared in conformity with: (i) U.S. generally accepted accounting principles (“GAAP”); and (ii) the rules and regulations of the U.S. Securities and Exchange Commission (“SEC”) regarding interim financial reporting. The preparation of the Financial Statements in conformity with GAAP requires us to make estimates and assumptions that affect the reported financial statement balances, as well as the disclosure of contingent assets and liabilities. Actual results could differ from those estimates. All significant intercompany accounts and transactions between the Parent and its subsidiaries are eliminated in consolidation.
 
These Financial Statements reflect all adjustments that, in our opinion, are normal, recurring, and necessary for a fair presentation of our results of operations and financial condition. The Financial Statements cover the second quarters ended June 30, 2012 (“Second Quarter 2012”) and June 30, 2011 (“Second Quarter 2011”) and the six-month periods ended June 30, 2012 ("Six Months 2012") and June 30, 2011 ("Six Months 2011"). The Financial Statements do not include all of the information and disclosures required by GAAP and the SEC for audited financial statements. Results of operations for any interim period are not necessarily indicative of results for a full year. Consequently, the Financial Statements should be read in conjunction with the consolidated financial statements contained in our Annual Report on Form 10-K for the year ended December 31, 2011 (“2011 Annual Report”).
 
NOTE 3. Reclassification 
Certain prior year amounts in these Financial Statements and related footnotes have been reclassified to conform to the current year presentation. Such reclassifications had no effect on our net income, stockholders’ equity, or cash flows.
 
NOTE 4. Adoption of Accounting Pronouncements 
In October 2010, the FASB issued ASU 2010-26, Financial Services-Insurance (Topic 944): Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts (“ASU 2010-26”). ASU 2010-26 requires that only costs that are incremental or directly related to the successful acquisition of new or renewal insurance contracts are to be capitalized as a deferred acquisition cost. This includes, among other items, sales commissions paid to agents, premium taxes, and the portion of employee salaries and benefits directly related to time spent on acquired contracts. We adopted this guidance on January 1, 2012, with retrospective application and, as such, all historical data in this Form 10-Q has been restated to reflect the revised guidance.


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The following tables provide select restated financial information:
Balance Sheet Information
December 31, 2011
 
 
 
 
 
 
($ in thousands)
 
As Originally
Reported
 
Effect of
Change
 
As Adopted
Deferred policy acquisition costs
 
$
214,069

 
(78,308
)
 
135,761

Deferred federal income tax recoverable
 
92,686

 
27,408

 
120,094

Retained earnings
 
1,167,219

 
(50,900
)
 
1,116,319

  
Income Statement Information
Quarter ended June 30, 2011
 
 
 
 
 
 
($ in thousands, except per share amounts)
 
As Originally
Reported
 
Effect of
Change
 
As Adopted
Policy acquisition costs
 
$
113,843

 
1,320

 
115,163

Deferred federal income tax expense
 
(4,215
)
 
(462
)
 
(4,677
)
Net income
 
2,325

 
(858
)
 
1,467

Net income per share:
 
 

 
 

 
 

Basic
 
$
0.04

 
(0.01
)
 
0.03

Diluted
 
0.04

 
(0.01
)
 
0.03

 
Income Statement Information
Six months ended June 30, 2011
 
 
 
 
 
 
($ in thousands, except per share amounts)
 
As Originally
Reported
 
Effect of
Change
 
As Adopted
Policy acquisition costs
 
$
227,273

 
2,934

 
230,207

Deferred federal income tax expense
 
(2,268
)
 
(1,027
)
 
(3,295
)
Net income
 
$
23,874

 
(1,907
)
 
21,967

Net income per share:
 
 
 
 
 
 
Basic
 
$
0.44

 
(0.03
)
 
0.41

Diluted
 
0.43

 
(0.03
)
 
0.40

  
Cash Flow Information
Six months ended June 30, 2011
 
 
 
 
 
 
($ in thousands, except per share amounts)
 
As Originally
Reported
 
Effect of
Change
 
As Adopted
(Increase) decrease in deferred policy acquisition costs
 
$
(6,558
)
 
2,934

 
(3,624
)
Decrease in net federal income taxes recoverable
 
1,628

 
(1,027
)
 
601

  
In May 2011, the FASB issued ASU 2011-04, Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs (“ASU 2011-04”). This guidance changes the wording used to describe the requirements in U.S. GAAP for measuring fair value and disclosing information about fair value measurements to improve consistency in the application and description of fair value between GAAP and International Financial Reporting Standards. ASU 2011-04 clarifies that the concepts of highest and best use and valuation premise in a fair value measurement are relevant only when measuring the fair value of nonfinancial assets, and are not relevant when measuring the fair value of financial assets or liabilities. In addition, ASU 2011-04 expands the disclosures for unobservable inputs for Level 3 fair value measurements, requiring quantitative and qualitative information to be disclosed related to: (i) the valuation processes used; (ii) the sensitivity of the fair value measurement to changes in unobservable inputs and the interrelationships between those unobservable inputs; and (iii) the use of a nonfinancial asset in a way that differs from the asset’s highest and best use. ASU 2011-04 was effective prospectively for interim and annual periods beginning after December 15, 2011. We have included the disclosures required by this guidance in our notes to the Financial Statements, where appropriate.
 

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In June 2011, the FASB issued ASU 2011-05, Comprehensive Income (Topic 220): Presentation of Comprehensive Income (“ASU 2011-05”). ASU 2011-05 requires that all non-owner changes in stockholders’ equity be presented either in a single continuous statement of comprehensive income or in two separate but consecutive statements. The standard eliminates the option to report other comprehensive income and its components in the statement of stockholders’ equity. Based on an amendment issued in December 2011, companies are not required to present separate line items on the income statement for reclassification adjustments out of accumulated other comprehensive income into net income, as would have been required under the initial ASU. This guidance, which is ASU 2011-12, Comprehensive Income (Topic 220): Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05, is effective concurrently with ASU 2011-05. We have retroactively restated our financial statements in this Form 10-Q to comply with the presentation required under this accounting guidance.
 
In September 2011, the FASB issued ASU 2011-08, Intangibles-Goodwill and Other (Topic 350): Testing Goodwill for Impairment, which simplifies the requirements to test goodwill for impairment.  This guidance permits an entity to first assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount.  If, after assessing events and circumstances, an entity determines that it is not more likely than not that the fair value of the reporting unit is less than the carrying amount, then performing the two-step impairment test is unnecessary.  However, if the entity concludes otherwise, then it is required to perform the quantitative impairment test.  This guidance was effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011, and early adoption was permitted. The adoption of this guidance did not impact our financial condition or results of operation.
  
NOTE 5. Statements of Cash Flow
Cash paid during the six month periods ended June 30, 2012 and June 30, 2011 for interest and federal income taxes was as follows:
 
 
Six Months ended June 30,
($ in thousands)
 
2012
 
2011
Cash paid during the period for:
 
 

 
 

Interest
 
$
9,389

 
9,103

Federal income tax
 
6,300

 
3,673

 
NOTE 6. Investments
(a) The amortized cost, carrying value, unrealized and unrecognized holding gains and losses, and fair values of held-to-maturity (“HTM”) fixed maturity securities were as follows:
 
June 30, 2012
 
 
 
 
 
 
 
 
 
 
 
 
($ in thousands)
 
Amortized Cost
 
Net
 Unrealized Gains
 (Losses)
 
Carrying
Value
 
Unrecognized
 Holding
Gains
 
Unrecognized Holding
 Losses
 
Fair
Value
Foreign government
 
$
5,292

 
252

 
5,544

 

 
(105
)
 
5,439

Obligations of state and political subdivisions
 
557,338

 
9,310

 
566,648

 
32,642

 
(4
)
 
599,286

Corporate securities
 
57,947

 
(1,299
)
 
56,648

 
5,329

 

 
61,977

Asset-backed securities (“ABS”)
 
7,579

 
(1,265
)
 
6,314

 
1,223

 

 
7,537

Commercial mortgage-backed securities (“CMBS”)
 
9,699

 
(1,352
)
 
8,347

 
5,395

 

 
13,742

Total HTM fixed maturity securities
 
$
637,855

 
5,646

 
643,501

 
44,589

 
(109
)
 
687,981



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Table of Contents

December 31, 2011
 
 
 
 
 
 
 
 
 
 
 
 
($ in thousands)
 
Amortized Cost
 
Net
 Unrealized Gains
 (Losses)
 
Carrying
Value
 
Unrecognized
 Holding
Gains
 
Unrecognized Holding
 Losses
 
Fair
Value
Foreign government
 
$
5,292

 
292

 
5,584

 

 
(88
)
 
5,496

Obligations of state and political subdivisions
 
614,118

 
11,894

 
626,012

 
31,529

 
(156
)
 
657,385

Corporate securities
 
64,840

 
(2,189
)
 
62,651

 
6,887

 

 
69,538

ABS
 
8,077

 
(1,469
)
 
6,608

 
1,353

 
(7
)
 
7,954

CMBS
 
14,455

 
(2,962
)
 
11,493

 
6,177

 

 
17,670

Total HTM fixed maturity securities
 
$
706,782

 
5,566

 
712,348

 
45,946

 
(251
)
 
758,043

 
Unrecognized holding gains/losses of HTM securities are not reflected in the Financial Statements, as they represent fair value fluctuations from the later of: (i) the date a security is designated as HTM; or (ii) the date that an other-than-temporary impairment (“OTTI”) charge is recognized on an HTM security, through the date of the balance sheet. Our HTM securities had an average duration of 2.8 years as of June 30, 2012.
 
During Six Months 2012, five securities with a carrying value of $7.9 million and a net unrecognized gain position of $1.0 million were reclassified from an HTM designation to an available-for-sale (“AFS”) designation due to credit rating downgrades by Moody’s Investors Services ("Moody's") and Standard and Poor’s ("S&P") Financial Services. These unexpected rating downgrades raised significant concerns about the issuers’ credit worthiness, which changed our intention to hold these securities to maturity.


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Table of Contents

(b) The cost/amortized cost, unrealized gains (losses), and fair value of AFS securities were as follows:
 
June 30, 2012
 
 
 
 
 
 
 
 
($ in thousands)
 
Cost/
Amortized
Cost
 
Unrealized
Gains
 
Unrealized
Losses
 
Fair
Value
U.S. government and government agencies1
 
$
268,949

 
19,050

 
(3
)
 
287,996

Foreign government
 
41,557

 
1,537

 
(312
)
 
42,782

Obligations of states and political subdivisions
 
695,158

 
42,307

 
(964
)
 
736,501

Corporate securities
 
1,283,114

 
66,588

 
(955
)
 
1,348,747

ABS
 
93,031

 
1,785

 
(7
)
 
94,809

CMBS2
 
115,965

 
4,882

 
(2,804
)
 
118,043

Residential mortgage-backed
securities (“RMBS”)3
 
477,045

 
17,636

 
(553
)
 
494,128

AFS fixed maturity securities
 
2,974,819

 
153,785

 
(5,598
)
 
3,123,006

AFS equity securities
 
130,257

 
20,647

 
(2,787
)
 
148,117

Total AFS securities
 
$
3,105,076

 
174,432

 
(8,385
)
 
3,271,123

 
December 31, 2011
 
 
 
 
 
 
 
 
($ in thousands)
 
Cost/
Amortized
Cost
 
Unrealized
Gains
 
Unrealized
Losses
 
Fair
Value
U.S. government and government agencies1
 
$
333,504

 
20,292

 

 
353,796

Foreign government
 
33,687

 
1,042

 
(556
)
 
34,173

Obligations of states and political subdivisions
 
578,214

 
44,491

 
(46
)
 
622,659

Corporate securities
 
1,168,439

 
50,167

 
(5,296
)
 
1,213,310

ABS
 
77,706

 
1,289

 
(46
)
 
78,949

CMBS2
 
107,838

 
6,427

 
(1,667
)
 
112,598

RMBS3
 
467,468

 
16,187

 
(1,767
)
 
481,888

AFS fixed maturity securities
 
2,766,856

 
139,895

 
(9,378
)
 
2,897,373

AFS equity securities
 
143,826

 
13,617

 
(88
)
 
157,355

Total AFS securities
 
$
2,910,682

 
153,512

 
(9,466
)
 
3,054,728

 
1 U.S. government includes corporate securities fully guaranteed by the Federal Deposit Insurance Corporation (“FDIC”) with a fair value of $14.2 million at June 30, 2012 and $76.5 million at December 31, 2011.
2 CMBS includes government guaranteed agency securities with a fair value of $67.0 million at June 30, 2012 and $72.9 million at December 31, 2011.
3 RMBS includes government guaranteed agency securities with a fair value of $102.6 million at June 30, 2012 and $98.2 million at December 31, 2011.
 
Unrealized gains/losses of AFS securities represent fair value fluctuations from the later of: (i) the date a security is designated as AFS; or (ii) the date that an OTTI charge is recognized on an AFS security, through the date of the balance sheet. These unrealized gains and losses are recorded in accumulated other comprehensive income (“AOCI”) on the Consolidated Balance Sheets.
 

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(c) The following tables summarize, for all securities in a net unrealized/unrecognized loss position at June 30, 2012 and December 31, 2011, the fair value and gross pre-tax net unrealized/unrecognized loss by asset class and by length of time those securities have been in a net loss position:

June 30, 2012
 
Less than 12 months
 
12 months or longer
($ in thousands)
 
Fair Value
 
Unrealized
Losses1
 
Fair Value
 
Unrealized
Losses1
AFS securities
 
 

 
 

 
 

 
 

U.S. government and government agencies
 
$
8,158

 
(3
)
 

 

Foreign government
 
4,758

 
(312
)
 

 

Obligations of states and political subdivisions
 
78,115

 
(958
)
 
511

 
(6
)
Corporate securities
 
46,939

 
(434
)
 
13,924

 
(521
)
ABS
 
2,000

 
(2
)
 
630

 
(5
)
CMBS
 
9,353

 
(39
)
 
13,427

 
(2,765
)
RMBS
 
3,183

 
(9
)
 
14,109

 
(544
)
Total fixed maturity securities
 
152,506

 
(1,757
)
 
42,601

 
(3,841
)
Equity securities
 
32,036

 
(2,787
)
 

 

Subtotal
 
$
184,542

 
(4,544
)
 
42,601

 
(3,841
)
 
 
 
Less than 12 months
 
12 months or longer
($ in thousands)
 
Fair
Value
 
Unrealized
Losses1
 
Unrecognized
Gains2
 
Fair
Value
 
Unrealized
Losses1
 
Unrecognized
Gains2
HTM securities
 
 

 
 

 
 

 
 

 
 

 
 

Obligations of states and political subdivisions
 
$
1,820

 
(70
)
 
63

 
4,033

 
(283
)
 
165

Corporate securities
 
5,995

 
(129
)
 
120

 

 

 

ABS
 

 

 

 
2,800

 
(927
)
 
707

Subtotal
 
$
7,815

 
(199
)
 
183

 
6,833

 
(1,210
)
 
872

Total AFS and HTM
 
$
192,357

 
(4,743
)
 
183

 
49,434

 
(5,051
)
 
872


December 31, 2011
 
Less than 12 months
 
12 months or longer
($ in thousands)
 
Fair
Value
 
Unrealized
Losses1
 
Fair Value
 
Unrealized
Losses1
AFS securities:
 
 

 
 

 
 

 
 

Foreign government
 
$
8,299

 
(556
)
 

 

Obligations of states and political subdivisions
 
517

 
(1
)
 
1,740

 
(45
)
Corporate securities
 
157,510

 
(4,415
)
 
14,084

 
(881
)
ABS
 
15,808

 
(14
)
 
702

 
(32
)
CMBS
 
4,822

 
(48
)
 
14,564

 
(1,619
)
RMBS
 
29,803

 
(625
)
 
15,007

 
(1,142
)
Total fixed maturity securities
 
216,759

 
(5,659
)
 
46,097

 
(3,719
)
Equity securities
 
743

 
(88
)
 

 

Subtotal
 
$
217,502

 
(5,747
)
 
46,097

 
(3,719
)
 

11

Table of Contents


 
 
Less than 12 months
 
12 months or longer
($ in thousands)
 
Fair
Value
 
Unrealized
Losses1
 
Unrecognized
Gains2
 
Fair
Value
 
Unrealized
Losses1
 
Unrecognized
Gains2
HTM securities
 
 

 
 

 
 

 
 

 
 

 
 

Obligations of states and political subdivisions
 
$
7,244

 
(94
)
 
78

 
9,419

 
(519
)
 
324

ABS
 

 

 

 
2,816

 
(1,009
)
 
737

CMBS
 

 

 

 
2,794

 
(1,447
)
 
761

Subtotal
 
$
7,244

 
(94
)
 
78

 
15,029

 
(2,975
)
 
1,822

Total AFS and HTM
 
$
224,746

 
(5,841
)
 
78

 
61,126

 
(6,694
)
 
1,822

 
1 
Gross unrealized losses include non-OTTI unrealized amounts and OTTI losses recognized in AOCI.  In addition, this column includes remaining unrealized gain or loss amounts on securities that were transferred to an HTM designation in the first quarter of 2009 for those securities that are in a net unrealized/unrecognized loss position.
2 
Unrecognized gains represent fair value fluctuations from the later of:  (i) the date a security is designated as HTM; or (ii) the date that an OTTI charge is recognized on an HTM security.

As evidenced by the table below, our unrealized/unrecognized loss positions improved by $1.9 million as of June 30, 2012 compared to December 31, 2011 as follows:

($ in thousands)
 
 
June 30, 2012
 
December 31, 2011
Number of
Issues
% of Market/Book
Unrealized
Unrecognized Loss
 
Number of
Issues
% of
Market/Book
Unrealized
Unrecognized
Loss
141

80% - 99%
$
6,817

 
140

80% - 99%
$
10,166

4

60% - 79%
1,580

 

60% - 79%

1

40% - 59%
342

 
1

40% - 59%
469


20% - 39%

 

20% - 39%


0% - 19%

 

0% - 19%

 

 
$
8,739

 
 

 
$
10,635

 
We have reviewed the securities in the tables above in accordance with our OTTI policy, as described in Note 2. “Summary of Significant Accounting Policies” in Item 8. “Financial Statements and Supplementary Data.” of our 2011 Annual Report.
  
At June 30, 2012, we had 146 securities in an aggregate unrealized/unrecognized loss position of $8.7 million, $4.2 million of which have been in a loss position for more than 12 months. Securities with non-credit OTTI impairments comprised $2.6 million of the $4.2 million balance, with the remainder related to securities that were, on average, 4% impaired compared to their amortized cost. Three of these securities are experiencing immaterial principal and interest shortfalls.
  
At December 31, 2011, we had 141 securities in an aggregate unrealized/unrecognized loss position of $10.6 million, $4.9 million of which had been in a loss position for more than 12 months. Non-credit OTTI impairments comprised $2.1 million of the $4.9 million balance, with the remainder related to securities that were, on average, 6% impaired compared to their amortized cost.
 
We do not have the intent to sell any securities in an unrealized/unrecognized loss position nor do we believe we will be required to sell these securities, and therefore we have concluded that they are temporarily impaired as of June 30, 2012. This conclusion reflects our current judgment as to the financial position and future prospects of the entity that issued the investment security and underlying collateral. If our judgment about an individual security changes in the future, we may ultimately record a credit loss after having originally concluded that one did not exist, which could have a material impact on our net income and financial position in future periods.
 
(d) Fixed maturity securities at June 30, 2012, by contractual maturity, are shown below. Mortgage-backed securities are included in the maturity tables using the estimated average life of each security. Expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties.
 

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Table of Contents

Listed below are HTM fixed maturity securities at June 30, 2012:
($ in thousands)
 
Carrying Value
 
Fair Value
Due in one year or less
 
$
98,022

 
103,123

Due after one year through five years
 
464,672

 
494,584

Due after five years through 10 years
 
73,941

 
82,051

Due after 10 years
 
6,866

 
8,223

Total HTM fixed maturity securities
 
$
643,501

 
687,981

 
Listed below are AFS fixed maturity securities at June 30, 2012:
($ in thousands)
 
Fair Value
Due in one year or less
 
$
352,423

Due after one year through five years
 
1,861,652

Due after five years through 10 years
 
841,420

Due after 10 years
 
67,511

Total AFS fixed maturity securities
 
$
3,123,006

  
(e) The following table outlines a summary of our other investment portfolio by strategy and the remaining commitment amount associated with each strategy:
Other Investments
 
Carrying Value
 
June 30,
2012
($ in thousands)
 
June 30,
2012
 
December 31,
2011
 
Remaining Commitment
Alternative Investments
 
 

 
 

 
 

Secondary private equity
 
$
29,596

 
30,114

 
8,651

Private equity
 
23,739

 
21,736

 
3,984

Energy/power generation
 
21,578

 
25,913

 
10,383

Distressed debt
 
14,702

 
16,953

 
2,986

Real estate
 
12,961

 
13,767

 
10,473

Mezzanine financing
 
11,146

 
8,817

 
23,435

Venture capital
 
7,856

 
7,248

 
800

Total alternative investments
 
121,578

 
124,548

 
60,712

Other securities
 
3,962

 
3,753

 
1,494

Total other investments
 
$
125,540

 
128,301

 
62,206

 
The carrying value of our other investments decreased by $2.8 million compared to year end 2011. The carrying value was impacted by distributions of $13.9 million, partially offset by income of $5.0 million and additional contributions of $6.4 million. These contributions included $4.6 million under our previously existing commitments and $1.8 million under one of two new alternative investment limited partnerships that we entered into during Second Quarter 2012. The remaining commitment on these two new mezzanine financing limited partnerships amounted to $8.2 million at June 30, 2012. The two new investments contain redemption restrictions and fund liquidation characteristics that are consistent with our other alternative investments. For a description of our seven alternative investment strategies, as well as information regarding redemption, restrictions, and fund liquidations, refer to Note 5. “Investments” in Item 8. “Financial Statements and Supplementary Data.” of our 2011 Annual Report.
 
The following table sets forth aggregated summarized financial information for the partnerships in our alternative investment portfolio. The last line of the table below reflects our share of the aggregate income, which is the portion included in our Financial Statements. As the majority of these investments report results to us on a quarter lag, the summarized financial statement information for the three and six-month periods ended March 31 is as follows:


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Table of Contents

Income Statement Information
 
 
 
 
 
 
 
 
 
 
Quarter ended
March 31,
 
Six Months ended
March 31,
($ in millions)
 
2012
 
2011
 
2012
 
2011
Net investment income
 
$
54.0

 
132.6

 
90.1

 
286.8

Realized gains (losses)
 
234.6

 
355.3

 
985.3

 
163.0

Net change in unrealized (depreciation) appreciation
 
53.4

 
608.3

 
(434.0
)
 
2,072.5

Net income
 
$
342.0

 
1,096.2

 
641.4

 
2,522.3

Selective’s insurance subsidiaries’ other investments net income
 
$
3.0

 
7.9

 
5.0

 
19.5

 
(f) At June 30, 2012, we had 29 fixed maturity securities, with a carrying value of $63.4 million, pledged as collateral for our outstanding borrowing with the Federal Home Loan Bank of Indianapolis (“FHLBI”).  This borrowing, which has an outstanding principal balance of $58.0 million, is included in “Notes payable” on our Consolidated Balance Sheets.  In accordance with the terms of our agreement with the FHLBI, we retain all rights regarding the collateral securities, which are included in the “U.S. government and government agencies,” “RMBS,” and “CMBS” classifications of our AFS fixed maturity securities portfolio.
 
(g) The components of net investment income earned were as follows:
 
 
Quarter ended June 30,
 
Six Months ended June 30,
($ in thousands)
 
2012
 
2011
 
2012
 
2011
Fixed maturity securities
 
$
31,759


32,752


63,109


65,875

Equity securities
 
1,280


785


2,517


1,102

Short-term investments
 
29


33


67


95

Other investments
 
2,963


7,900


4,963


19,541

Miscellaneous income
 
25


22


64


47

Investment expenses
 
(2,050
)

(2,147
)

(4,086
)

(3,842
)
Net investment income earned
 
$
34,006

 
39,345

 
66,634

 
82,818

  
Net investment income earned, before tax, decreased by $5.3 million for Second Quarter 2012 compared to Second Quarter 2011, and decreased by $16.2 million for Six Months 2012 compared to Six Months 2011. These decreases were primarily driven by lower income from alternative investments within our other investment portfolio of $4.7 million and $14.1 million in Second Quarter 2012 and Six Months 2012, respectively. Our alternative investments, which are accounted for under the equity method, primarily consist of investments in limited partnerships, the majority of which report results to us on a one quarter lag.

(h) The following tables summarize OTTI by asset type for the periods indicated:
Second Quarter 2012
 
 
 
 
 
 
($ in thousands) 
 
Gross 
 
Included in Other
Comprehensive
Income (“OCI”)
 
Recognized in
Earnings
Fixed maturity securities
 
 

 
 

 
 

ABS
 
$
30

 

 
30

RMBS
 
10

 
(54
)
 
64

OTTI losses
 
$
40

 
(54
)
 
94

 
Second Quarter 2011
 
 
 
 
 
 
($ in thousands)
 
Gross
 
Included in OCI
 
Recognized in Earnings
Fixed maturity securities
 
 

 
 

 
 

CMBS
 
$
(260
)
 
(402
)
 
142

RMBS
 
97

 
70

 
27

OTTI losses
 
$
(163
)
 
(332
)
 
169



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Table of Contents

Six Months 2012
 
 
 
 
 
 
($ in thousands)
 
Gross
 
Included in OCI
 
Recognized in Earnings
Fixed maturity securities
 
 

 
 

 
 

ABS
 
$
62

 

 
62

CMBS
 
108

 

 
108

RMBS
 
(44
)
 
(218
)
 
174

Total fixed maturity securities
 
126

 
(218
)
 
344

Equity securities
 
171

 

 
171

OTTI losses
 
$
297

 
(218
)
 
515

Six Months 2011
 
 
 
 
 
 
($ in thousands)
 
Gross
 
Included in OCI
 
Recognized in Earnings
Fixed maturity securities
 
 

 
 

 
 

Obligations of state and political subdivisions
 
$
17

 

 
17

Corporate securities
 
244

 

 
244

CMBS
 
(186
)
 
(658
)
 
472

RMBS
 
294

 
228

 
66

OTTI losses
 
$
369

 
(430
)
 
799


The following tables set forth, for the periods indicated, credit loss impairments on fixed maturity securities for which a portion of the OTTI charge was recognized in OCI, and the corresponding changes in such amounts:
 
 
Quarter ended June 30,
($ in thousands)
 
2012
 
2011
Balance, beginning of period
 
$
6,711

 
14,368

Addition for the amount related to credit loss for which an OTTI was not previously recognized
 

 

Reductions for securities sold during the period
 

 

Reductions for securities for which the amount previously recognized in OCI was recognized in earnings because of intention or potential requirement to sell before recovery of amortized cost
 

 

Reductions for securities for which the entire amount previously recognized in OCI was recognized in earnings due to a decrease in cash flows expected
 

 
(372
)
Additional increases to the amount related to credit loss for which an OTTI was previously recognized
 
64

 
28

Accretion of credit loss impairments previously recognized due to an increase in cash flows expected to be collected
 

 

Balance, end of period
 
$
6,775

 
14,024


 
 
Six Months ended
June 30,
($ in thousands)
 
2012
 
2011
Balance, beginning of period
 
$
6,602

 
17,723

Addition for the amount related to credit loss for which an OTTI was not previously recognized
 

 

Reductions for securities sold during the period
 

 

Reductions for securities for which the amount previously recognized in OCI was recognized in earnings because of intention or potential requirement to sell before recovery of amortized cost
 

 

Reductions for securities for which the entire amount previously recognized in OCI was recognized in earnings due to a decrease in cash flows expected
 

 
(3,954
)
Additional increases to the amount related to credit loss for which an OTTI was previously recognized
 
173

 
255

Accretion of credit loss impairments previously recognized due to an increase in cash flows expected to be collected
 

 

Balance, end of period
 
$
6,775

 
14,024


15

Table of Contents

 
(i)The components of net realized gains, excluding OTTI charges, were as follows:
 
 
Quarter ended June 30,
 
Six Months ended
June 30,
($ in thousands)
 
2012
 
2011
 
2012
 
2011
HTM fixed maturity securities
 
 

 
 

 
 

 
 

Gains
 
$
2

 
8

 
155

 
9

Losses
 
(25
)
 
(108
)
 
(106
)
 
(322
)
AFS fixed maturity securities
 
 

 
 

 
 

 
 

Gains
 
368

 
1,947

 
773

 
2,354

Losses
 
(74
)
 

 
(117
)
 
(7
)
AFS equity securities
 
 

 
 

 
 

 
 

Gains
 

 
468

 
4,775

 
6,671

Losses
 

 

 
(428
)
 

Short-term investments
 
 

 
 

 
 

 
 

Losses
 

 

 
(2
)
 

Other investments
 
 
 
 
 
 
 
 
     Gains
 
1




1



Total other net realized investment gains
 
272


2,315


5,051


8,705

Total OTTI charges recognized in earnings
 
(94
)

(169
)

(515
)

(799
)
Total net realized gains
 
$
178


2,146


4,536


7,906

 
Realized gains and losses on the sale of investments are determined on the basis of the cost of the specific investments sold. Proceeds from the sale of AFS securities were $24.1 million in Second Quarter 2012 and $95.9 million in Six Months 2012. In addition to calls and maturities, the realized gain, excluding OTTI charges, in Six Months 2012 was driven primarily by the sale of AFS equity securities for proceeds of $57.5 million with net realized gains of $4.3 million due to a rebalancing of the equity securities portfolio.

Proceeds from the sale of AFS securities were $52.1 million in Second Quarter 2011 and $123.8 million in Six Months 2011. In addition to calls and maturities and certain bond sales, Six Months 2011 net realized gains, excluding OTTI charges, were driven by the sale of AFS equity securities for proceeds of $59.7 million and realized gains of $6.7 million due to a reallocation of the equity portfolio to a high dividend yield strategy.
 
NOTE 7. Fair Value Measurements
The following table presents the carrying amounts and estimated fair values of our financial instruments as of June 30, 2012 and December 31, 2011:
 
 
June 30, 2012
 
December 31, 2011
($ in thousands)
 
Carrying Amount
 
Fair
Value
 
Carrying Amount
 
Fair
Value
Financial Assets
 
 

 
 

 
 

 
 

Fixed maturity securities:
 
 

 
 

 
 

 
 

HTM
 
$
643,501

 
687,981

 
712,348

 
758,043

AFS
 
3,123,006

 
3,123,006

 
2,897,373

 
2,897,373

Equity securities, AFS
 
148,117

 
148,117

 
157,355

 
157,355

Short-term investments
 
135,823

 
135,823

 
217,044

 
217,044

Receivable for proceeds related to sale of Selective HR Solutions (“Selective HR”)
 
2,894

 
2,894

 
3,212

 
3,212

Financial Liabilities
 
 

 
 

 
 

 
 

Notes payable:
 
 

 
 

 
 

 
 

7.25% Senior Notes
 
49,910

 
59,534

 
49,908

 
51,111

6.70% Senior Notes
 
99,463

 
112,569

 
99,452

 
113,195

7.50% Junior Notes
 
100,000

 
100,880

 
100,000

 
100,360

2.90% borrowings from FHLBI
 
13,000

 
13,683

 
13,000

 
13,759

1.25% borrowings from FHLBI
 
45,000

 
45,121

 
45,000

 
44,629

Total notes payable
 
$
307,373

 
331,787

 
307,360

 
323,054


16

Table of Contents

 
The techniques used to value our financial assets are as follows:
For valuations of a large portion of our equity securities portfolio as well as U.S. Treasury notes held in our fixed maturity securities portfolio, we receive prices from an independent pricing service that are based on observable market transactions. We validate these prices against a second external pricing service, and if established market value comparison thresholds are breached, further analysis is performed, in conjunction with our external investment managers, to determine the price to be used. These securities are classified as Level 1 in the fair value hierarchy.

For approximately 95% of our fixed maturity securities portfolio, we utilize a market approach, using primarily matrix pricing models prepared by external pricing services. Matrix pricing models use mathematical techniques to value debt securities by relying on the securities relationship to other benchmark quoted securities, and not relying exclusively on quoted prices for specific securities, as the specific securities are not always frequently traded. As a matter of policy, we consistently use one pricing service as our primary source and secondary pricing services if prices are not available from the primary pricing service. In conjunction with our external investment portfolio managers, fixed maturity securities portfolio pricing is reviewed for reasonableness in the following ways: (i) comparing positions traded directly by the external investment portfolio managers to prices received from the third-party pricing services; (ii) comparing the primary vendor pricing to other third-party pricing services as well as benchmark indexed pricing; (iii) comparing market value fluctuations between months for reasonableness; and (iv) reviewing stale prices. If further analysis is needed, a challenge is sent to the primary pricing service for review and confirmation of the price. In addition to the tests described above, management also selects a sample of prices for a comparison to a secondary price source. Historically, we have not experienced significant variances in prices, and therefore, we have consistently used our primary pricing service. These prices are typically Level 2 in the fair value hierarchy.

For the small portion of our fixed maturity securities portfolio that we cannot price using our primary service, we typically use non-binding broker quotes. These prices are from various broker/dealers that utilize bid or ask prices, or benchmarks to indices, in measuring the fair value of a security. For the small portion of non-public equity securities that we hold, we typically receive prices from a third party pricing service or through statements provided by the security issuer. In conjunction with our external investment portfolio managers, these fair value measurements are reviewed for reasonableness. This review typically includes an analysis of price fluctuations between months with variances over established thresholds being analyzed further. These prices are generally classified as Level 3 in the fair value hierarchy, as the inputs cannot be corroborated by observable market data.

Short-term investments are carried at cost, which approximates fair value. Given the liquid nature of our short-term investments, we generally validate their fair value by way of active trades within approximately one week of the financial statement close. These securities are classified as Level 1 in the fair value hierarchy.

Our investments in other miscellaneous securities are generally accounted for under the equity method. Investments in tax credits are carried under the effective yield method of accounting.

The fair value of the receivable for proceeds related to the 2009 sale of Selective HR is estimated using a discounted cash flow analysis, which includes our judgment regarding future worksite life generation and retention assumptions. These assumptions are derived based on our historical experience modified to reflect current and anticipated future trends. Proceeds related to the sale are scheduled to be received over a 10-year period based on the ability of the purchaser to retain and generate new worksite lives though our independent agency distribution channel. We have concluded that these proceeds are not directly related to the operations of Selective HR since we have no continuing involvement with the operations of this company and have no continuing cash flows other than these proceeds. This receivable is classified as Level 3 in the fair value hierarchy.

The techniques used to value our financial liabilities are as follows:
The fair values of the 7.25% Senior Notes due November 15, 2034, the 6.70% Senior Notes due November 1, 2035, and the 7.50% Junior Subordinated Notes due September 27, 2066 are based on quoted market prices. These prices are typically Level 1 in the fair value hierarchy.

The fair value of the 2.90% and 1.25% borrowings from the FHLBI are estimated using a discounted cash flow analysis based on a current borrowing rate provided by the FHLBI consistent with the remaining term of the borrowing. These prices are typically Level 2 in the fair value hierarchy.


17

Table of Contents

The following tables provide quantitative disclosures of our financial assets that were measured at fair value at June 30, 2012 and December 31, 2011:
 
June 30, 2012
 
 
 
Fair Value Measurements Using
($ in thousands)
 
Assets
 Measured at
 Fair Value
 at 6/30/12
 
Quoted Prices in
Active Markets for
Identical Assets/
Liabilities (Level 1)1
 
Significant Other
 Observable
Inputs
 (Level 2)1
 
Significant Unobservable
 Inputs
 (Level 3)
Description
 
 

 
 

 
 

 
 

Measured on a recurring basis:
 
 

 
 

 
 

 
 

U.S. government and government agencies2
 
$
287,996

 
129,555

 
138,275

 
20,166

Foreign government
 
42,782

 

 
42,782

 

Obligations of states and political subdivisions
 
736,501

 

 
736,501

 

Corporate securities
 
1,348,747

 

 
1,345,676

 
3,071

ABS
 
94,809

 

 
94,809

 

CMBS
 
118,043

 

 
113,368

 
4,675

RMBS
 
494,128

 

 
494,128

 

Total AFS fixed maturity securities
 
3,123,006

 
129,555

 
2,965,539

 
27,912

Equity securities
 
148,117

 
144,510

 

 
3,607

Short-term investments
 
135,823

 
135,823

 

 

Receivable for proceeds related to sale of Selective HR
 
2,894

 

 

 
2,894

Total assets
 
$
3,409,840

 
409,888

 
2,965,539

 
34,413

 
December 31, 2011
 
 
 
Fair Value Measurements Using
($ in thousands)
 
Assets
 Measured at
Fair Value
at 12/31/11
 
Quoted Prices in
 Active Markets for
Identical Assets/Liabilities
(Level 1)1
 
Significant Other
 Observable
Inputs
 (Level 2)1
 
Significant Unobservable
Inputs
 (Level 3)
Description
 
 

 
 

 
 

 
 

Measured on a recurring basis:
 
 

 
 

 
 

 
 

U.S. government and government agencies2
 
$
353,796

 
126,475

 
205,580

 
21,741

Foreign government
 
34,173

 

 
34,173

 

Obligations of states and political subdivisions
 
622,659

 

 
622,659

 

Corporate securities
 
1,213,310

 

 
1,210,707

 
2,603

ABS
 
78,949

 

 
78,949

 

CMBS
 
112,598

 

 
112,244

 
354

RMBS
 
481,888

 

 
481,888

 

Total AFS fixed maturity securities
 
2,897,373

 
126,475

 
2,746,200

 
24,698

Equity securities
 
157,355

 
157,355

 

 

Short-term investments
 
217,044

 
217,044

 

 

Receivable for proceeds related to sale of Selective HR
 
3,212

 

 

 
3,212

Total assets
 
$
3,274,984

 
500,874

 
2,746,200

 
27,910

 
1 
There were no transfers of securities between Level 1 and Level 2 in Six Months 2012 and in Six Months 2011.
2 
U.S. government includes corporate securities fully guaranteed by the FDIC.
 

18

Table of Contents

The following table provides a summary of the changes in the fair value of securities measured using Level 3 inputs and related quantitative information as of June 30, 2012:


Six Months 2012
 
 
 
 
 
 
 
 
 
 
 
 
($ in thousands)
 
Government
 
Corporate
 
CMBS
 
Equity
 
Receivable for
Proceeds
Related to Sale
of Selective HR
 
Total
Fair value, December 31, 2011
 
$
21,741

 
2,603

 
354

 

 
3,212

 
27,910

Total net (losses) gains for the period included in:
 
 

 
 

 
 

 


 
 

 


OCI1
 
270

 
107

 
128

 

 

 
505

Net income2,3
 
(107
)
 

 

 

 
127

 
20

Purchases
 

 

 

 

 

 

Sales
 

 

 

 

 

 

Issuances
 

 

 

 

 

 

Settlements
 
(1,738
)
 
(427
)
 

 

 
(445
)
 
(2,610
)
Transfers into Level 3
 

 
788

 
4,193

 
3,607

 

 
8,588

Transfers out of Level 3
 

 

 

 

 

 

Fair value, June 30, 2012
 
$
20,166

 
3,071

 
4,675

 
3,607

 
2,894

 
34,413


1 Amounts are reported in “Unrealized holding gains arising during period” on the Consolidated Statements of Comprehensive Income.
2 Amounts are reported in “Net realized gains (losses)” for realized gains and losses and “Net investment income earned” for amortization of securities on the Consolidated Statements of Income.
3 Amounts are reported in “Other income” for the receivable related to the sale of Selective HR on the Consolidated Statements of Income, and are related to interest accretion on the receivable.

Fixed maturity securities transfered into Level 3 were securities that had previously been classified as HTM and therefore not measured at fair value. Recent downgrades in the securities' ratings in Second Quarter 2012 resulted in a transfer into the AFS category with the securities now being measured at fair value as of June 30, 2012. The transfer of equity securities into Level 3 were driven primarily by the nature of the quotes used at the valuation date.

As discussed above, the fair value of our Level 3 fixed maturity securities are typically obtained through non-binding broker quotes, which we review for reasonableness. We also review for reasonableness the fair values received on our non-publicly traded equity securities. The receivable related to the sale of Selective HR is also a Level 3 fair value measurement using unobservable inputs, the most significant of which is our assumption regarding the retention of business. If this assumption were to change by +/-10%, the value of this receivable would increase/decrease by approximately $0.1 million.



19

Table of Contents

The following table provides a summary of the changes in the fair value of securities measured using Level 3 inputs in 2011:
 
2011
 
 
 
 
 
 
 
 
 
 
($ in thousands)
 
Government
 
Corporate
 
CMBS
 
Receivable for
 Proceeds
Related to Sale
 of Selective HR
 
Total
Fair value, December 31, 2010
 
$

 

 
185

 
5,002

 
5,187

Total net (losses) gains for the period included in:
 
 

 
 

 
 

 
 

 
 

OCI1
 

 

 
507

 

 
507

Net income2,3
 

 

 
(322
)
 
(638
)
 
(960
)
Purchases
 

 

 

 

 

Sales
 

 

 

 

 

Issuances
 

 

 

 

 

Settlements
 

 

 
(16
)
 
(1,152
)
 
(1,168
)
Transfers into Level 3
 
21,741

 
2,603

 

 

 
24,344

Transfers out of Level 3
 

 

 

 

 

Fair value, December 31, 2011
 
$
21,741

 
2,603

 
354

 
3,212

 
27,910

1 Amounts are reported in “Other net unrealized gains on investment securities, net of deferred income tax” on the Consolidated Statements of Stockholders’ Equity in our 2011 Annual Report.
2 Amounts are reported in “Net realized gains (losses)” for realized gains and losses and “Net investment income earned” for amortization for the CMBS securities on the Consolidated Statements of Income in our 2011 Annual Report.
3 Amounts are reported in either “Loss on disposal of discontinued operations, net of tax” or “Other income” for the receivable related to the sale of Selective HR on the Consolidated Statements of Income.  Amounts in “Loss on disposal of discontinued operations, net of tax” related to charges to reduce the fair value of our receivable, and amounts in “Other income” related to interest accretion on the receivable in our 2011 Annual Report.
 
The transfers of the government and corporate securities into Level 3 classification at December 31, 2011 were primarily the result of broker-priced securities being transferred from an HTM to an AFS designation in 2011.
 
The following tables provide quantitative information regarding our financial assets and liabilities that were disclosed at fair value at June 30, 2012:

June 30, 2012
 
 
 
Fair Value Measurements Using
($ in thousands)
 
Assets/
Liabilities
Disclosed at
Fair Value at 6/30/12
 
Quoted Prices in
 Active Markets for
 Identical Assets/
Liabilities
(Level 1)
 
Significant Other
Observable
Inputs
(Level 2)
 
Significant
Unobservable
Inputs
(Level 3)
Financial Assets
 
 

 
 

 
 

 
 

HTM:
 
 

 
 

 
 

 
 

Foreign government
 
$
5,439

 

 
5,439

 

Obligations of states and political subdivisions
 
599,286

 

 
599,286

 

Corporate securities
 
61,977

 

 
57,049

 
4,928

ABS
 
7,537

 

 
5,945

 
1,592

CMBS
 
13,742

 

 
13,742

 

Total HTM fixed maturity securities
 
$
687,981

 

 
681,461

 
6,520

Financial Liabilities
 
 

 
 

 
 

 
 

Notes payable:
 
 

 
 

 
 

 
 

7.25% Senior Notes
 
$
59,534

 
59,534

 

 

6.70% Senior Notes
 
112,569

 
112,569

 

 

7.50% Junior Notes
 
100,880

 
100,880

 

 

2.90% borrowings from FHLBI
 
13,683

 

 
13,683

 

1.25% borrowings from FHLBI
 
45,121

 

 
45,121

 

Total notes payable
 
$
331,787

 
272,983

 
58,804

 

 

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NOTE 8. Reinsurance
The following table contains a listing of direct, assumed, and ceded reinsurance amounts for premiums written, premiums earned, and losses and loss expenses incurred. For more information concerning reinsurance, refer to Note 8. “Reinsurance” in Item 8. “Financial Statements and Supplementary Data.” in our 2011 Annual Report.
 
 
 
Quarter ended June 30,
 
Six Months ended
June 30,
($ in thousands)
 
2012
 
2011
 
2012
 
2011
Premiums written:
 
 

 
 

 
 

 
 

Direct
 
$
507,520

 
447,595

 
983,486

 
870,937

Assumed
 
4,747

 
1,537

 
26,736

 
7,190

Ceded
 
(86,704
)
 
(74,629
)
 
(164,487
)
 
(141,789
)
Net
 
$
425,563

 
374,503

 
845,735

 
736,338

Premiums earned:
 
 

 
 

 
 

 
 

Direct
 
$
463,330

 
418,977

 
915,318

 
831,856

Assumed
 
16,039

 
5,351

 
31,088

 
11,240

Ceded
 
(87,157
)
 
(68,748
)
 
(175,365
)
 
(136,173
)
Net
 
$
392,212

 
355,580

 
771,041

 
706,923

Losses and loss expenses incurred:
 
 

 
 

 
 

 
 

Direct
 
$
301,451

 
296,963

 
553,654

 
566,367

Assumed
 
10,470

 
3,739

 
21,069

 
7,572

Ceded
 
(24,018
)
 
(26,147
)
 
(33,914
)
 
(50,178
)
Net
 
$
287,903

 
274,555

 
540,809

 
523,761

 
Direct premium written ("DPW") increases in both Second Quarter and Six Months 2012 were attributable to our newly acquired E&S business coupled with higher renewal premiums in our standard insurance operations. In addition, an increase in new business from our standard Insurance Operations contributed to the increase in DPW in Six Months 2012 compared to Six Months 2011.

Direct premium earned increases in Second Quarter 2012 and Six Months 2012 were consistent with the fluctuation in DPW for the twelve-month period ended June 30, 2012 as compared to the twelve-month period ended June 30, 2011.

Assumed premiums written and earned increased in Second Quarter and Six Months 2012 compared to the same periods last year primarily due to the August 2011 E&S renewal rights acquisition.
Direct losses and loss expenses incurred were significantly impacted by catastrophe losses in both 2012 and 2011. Catastrophe losses were $30.2 million and $38.1 million in Second Quarter 2012 and 2011, respectively, and $37.1 million and $44.9 million in Six Months 2012 and 2011, respectively.
Ceded losses and loss expenses incurred decreased by $2.1 million in Second Quarter 2012 and $16.3 million in Six Months 2012, compared to the same periods last year. These decreases were primarily due to NFIP Hurricane Irene and Lee claims from August and September 2011 being settled in 2012 for less than their original estimates. This decrease was partially offset by ceded loss activity related to our E&S business driven by cessions to Montpelier Reinsurance Ltd. in connection with the December 2011 acquisition of MUSIC.
The ceded premiums and losses related to our involvement with the National Flood Insurance Program (“NFIP”), in which all of our Flood premiums, losses, and loss expenses are ceded to the NFIP, are as follows:

National Flood Insurance Program
 
Quarter ended June 30,
 
Six Months ended
June 30,
($ in thousands)
 
2012
 
2011
 
2012
 
2011
Ceded premiums written
 
$
(60,525
)
 
(55,265
)
 
(112,249
)
 
(103,579
)
Ceded premiums earned
 
(52,768
)
 
(48,907
)
 
(104,673
)
 
(96,855
)
Ceded losses and loss expenses incurred
 
$
(6,754
)
 
(15,339
)
 
8,168

 
(29,879
)

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Table of Contents

 
NOTE 9. Segment Information
We have classified our operations into two segments, the disaggregated results of which are reported to and used by senior management to manage our operations:
Insurance Operations, which is evaluated based on statutory underwriting results (net premiums earned, incurred losses and loss expenses, policyholders dividends, policy acquisition costs, and other underwriting expenses) and statutory combined ratios; and
Investments, which is evaluated based on net investment income and net realized gains and losses.

Our Insurance Operations segment has historically reflected the results of our standard commercial lines and personal lines market insurance products. In 2011, through our acquisition activities, we began writing E&S business. This business has not met the quantitative thresholds for individual segment reporting, and as our E&S operations share various economic, regulatory, and production-related characteristics with our standard market insurance products, we have aggregated their results into our Insurance Operations segment.
 
In computing the results of each segment, we do not make adjustments for interest expense, net general corporate expenses, or federal income taxes. We do not maintain separate investment portfolios for the segments, and therefore, do not allocate assets to the segments.
 
The following summaries present revenue (net investment income and net realized gain (loss) on investments in the case of the Investments segment) and pre-tax income for the individual segments:
Revenue by Segment
 
Quarter ended June 30,
 
Six Months ended
June 30,
($ in thousands)
 
2012
 
2011
 
2012
 
2011
Insurance Operations:
 
 

 
 

 
 

 
 

Net premiums earned:
 
 

 
 

 
 

 
 

Commercial automobile
 
$
71,540

 
69,198

 
$
142,024

 
138,868

Workers compensation
 
66,661

 
63,855

 
132,472

 
126,381

General liability
 
92,632

 
85,672

 
182,775

 
168,238

Commercial property
 
50,377

 
47,877

 
99,748

 
96,070

Business owners’ policies
 
17,266

 
16,407

 
34,123

 
32,892

Bonds
 
4,700

 
4,725

 
9,363

 
9,492

Other
 
19,080

 
2,561

 
31,971

 
5,117

Total commercial lines
 
322,256

 
290,295

 
632,476

 
577,058

Personal automobile
 
37,897

 
37,189

 
75,353

 
74,151

Homeowners
 
28,808

 
25,060

 
56,766

 
49,615

Other
 
3,251

 
3,036

 
6,446

 
6,099

Total personal lines
 
69,956

 
65,285

 
138,565

 
129,865

Total net premiums earned
 
392,212

 
355,580

 
771,041

 
706,923

Miscellaneous income
 
2,438

 
2,388

 
5,895

 
5,158

Total Insurance Operations revenues
 
394,650

 
357,968

 
776,936

 
712,081

Investments:
 
 

 
 

 
 

 
 

Net investment income
 
34,006

 
39,345

 
66,634

 
82,818

Net realized investment gains
 
178

 
2,146

 
4,536

 
7,906

Total investment revenues
 
34,184

 
41,491

 
71,170

 
90,724

Total all segments
 
428,834

 
399,459

 
848,106

 
802,805

Other income
 
73

 
111

 
149

 
221

Total revenues
 
$
428,907

 
399,570

 
$
848,255

 
803,026

 

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Table of Contents

Income Before Federal Income Tax
 
Quarter ended June 30,
 
Six Months ended
June 30,
($ in thousands)
 
2012
 
2011
 
2012
 
2011
Insurance Operations:
 
 

 
 

 
 

 
 

Commercial lines underwriting
 
$
(19,524
)
 
(23,446
)
 
$
(24,008
)
 
(29,638
)
Personal lines underwriting
 
(7,438
)
 
(10,556
)
 
(4,317
)
 
(17,062
)
Underwriting loss, before federal income tax
 
(26,962
)
 
(34,002
)
 
(28,325
)
 
(46,700
)
GAAP combined ratio
 
106.9
%
 
109.6
%
 
103.7
%
 
106.6
%
Statutory combined ratio
 
106.2
%
 
109.5
%
 
102.7
%
 
106.1
%
Investments:
 
 

 
 

 
 

 
 

Net investment income
 
$
34,006

 
39,345

 
$
66,634

 
82,818

Net realized investment gains
 
178

 
2,146

 
4,536

 
7,906

Total investment income, before federal income tax
 
34,184

 
41,491

 
71,170

 
90,724

Total all segments
 
7,222

 
7,489

 
42,845

 
44,024

Interest expense
 
(4,723
)
 
(4,559
)
 
(9,423
)
 
(9,116
)
General corporate and other expenses
 
(3,191
)
 
(3,029
)
 
(10,923
)
 
(8,849
)
(Loss) Income before federal income tax
 
$
(692
)
 
(99
)
 
$
22,499

 
26,059

 
NOTE 10. Retirement Plans
The following tables show the costs of the Retirement Income Plan for Selective Insurance Company of America (“Retirement Income Plan”) and the retirement life insurance component (“Retirement Life Plan”) of the Selective Insurance Company of America Welfare Benefits Plan. For more information concerning these plans, refer to Note 16. “Retirement Plans” in Item 8. “Financial Statements and Supplementary Data.” of our 2011 Annual Report.
 
 
 
Retirement Income Plan
Quarter ended June 30,
 
Retirement Life Plan
Quarter ended June 30,
($ in thousands)
 
2012
 
2011
 
2012
 
2011
Components of Net Periodic Benefit Cost:
 
 

 
 

 
 

 
 

Service cost
 
$
2,154

 
2,174

 

 

Interest cost
 
3,230

 
3,155

 
74

 
76

Expected return on plan assets
 
(3,547
)
 
(3,481
)
 

 

Amortization of unrecognized prior service cost
 
37

 
38

 

 

Amortization of unrecognized net loss
 
1,383

 
1,099

 
8

 
5

Net periodic cost
 
$
3,257

 
2,985

 
82

 
81


 
 
Retirement Income Plan
Six Months ended June 30,
 
Retirement Life Plan
Six Months ended June 30,
($ in thousands)
 
2012
 
2011
 
2012
 
2011
Components of Net Periodic Benefit Cost:
 
 

 
 

 
 

 
 

Service cost
 
$
4,308

 
4,347

 

 

Interest cost
 
6,460

 
6,310

 
148

 
153

Expected return on plan assets
 
(7,094
)
 
(6,963
)
 

 

Amortization of unrecognized prior service cost
 
75

 
75

 

 

Amortization of unrecognized net loss
 
2,766

 
2,200

 
15

 
9

Net periodic cost
 
$
6,515

 
5,969

 
163

 
162

Weighted-Average Expense Assumptions for the years ended December 31:
 
 

 
 
 
 

 
 
Discount rate
 
5.16
%
 
5.55
 
5.16
%
 
5.55
Expected return on plan assets
 
7.75
%
 
8.00
 

 
Rate of compensation increase
 
4.00
%
 
4.00
 

 

We presently anticipate contributing $8.4 million to the Retirement Income Plan in 2012, $4.7 million of which has been funded as of June 30, 2012.
 

23

Table of Contents

NOTE 11. Comprehensive Income
The components of comprehensive income, both gross and net of tax, for Second Quarter 2012 and 2011 are as follows:
 
Second Quarter 2012
 
 
 
 
 
 
($ in thousands)
 
Gross
 
Tax
 
Net
Net income
 
$
(692
)
 
(980
)
 
288

Components of OCI:
 
 

 
 

 
 

Unrealized gains on securities:
 
 

 
 

 
 

Unrealized holding gains during the period
 
7,849

 
2,748

 
5,101

Portion of OTTI recognized in OCI
 
114

 
39

 
75

Amortization of net unrealized gains on HTM securities
 
(682
)
 
(239
)
 
(443
)
Reclassification adjustment for gains included in net income
 
(218
)
 
(76
)
 
(142
)
Net unrealized gains
 
7,063

 
2,472

 
4,591

Defined benefit pension and post-retirement plans:
 
 

 
 

 
 

Reversal of amortization items:
 
 

 
 

 
 

Net actuarial loss
 
1,391

 
486

 
905

Prior service cost
 
37

 
13

 
24

Defined benefit pension and post-retirement plans
 
1,428

 
499

 
929

Comprehensive income
 
$
7,799

 
1,991

 
5,808

 
Second Quarter 2011
 
 
 
 
 
 
($ in thousands)
 
Gross
 
Tax
 
Net
Net income
 
$
(99
)
 
(1,566
)
 
1,467

Components of OCI:
 
 

 
 

 
 

Unrealized gains on securities:
 
 

 
 

 
 

Unrealized holding gains during the period
 
30,099

 
10,536

 
19,563

Portion of OTTI recognized in OCI
 
418

 
146

 
272

Amortization of net unrealized gains on HTM securities
 
(1,258
)
 
(441
)
 
(817
)
Reclassification adjustment for gains included in net income
 
(2,144
)
 
(751
)
 
(1,393
)
Net unrealized gains
 
27,115

 
9,490

 
17,625

Defined benefit pension and post-retirement plans:
 
 

 
 

 
 

Reversal of amortization items:
 
 

 
 

 
 

Net actuarial loss
 
1,104

 
386

 
718

Prior service cost
 
38

 
13

 
25

Defined benefit pension and post-retirement plans
 
1,142

 
399

 
743

Comprehensive income
 
$
28,158

 
8,323

 
19,835


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The components of comprehensive income, both gross and net of tax, for Six Months 2012 and 2011 are as follows:
Six Months 2012
 
 
 
 
 
 
($ in thousands)
 
Gross
 
Tax
 
Net
Net income
 
$
22,499

 
4,118

 
18,381

Components of OCI:
 
 

 
 

 
 

Unrealized gains on securities:
 
 

 
 

 
 

Unrealized holding gains during the period
 
27,653

 
9,679

 
17,974

Portion of OTTI recognized in OCI
 
481

 
168

 
313

Amortization of net unrealized gains on HTM securities
 
(1,476
)
 
(517
)
 
(959
)
Reclassification adjustment for gains included in net income
 
(4,577
)
 
(1,602
)
 
(2,975
)
Net unrealized gains
 
22,081

 
7,728

 
14,353

Defined benefit pension and post-retirement plans:
 
 

 
 

 
 

Reversal of amortization items:
 
 

 
 

 
 

Net actuarial loss
 
2,781

 
973

 
1,808

Prior service cost
 
75

 
26

 
49

Defined benefit pension and post-retirement plans
 
2,856

 
999

 
1,857

Comprehensive income
 
$
47,436

 
12,845

 
34,591


Six Months 2011
 
 
 
 
 
 
($ in thousands)
 
Gross
 
Tax
 
Net
Net income
 
$
26,059

 
4,092

 
21,967

Components of OCI:
 
 

 
 

 
 

Unrealized gains on securities:
 
 

 
 

 
 

Unrealized holding gains during the period
 
29,166

 
10,209

 
18,957

Portion of OTTI recognized in OCI
 
598

 
209

 
389

Amortization of net unrealized gains on HTM securities
 
(2,433
)
 
(852
)
 
(1,581
)
Reclassification adjustment for gains included in net income
 
(7,893
)
 
(2,763
)
 
(5,130
)
Net unrealized gains
 
19,438

 
6,803

 
12,635

Defined benefit pension and post-retirement plans:
 
 

 
 

 
 

Reversal of amortization items:
 
 

 
 

 
 

Net actuarial loss
 
2,209

 
773

 
1,436

Prior service cost
 
75

 
26

 
49

Defined benefit pension and post-retirement plans
 
2,284

 
799

 
1,485

Comprehensive income
 
$
47,781

 
11,694

 
36,087

  
The balances of, and changes in, each component of AOCI (net of taxes) as of June 30, 2012 are as follows:

June 30, 2012
 
Net Unrealized Gain (Loss)
 
 
 
 
($ in thousands)
 
OTTI
Related
 
HTM
Related
 
All
Other
 
Defined Benefit
Pension and Post-Retirement Plans
 
Total Accumulated OCI
Balance, December 31, 2011
 
$
(3,500
)
 
4,622

 
96,125

 
(54,953
)
 
42,294

Changes in component during period
 
313

 
(898
)
 
14,938

 
1,857

 
16,210

Balance, June 30, 2012
 
$
(3,187
)
 
3,724

 
111,063

 
(53,096
)
 
58,504



Note 12. Commitments and Contingencies
At June 30, 2012, we had contractual obligations that expire at various dates through 2022 to invest up to an additional $62.2 million in alternative and other investments. There is no certainty that any such additional investment will be required.



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Note 13. Litigation
In the ordinary course of conducting business, we are named as defendants in various legal proceedings. Most of these proceedings are claims litigation involving our eight insurance subsidiaries (the “Insurance Subsidiaries”) as either: (a) liability insurers defending or providing indemnity for third-party claims brought against insureds; or (b) insurers defending first-party coverage claims brought against them. We account for such activity through the establishment of unpaid loss and loss adjustment expense reserves. We expect that the ultimate liability, if any, with respect to such ordinary course claims litigation, after consideration of provisions made for potential losses and costs of defense, will not be material to our consolidated financial condition, results of operations, or cash flows.
 
Our Insurance Subsidiaries are also from time-to-time involved in other legal actions, some of which assert claims for substantial amounts. These actions include, among others, putative class actions seeking certification of a state or national class. Such putative class actions have alleged, for example, improper reimbursement of medical providers paid under workers compensation and personal and commercial automobile insurance policies. Our Insurance Subsidiaries also are involved from time-to-time in individual actions in which extra-contractual damages, punitive damages, or penalties are sought, such as claims alleging bad faith in the handling of insurance claims. We believe that we have valid defenses to these cases. We expect that the ultimate liability, if any, with respect to such lawsuits, after consideration of provisions made for estimated losses, will not be material to our consolidated financial condition. Nonetheless, given the large or indeterminate amounts sought in certain of these actions, and the inherent unpredictability of litigation, an adverse outcome in certain matters could, from time-to-time, have a material adverse effect on our consolidated results of operations or cash flows in particular quarterly or annual periods.
 

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Table of Contents

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Forward-Looking Statements
In this Quarterly Report on Form 10-Q, we discuss and make statements regarding our intentions, beliefs, current expectations, and projections regarding our company’s future operations and performance. Such statements are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements are often identified by words such as “anticipates,” “believes,” “expects,” “will,” “should,” and “intends” and their negatives. We caution prospective investors that such forward-looking statements are not guarantees of future performance. Risks and uncertainties are inherent in our future performance. Factors that could cause actual results to differ materially from those indicated by such forward-looking statements include, but are not limited to, those discussed under Item 1A. “Risk Factors” below in Part II “Other Information”. These risk factors may not be exhaustive. We operate in a continually changing business environment and new risk factors emerge from time to time. We can neither predict such new risk factors nor can we assess the impact, if any, of such new risk factors on our businesses or the extent to which any factor or combination of factors may cause actual results to differ materially from those expressed or implied in any forward-looking statements in this report. In light of these risks, uncertainties, and assumptions, the forward-looking events discussed in this report might not occur. We make forward-looking statements based on currently available information and assume no obligation to update these statements due to changes in underlying factors, new information, future developments, or otherwise.
  
Introduction
We classify our business into two operating segments:
Insurance Operations, which sells property and casualty insurance products and services; and
Investments, which invests the premiums collected by our insurance operations.

Our Insurance Operations offers standard Commercial Lines and Personal Lines market insurance products and services through seven insurance subsidiaries and, in 2011, we began offering commercial excess and surplus lines (“E&S”) insurance products through one insurance subsidiary as the result of the following acquisition activity:
The purchase of the renewal rights to an E&S book of business in August 2011; and
The purchase of Montpelier U.S. Insurance Company (now known as Mesa Underwriters Specialty Insurance Company) (“MUSIC”) in December 2011.

In the third quarter of 2012, we created two new insurance subsidiaries, Selective Casualty Insurance Company and Selective Fire and Casualty Insurance Company. These two new companies, which are expected to begin writing premium in 2013, have been included in our reinsurance pooling agreement as of July 1, 2012. See the "Reinsurance" section below for details regarding the pooling change.  Our ten insurance subsidiaries are collectively referred to as the “Insurance Subsidiaries”. For additional information regarding our recent acquisitions, refer to Note 13. “Business Combinations” in Item 8. “Financial Statements and Supplementary Data.” of our Annual Report on Form 10-K for the year ended December 31, 2011 (“2011 Annual Report”).

The purpose of the Management’s Discussion and Analysis (“MD&A”) is to provide an understanding of the consolidated results of operations and financial condition and known trends and uncertainties that may have a material impact in future periods. Consequently, investors should read the MD&A in conjunction with the consolidated financial statements in our 2011 Annual Report.
  

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In the MD&A, we will discuss and analyze the following:
Critical Accounting Policies and Estimates;
Financial Highlights of Results for the second quarter ended June 30, 2012 ("Second Quarter 2012") and the six-month period ended June 30, 2012 ("Six Months 2012");
Results of Operations and Related Information by Segment;
Financial Condition, Liquidity, Short-term Borrowings, and Capital Resources;
Ratings;
Off-balance Sheet Arrangements; and
Contractual Obligations, Contingent Liabilities, and Commitments.

Critical Accounting Policies and Estimates
These unaudited interim consolidated financial statements include amounts based on our informed estimates and judgments for those transactions that are not yet complete. Such estimates and judgments affect the reported amounts in the consolidated financial statements. Those estimates and judgments most critical to the preparation of the consolidated financial statements involve the following: (i) reserves for losses and loss expenses; (ii) deferred policy acquisition costs; (iii) premium audit; (iv) pension and post-retirement benefit plan actuarial assumptions; (v) other-than-temporary investment impairments; and (vi) reinsurance. These estimates and judgments require the use of assumptions about matters that are highly uncertain and, therefore, are subject to change as facts and circumstances develop. If different estimates and judgments had been applied, materially different amounts might have been reported in the financial statements. For additional information regarding our critical accounting policies, refer to our 2011 Annual Report, pages 47 through 56.
 

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Financial Highlights of Results for Second Quarter 2012 and Six Months 20121 
 
 
Quarter ended June 30,
 
 
 
 
 
Six Months ended June 30,
 
 
 
 
(Shares and $ in thousands, except per share amounts)
 
2012
 
2011
 
Change
% or Points
 
 
 
2012
 
2011
 
Change
% or Points
 
 
GAAP measures:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Revenues
 
$
428,907

 
399,570

 
7

 
%
 
848,255

 
803,026

 
6

 
%
Pre-tax net investment income
 
34,006

 
39,345

 
(14
)
 
 
 
66,634

 
82,818

 
(20
)
 
 
   Pre-tax net income
 
(692
)
 
(99
)
 
599

 
 
 
22,499

 
26,059

 
(14
)
 
 
Net income
 
288

 
1,467

 
(80
)
 
 
 
18,381

 
21,967

 
(16
)
 
 
Diluted net income per share
 
0.01

 
0.03

 
(67
)
 
 
 
0.33

 
0.40

 
(18
)
 
 
Diluted weighted-average outstanding shares
 
55,681

 
55,135

 
1

 
 
 
55,642

 
55,092

 
1

 
 
GAAP combined ratio
 
106.9
%
 
109.6

 
(2.7
)
 
pts 
 
103.7
%
 
106.6

 
(2.9
)
 
pts
   Statutory combined ratio
 
106.2
%
 
109.5

 
(3.3
)
 
 
 
102.7
%
 
106.1

 
(3.4
)
 
 
Return on average equity
 
0.1
%
 
0.6

 
(0.5
)
 
 
 
3.4
%
 
4.3

 
(0.9
)
 
 
Non-GAAP measures:
 


 
 

 
 
 
 
 


 
 

 


 
 
Operating income2
 
$
172

 
72

 
139

 
%
 
15,432

 
16,828

 
(8
)
 
%
Diluted operating income per share2
 
0.01

 

 
NA

 
 
 
0.28

 
0.31

 
(10
)
 
 
Operating return on average equity2
 
0.1
%
 

 
0.1

 
pts 
 
2.9
%
 
3.3
%
 
(0.4
)
 
pts

1 
Refer to the Glossary of Terms attached to our 2011 Annual Report as Exhibit 99.1 for definitions of terms used in this Form 10-Q.
2 
Operating income is used as an important financial measure by us, analysts, and investors, because the realization of investment gains and losses on sales in any given period is largely discretionary as to timing. In addition, these realized investment gains and losses, as well as other-than-temporary impairments (“OTTI”) that are charged to earnings could distort the analysis of trends. See below for a reconciliation of operating income to net income in accordance with U.S. generally accepted accounting principles (“GAAP”). Operating return on average equity is calculated by dividing annualized operating income by average stockholders’ equity.
 
Revenue increases in both the quarterly and year-to-date periods reflect higher premium from our Insurance Operations, partially offset by reductions in net investment income. Premium increases were attributable to our newly-acquired E&S business, as well as standard Commercial Lines and Personal Lines renewal pure price increases and higher retention. See the Insurance Operations discussion below for additional information.

Our pre-tax net income in both Second Quarter 2012 and 2011 was significantly impacted by catastrophe losses. These losses amounted to $30.2 million in Second Quarter 2012 and $38.1 million in the second quarter of 2011 ("Second Quarter 2011"). In addition, pre-tax net investment income was down $5.3 million, or 14% in Second Quarter 2012 compared to Second Quarter 2011, driven by lower returns on the alternative investment portion of our other investments portfolio. Our alternative investments, which are accounted for under the equity method, primarily consist of investments in limited partnerships, the majority of which report results to us on a one quarter lag. See Note 6. “Investments” in Item 1. “Financial Statements” of this Form 10-Q for additional information regarding our alternative investment portfolio.

Similar to the quarterly results, Six Months 2012 and 2011 were both significantly impacted by catastrophe losses of $37.1 million and $44.9 million, respectively. In addition, reductions in alternative investment returns, coupled with lower yields on our fixed maturity securities portfolio, drove the $16.2 million, or 20%, reduction in net investment income for Six Months 2012 versus Six Months 2011.


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Table of Contents

The net income fluctuation in both the quarterly and year-to-date periods reflect the pre-tax income changes discussed above.
 
The following table reconciles operating income and net income for the periods presented above:

 
 
Quarter ended
 June 30,
 
Six Months ended 
June 30,
($ in thousands, except per share amounts)
 
2012
 
2011
 
2012
 
2011
Operating income
 
$
172

 
72

 
15,432

 
16,828

Net realized gains, net of tax
 
116

 
1,395

 
2,949

 
5,139

Net income
 
288

 
1,467

 
18,381

 
21,967

Diluted operating income per share
 
$
0.01

 

 
0.28

 
0.31

Diluted net realized gains per share
 

 
0.03

 
0.05

 
0.09

Diluted net income per share
 
$
0.01

 
0.03

 
0.33

 
0.40


The variances in operating income are reflective of the results discussed above.

Results of Operations and Related Information by Segment
 
Insurance Operations
 
Our standard Commercial Lines and Personal Lines market insurance products and services are sold primarily in 22 states in the Eastern and Midwestern U.S. through approximately 1,000 independent insurance agencies. Our recent E&S acquisitions provide us the opportunity to write contract binding authority E&S business in all 50 states and the District of Columbia through approximately 100 wholesale agents across the entire country.
 
Our Insurance Operations segment consists of two components: (i) Commercial Lines, which markets primarily to businesses and represents approximately 82% of net premiums written (“NPW”); and (ii) Personal Lines, which markets primarily to individuals and represents approximately 18% of NPW. Our E&S operations write exclusively commercial lines of business, and for purposes of this MD&A, this business is included within Commercial Lines. The underwriting performance of these lines is generally measured by four different statutory ratios: (i) the loss and loss expense ratio; (ii) the underwriting expense ratio; (iii) the dividend ratio; and (iv) the combined ratio.
 

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Table of Contents

Summary of Insurance Operations
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
All Lines
 
Quarter ended June 30,
 
 
 
 
 
Six months ended June 30,
 
 
 
 
($ in thousands)
 
2012
 
2011
 
Change % or Points
 
 
 
2012
 
2011
 
Change % or Points
 
 
GAAP Insurance Operations Results:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
NPW
 
$
425,563

 
374,503

 
14

 
%
 
845,735

 
736,338

 
15

 
%
Net premiums earned (“NPE”)
 
392,212

 
355,580

 
10

 
 
 
771,041

 
706,923

 
9

 
 
Less:
 
 
 
 

 
 
 
 
 
 
 
 

 
 
 
 
Losses and loss expenses incurred
 
287,903

 
274,555

 
5

 
 
 
540,809

 
523,761

 
3

 
 
Net underwriting expenses incurred
 
130,041

 
113,566

 
15

 
 
 
256,413

 
227,115

 
13

 
 
Dividends to policyholders
 
1,230

 
1,461

 
(16
)
 
 
 
2,144

 
2,747

 
(22
)
 
 
Underwriting loss
 
$
(26,962
)
 
(34,002
)
 
21

 
%
 
(28,325
)
 
(46,700
)
 
39

 
%
GAAP Ratios:
 
 
 
 

 
 
 
 
 
 
 
 

 
 
 
 
Loss and loss expense ratio
 
73.4
%
 
77.2

 
(3.8
)
 
pts 
 
70.1

 
74.1

 
(4.0
)
 
pts 
Underwriting expense ratio
 
33.2

 
32.0

 
1.2

 
 
 
33.3

 
32.1

 
1.2

 
 
Dividends to policyholders ratio
 
0.3

 
0.4

 
(0.1
)
 
 
 
0.3

 
0.4

 
(0.1
)
 
 
Combined ratio
 
106.9

 
109.6

 
(2.7
)
 
 
 
103.7

 
106.6

 
(2.9
)
 
 
Statutory Ratios:
 
 
 
 

 
 
 
 
 
 
 
 

 
 
 
 
Loss and loss expense ratio
 
73.4

 
77.2

 
(3.8
)
 
 
 
70.1

 
74.1

 
(4.0
)
 
 
Underwriting expense ratio
 
32.5

 
31.9

 
0.6

 
 
 
32.3

 
31.6

 
0.7

 
 
Dividends to policyholders ratio
 
0.3

 
0.4

 
(0.1
)
 
 
 
0.3

 
0.4

 
(0.1
)
 
 
Combined ratio
 
106.2
%
 
109.5

 
(3.3
)
 
pts 
 
102.7

 
106.1

 
(3.4
)
 
pts 
 
NPW increases in both Second Quarter and Six Months 2012 compared to the prior year periods were attributable to our newly acquired E&S business coupled with higher renewal premiums in our standard Insurance Operations, reflecting increases in renewal pure price. In addition, new business in our standard Insurance Operations increased by 20%, or $25.1 million, in Six Months 2012 compared to Six Months 2011. The following provides quantitative information regarding these premium fluctuations:
 
 
Quarter ended June 30,
 
Six months ended June 30,
($ in millions)
 
2012
 
2011
 
2012
 
2011
E&S premiums
 
$
28.3

 

 
54.1

 

Standard Insurance Operations retention
 
84
%
 
83
%
 
84
%
 
82
%
Standard Commercial Lines renewal pure price increases
 
6.5
%
 
2.6
%
 
5.8
%
 
2.7
%

NPE increases in Second Quarter and Six Months 2012 were consistent with the fluctuation in NPW for the twelve-month period ended June 30, 2012 as compared to the twelve-month period ended June 30, 2011.

Although the GAAP loss and loss expense ratio improved both in the quarterly and year-to-date periods, results were heavily impacted in both years by catastrophe losses. In 2012, the majority of these losses were incurred by two storms in the second quarter amounting to approximately $26 million of the $30.2 million total. The following tables provide quantitative information regarding catastrophe losses:

 
 
Quarter ended June 30,
 
 
 
Six months ended June 30,
 
 
 
Catastrophe Losses
 
Impact to
 
 
 
Catastrophe Losses
 
Impact to
 
($ in millions)
 
 Incurred
 
Loss Ratio
 
 
 
 Incurred
 
Loss Ratio
 
2012
$
30.2
 
7.7

pts
 
$
37.1
 
4.8
pts
2011
 
38.1
 
10.7

 
 
 
44.9
 
6.4
 

In addition, non-catastrophe property losses decreased by $3.1 million, or 1.8 points, in Six Months 2012 compared to Six Months 2011.


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Table of Contents

The GAAP underwriting expense ratio in both Second Quarter and Six Months 2012 increased by 1.2 points compared to the prior year periods, primarily driven by expenses associated with our E&S business. As MUSIC unearned premiums as of the acquisition date were fully ceded, our underwriting expense ratio will be under pressure going forward until the premiums that we write subsequent to the purchase are earned to support the ongoing expenses of these operations.

Insurance Operations Outlook  
The insurance industry has recently demonstrated, for both standard Commercial Lines and Personal Lines, a moderate amount of renewal pricing and increased underwriting discipline in part due to the extreme levels of catastrophe losses and a very low interest rate environment. However, new business, particularly in standard Commercial Lines, remains very competitive. The industry is expected to remain unprofitable as evidenced by A.M. Best's industry combined ratio projection of 102.0% for 2012, including approximately two points of favorable prior year reserve development. Our Insurance Operations segment reported a statutory combined ratio of 106.2% and 102.7% for Second Quarter and Six Months 2012, respectively, as compared to 109.5% and 106.1% in Second Quarter and Six Months 2011, respectively. These combined ratios were significantly impacted by the large amount of catastrophic events that occurred throughout 2012 and 2011.
 
A.M. Best continues to maintain its negative outlook on the commercial lines sector as widespread significant pricing improvements have not yet materialized. A recent report from the Commercial Lines Insurance Pricing Survey showed that industry pricing increased by 4.6% during the first quarter of 2012. While industry pricing continues to improve, we are on our 13th consecutive quarter of Commercial Lines renewal pure price increases with 6.5% in Second Quarter 2012, and retention continues to be strong at 82%, a two-point increase compared to the prior year period. The 5.8% Commercial Lines renewal pure price increase that we have obtained for Six Months 2012 demonstrates the overall strength of the relationships that we have with our independent agents, even in difficult economic times.
 
The personal lines market continues to be more receptive to price increases, and A.M. Best has continued to maintain a stable outlook for the sector, citing that capitalization will continue to be strong and rating actions will generally be affirmations. Our Personal Lines operations continue to experience NPW growth driven by ongoing rate increases that went into effect over the past several years. Personal Lines filed rate increases that were effective for the quarter averaged 6%, while retention remained relatively flat at 87%. As we achieve rate increases in excess of loss trends, we expect Personal Lines profitability to improve.
 
Given the elevated level of catastrophe losses incurred through Six Months 2012, we expect to generate overall full year statutory and GAAP combined ratios of between 102% and 103%, which include a full-year catastrophe loss assumption of approximately 3.5 points. These combined ratios do not include any assumptions for additional reserve development, favorable or unfavorable. Weighted average shares at year-end 2012 are expected to be approximately 55.6 million. Investment income at year-end 2012 is expected to be $100 to $105 million, after-tax.


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Review of Underwriting Results by Line of Business
 
Commercial Lines
Commercial Lines
 
Quarter ended June 30,
 
 
 
 
 
Six months ended June 30,
 
 
 
 
($ in thousands)
 
2012
 
2011
 
Change % or Points
 
 
 
2012
 
2011
 
Change % or Points
 
 
GAAP Insurance Operations Results:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
NPW
 
$
348,758

 
303,305

 
15

 
 
703,384

 
603,639

 
17

 
NPE
 
322,256

 
290,295

 
11

 
 
 
632,476

 
577,058

 
10

 
 
Less:
 
 
 
 

 
 
 
 
 
 
 
 

 
 
 
 
Losses and loss expenses incurred
 
229,928

 
216,363

 
6

 
 
 
435,201

 
412,385

 
6

 
 
Net underwriting expenses incurred
 
110,622

 
95,917

 
15

 
 
 
219,139

 
191,564

 
14

 
 
Dividends to policyholders
 
1,230

 
1,461

 
(16
)
 
 
 
2,144

 
2,747

 
(22
)
 
 
Underwriting loss
 
$
(19,524
)
 
(23,446
)
 
17

 
%
 
(24,008
)
 
(29,638
)
 
19

 
GAAP Ratios:
 
 
 
 

 
 
 
 
 
 
 
 

 
 
 
 
Loss and loss expense ratio
 
71.3
%
 
74.5

 
(3.2
)
 
pts 
 
68.8

 
71.5

 
(2.7
)
 
pts 
Underwriting expense ratio
 
34.4

 
33.1

 
1.3

 
 
 
34.7

 
33.1

 
1.6

 
 
Dividends to policyholders ratio
 
0.4

 
0.5

 
(0.1
)
 
 
 
0.3

 
0.5

 
(0.2
)
 
 
Combined ratio
 
106.1

 
108.1

 
(2.0
)
 
 
 
103.8

 
105.1

 
(1.3
)
 
 
Statutory Ratios:
 
 
 
 

 
 
 
 
 
 
 
 

 
 
 
 
Loss and loss expense ratio
 
71.3

 
74.5

 
(3.2
)
 
 
 
68.8

 
71.5

 
(2.7
)
 
 
Underwriting expense ratio
 
33.9

 
33.2

 
0.7

 
 
 
33.3

 
32.4

 
0.9

 
 
Dividends to policyholders ratio
 
0.4

 
0.5

 
(0.1
)
 
 
 
0.3

 
0.5

 
(0.2
)
 
 
Combined ratio
 
105.6
%
 
108.2

 
(2.6
)
 
pts 
 
102.4
%
 
104.4

 
(2.0
)
 
pts 

NPW increases in both Second Quarter and Six Months 2012 were attributable to our newly acquired E&S business coupled with higher renewal premiums in our standard Insurance Operations. In addition, new business in our standard Insurance Operations increased by 25%, or $25.9 million, in Six Months 2012 compared to Six Months 2011. The following provides quantitative information regarding these premium fluctuations:
 
 
Quarter ended June 30,
 
Six months ended June 30,
($ in millions)
 
2012
 
2011
 
2012
 
2011
 
 
 
 
 
 
 
E&S premiums
 
$
28.3

 

 
54.1

 

Standard Insurance Operations retention
 
82
%
 
80
%
 
82
%
 
80
%
Standard Commercial Lines renewal pure price increases
 
6.5
%
 
2.6
%
 
5.8
%
 
2.7
%

NPE increases in Second Quarter and Six Months 2012 compared to Second Quarter and Six Months 2011 are consistent with the fluctuation in NPW for the twelve-month period ended June 30, 2012 as compared to the twelve-month period ended June 30, 2011.

Although the GAAP loss and loss expense ratio improved both in the quarterly and year-to-date periods, results were heavily impacted in both years by catastrophe losses. The following tables provide quantitative information regarding catastrophe losses:

 
 
Second Quarter
 
 
 
Six Months
 
($ in millions)
 
Catastrophe Losses Incurred
 
Impact to Loss and Loss Expense Ratio
 
 
 
Catastrophe Losses Incurred
 
Impact to Loss and Loss Expense Ratio
 
2012
$
18.6
 
5.8

pts
 
$
22.5
 
3.6
pts
2011
 
25.8
 
8.9

 
 
 
30.8
 
5.3
 



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The increases in the GAAP underwriting expense ratios in both periods was driven by underwriting expenses associated with our E&S business. These expenses, which amounted to $8.5 million in Second Quarter 2012 and $15.6 million in Six Months 2012, added approximately 2.5 points to the expense ratio in both periods. As MUSIC unearned premiums as of the acquisition date were fully ceded, our underwriting expense ratio will be under pressure going forward until the premiums that we write subsequent to the purchase are earned to support the ongoing expenses of these operations. This was partially offset by growth in NPE that has outpaced overhead costs.

The following is a discussion of our most significant standard market commercial lines of business:
 
General Liability

 
 
Quarter ended June 30,
 
 
 
 
 
Six months ended June 30,
 
 
 
 
($ in thousands)
 
2012
 
2011
 
Change % or Points
 
 
 
2012
 
2011
 
Change % or Points
 
 
Statutory NPW
 
$
99,222

 
90,463

 
10

 
%
 
199,850

 
179,235

 
12

 
Statutory NPE
 
92,632

 
85,672

 
8

 
 
 
182,775

 
168,238

 
9

 
 
Statutory combined ratio
 
102.3
%
 
103.0

 
(0.7
)
 
pts 
 
101.3
%
 
101.7

 
(0.4
)
 
pts
% of total statutory commercial NPW
 
28
%
 
30

 
 
 
 
 
28
%
 
30

 
 
 
 

We continue to see improvements in pricing in the general liability line, as our renewal pure price increases were 7.2% and 6.6% in Second Quarter and Six Months 2012, respectively. NPW increased in both periods, which is evidenced by the following:
New business was up 13%, or $1.9 million, to $17.2 million in Second Quarter 2012; and 29%, or $8.2 million, to $36.3 million in Six Months 2012;
A two-point improvement in retention to approximately 81% in Second Quarter 2012 and Six Months 2012 compared to the same periods last year; and
Audit and endorsement premium of $2.4 million and $4.4 million in Second Quarter and Six Months 2012, compared to $0.8 million and return premium of $2.1 million in Second Quarter and Six Months 2011, respectively.

The statutory combined ratio for Second Quarter and Six Months 2012 was flat for this line compared to the same periods last year. While premium increases outpaced loss costs in Second Quarter and Six Months 2012 and there was no prior year development in Second Quarter or Six Months 2012, 2011 was impacted by favorable prior year development of approximately $1 million, or 1.2 points, in Second Quarter 2011 and $4 million, or 2.3 points, in Six Months 2011. The prior year development in 2011 was driven by 2005 through 2009 accident years partially offset by adverse development in the 2010 accident year.


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Table of Contents

Workers Compensation
 
 
 
Quarter ended
June 30,
 
 
 
 
 
Six Months ended
June 30,
 
 
 
 
($ in thousands)
 
2012
 
2011
 
Change % or Points
 
 
 
2012
 
2011
 
Change % or Points
 
 
Statutory NPW
 
$
66,764

 
66,705

 

 
 
139,952

 
134,473

 
4

 
Statutory NPE
 
66,661

 
63,855

 
4

 
 
 
132,472

 
126,381

 
5

 
 
Statutory combined ratio
 
112.7
%
 
116.3

 
(3.6
)
 
pts 
 
111.8
%
 
119.5

 
(7.7
)
 
pts
% of total statutory commercial NPW
 
19
%
 
22

 
 
 
 
 
20
%
 
22

 
 
 
 
 
We continue to see improvements in pricing in the workers compensation line as our renewal pure price increase was 8.7% and 7.8% in Second Quarter and Six Months 2012, respectively. In addition, fluctuations in NPE include the following:
New business was down 16%, or $1.9 million, to $10.0 million, in Second Quarter 2012; and up 10%, or $2.2 million, to $25.4 million, in Six Months 2012 compared to the same periods last year;
A two-point improvement in retention to 81% in Second Quarter 2012 compared to Second Quarter 2011, and a two-point improvement to 80% in Six Months 2012 compared to Six Months 2011; and
Audit and endorsement premium of $3.9 million and $8.4 million in Second Quarter and Six Months 2012, compared to $2.5 million and $1.9 million in Second Quarter and Six Months 2011, respectively.
 
The improvement in the statutory combined ratio of this line reflects no net prior year development in Second Quarter and Six Months 2012, compared to unfavorable prior year development of $1 million, or 1.6 points, in Second Quarter 2011 and $7 million, or 5.5 points, in Six Months 2011. This prior year development was driven mainly by the 2010 accident year.

Commercial Automobile
 
 
Quarter ended
June 30,
 
 
 
 
 
Six Months ended
June 30,
 
 
 
 
($ in thousands)
 
2012
 
2011
 
Change % or Points
 
 
 
2012
 
2011
 
Change % or Points
 
 
Statutory NPW
 
$
74,912

 
72,740

 
3

 
%
 
150,750

 
144,469

 
4

 
%
Statutory NPE
 
71,540

 
69,199

 
3

 
 
 
142,024

 
138,869

 
2

 
 
Statutory combined ratio
 
96.0
%
 
92.5

 
3.5

 
pts
 
96.3
%
 
92.4

 
3.9

 
pts
% of total statutory commercial NPW
 
21
%
 
24

 
 
 
 
 
21
%
 
24

 
 
 
 

NPW increased on the commercial automobile line of business in both Second Quarter and Six Months 2012 compared to the same periods last year driven by:
New business was up 24%, or $5.3 million, to $27.4 million in Six Months 2012;
Renewal pure price rate increases of approximately 5% for Second Quarter and Six Months 2012; and
A one-point improvement in retention to 82% in Second Quarter 2012 and a two-point improvement to 82% in Six Months 2012.

The increase in the statutory combined ratio was primarily driven by lower favorable casualty prior year development in Second Quarter and Six Months 2012 compared to the same periods last year. Prior year casualty development was as follows:
2012: $2 million, or 2.1 points, of favorable development in Second Quarter 2012; and $3 million, or 1.8 points in Six Months 2012 driven by the 2009 accident year, partially offset by accident years 2011 and 2010; and
2011: $4 million, or 5.1 points, of favorable development in Second Quarter 2011, and $8 million, or 5.8 points, in Six Months 2011 driven by accident years 2006 through 2009.
 

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Table of Contents

Commercial Property
  
 
 
Quarter ended
June 30,
 
 
 
 
 
Six Months ended
June 30,
 
 
 
 
($ in thousands)
 
2012
 
2011
 
Change % or Points
 
 
 
2012
 
2011
 
Change % or Points
 
 
Statutory NPW
 
$
53,195

 
49,049

 
8

 
%
 
106,222

 
97,380

 
9

 
%
Statutory NPE
 
50,377

 
47,877

 
5

 
 
 
99,748

 
96,070

 
4

 
 
Statutory combined ratio
 
116.3
%
 
130.9

 
(14.6
)
 
pts
 
100.3
%
 
108.8

 
(8.5
)
 
pts
% of total statutory commercial NPW
 
15
%
 
16

 
 
 
 
 
15
%
 
16

 
 
 
 
 
NPW for the commercial property line of business increased in both Second Quarter and Six Months 2012 compared to the same periods in 2011 primarily due to: 
New business was up 17%, or $1.7 million, to $11.9 million, in Second Quarter 2012, and up 42%, or $7.8 million, to $26.0 million in Six Months 2012;
An increase in retention of one point, to 81%, in Second Quarter 2012, and a two-point increase, to 81%, in Six Months 2012; and
Renewal pure price increases of 5.5% in Second Quarter 2012 and 4.8% in Six Months 2012.

The statutory combined ratio was impacted by catastrophe losses of $14.4 million and $15.8 million in Second Quarter and Six Months 2012, respectively. While still elevated, there was a decrease in catastrophe losses in Second Quarter 2012 of $6.8 million, or 15.7 points, compared to Second Quarter 2011 and a decrease of $9.1 million, or 10.1 points, in Six Months 2012 compared to Six Months 2011.

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Table of Contents


Personal Lines
Personal Lines
 
Quarter ended June 30,
 
 
 
 
 
Six months ended June 30,
 
 
 
 
($ in thousands)
 
2012
 
2011
 
Change % or Points
 
 
 
2012
 
2011
 
Change % or Points
 
 
GAAP Insurance Operations Results:
 
 

 
 

 
 

 
 
 
 

 
 

 
 

 
 
NPW
 
$
76,805

 
71,198

 
8

 
%
 
142,351

 
132,699

 
7

 
%
NPE
 
69,956

 
65,285

 
7

 
 
 
138,565

 
129,865

 
7

 
 
Less:
 
 
 
 

 
 
 
 
 
 
 
 

 
 
 
 
Losses and loss expenses incurred
 
57,975

 
58,192

 

 
 
 
105,608

 
111,376

 
(5
)
 
 
Net underwriting expenses incurred
 
19,419

 
17,649

 
10

 
 
 
37,274

 
35,551

 
5

 
 
Underwriting loss
 
$
(7,438
)
 
(10,556
)
 
30

 
%
 
(4,317
)
 
(17,062
)
 
75

 
%
GAAP Ratios:
 
 
 
 

 
 
 
 
 
 
 
 

 
 
 
 
Loss and loss expense ratio
 
82.9
%
 
89.1

 
(6.2
)
 
pts
 
76.2
%
 
85.8

 
(9.6
)
 
pts
Underwriting expense ratio
 
27.7

 
27.1

 
0.6

 
 
 
26.9

 
27.3

 
(0.4
)
 
 
Combined ratio
 
110.6

 
116.2

 
(5.6
)
 
 
 
103.1

 
113.1

 
(10.0
)
 
 
Statutory Ratios:
 
 
 
 

 
 
 
 
 
 
 
 

 
 
 
 
Loss and loss expense ratio
 
82.9

 
89.2

 
(6.3
)
 
 
 
76.2

 
85.7

 
(9.5
)
 
 
Underwriting expense ratio
 
26.3

 
26.1

 
0.2

 
 
 
27.2

 
27.6

 
(0.4
)
 
 
Combined ratio
 
109.2
%
 
115.3

 
(6.1
)
 
pts
 
103.4
%
 
113.3

 
(9.9
)
 
pts

NPW increased in Second Quarter and Six Months 2012 compared to Second Quarter and Six Months 2011 primarily due to:
Filed rate increases that averaged 5.6% and 5.7% in Second Quarter and Six Months 2012, respectively; and
Retention of 86% in Six Months 2012, which was up slightly from last year.

NPE increases in Second Quarter and Six Months 2012, compared to the same periods last year, are consistent with the fluctuation in NPW for the 12-month period ended June 30, 2012 as compared to the 12-month period ended June 30, 2011.

Although the GAAP loss and loss expense ratio improved both in the quarterly and year-to-date periods, results were heavily impacted in both years by catastrophe losses. The following tables provide quantitative information regarding catastrophe losses:

 
 
Second Quarter
 
 
 
Six Months
 
($ in millions)
 
Catastrophe Losses Incurred
 
Impact to Loss and Loss Expense Ratio
 
 
 
Catastrophe Losses Incurred
 
Impact to Loss and Loss Expense Ratio
 
2012
$
11.6
 
16.5

pts
 
$
14.6
 
10.5
pts
2011
 
12.3
 
18.9

 
 
 
14.1
 
10.9
 

The Second Quarter and Six Months 2012 loss and loss expenses ratio also reflects favorable prior year casualty development. We experienced favorable prior year casualty development of 1.5 points in both Second Quarter and Six Months 2012, driven by the homeowners line of business, compared to adverse development of 0.8 points and 0.5 points in Second Quarter and Six Months 2011, respectively, which was driven by the personal auto line of business. The Six Month 2012 reduction in the loss and loss expense ratio was also reflective of a decrease in non-catastrophe property losses of $4.4 million, or 5.3 points.




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Table of Contents



Reinsurance

We use reinsurance to protect our capital resources and insure us against losses on property and casualty risks that we underwrite. We use two main reinsurance vehicles: (i) a reinsurance pooling agreement among our insurance subsidiaries ("Pooling Agreement") in which each company agrees to share in premiums and losses based on certain specified percentages; and (ii) reinsurance contracts and arrangements with third parties that cover various policies that our Insurance Operations issue to insureds.

Pooling Agreement
The primary purposes of the Pooling Agreement are the following:

Pool or share proportionately the underwriting profit and loss results of property and casualty insurance underwriting operations through reinsurance;
Prevent any of our insurance subsidiaries from suffering undue loss;
Reduce administration expenses; and
Permit all of the insurance subsidiaries to obtain a uniform rating from A.M. Best.

Under the Pooling Agreement, as of June 30, 2012, the following Insurance Subsidiaries mutually reinsured all
insurance risks written by them pursuant to the respective percentage set forth opposite each Insurance Subsidiary's
name on the table below:
    
Insurance Subsidiary
Respective Percentage
Selective Insurance Company of America
44.5%
Selective Way Insurance Company
21.0%
Selective Insurance Company of South Carolina
9.0%
Selective Insurance Company of the Southeast
7.0%
Selective Insurance Company of New York
7.0%
Selective Auto Insurance Company of New Jersey
6.0%
Mesa Underwriters Specialty Insurance Company
5.0%
Selective Insurance Company of New England
0.5%

On July 1, 2012, the Pooling Agreement was amended to add two newly-formed insurance companies, Selective Casualty Insurance Company and Selective Fire and Casualty Insurance Company with the following revised percentages:
    
Insurance Subsidiary
Respective Percentage
Selective Insurance Company of America
32.0%
Selective Way Insurance Company
21.0%
Selective Insurance Company of South Carolina
9.0%
Selective Insurance Company of the Southeast
7.0%
Selective Insurance Company of New York
7.0%
Selective Casualty Insurance Company(1)
7.0%
Selective Auto Insurance Company of New Jersey
6.0%
Mesa Underwriters Specialty Insurance Company
5.0%
Selective Insurance Company of New England
3.0%
Selective Fire and Casualty Insurance Company(1)
3.0%
     
(1) Anticipated to begin writing business on January 1, 2013.


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Table of Contents

Reinsurance Treaties and Arrangement
We successfully completed negotiations of our July 1, 2012 excess of loss treaties with highlights as follows:

Property Excess of Loss
The property excess of loss treaty (“Property Treaty”) was renewed with terms providing for per risk coverage of $38.0 million in excess of a $2.0 million retention. The prior treaty term provided per risk coverage of $28.0 million in excess of a $2.0 million retention. The per occurrence cap on the total program is $84.0 million;
The first layer continues to have unlimited reinstatements. The annual aggregate limit for the second $30.0 million in excess of $10.0 million layer, increased to $120.0 million from $80.0 million; and
Consistent with the prior year treaty, the Property Treaty excludes nuclear, biological, chemical, and radiological terrorism losses.

Casualty Excess of Loss
The casualty excess of loss treaty (“Casualty Treaty”) was renewed with substantially the same terms as the expiring treaty providing the following per occurrence coverage:
The first through the sixth layers provide coverage for 100% of up to $88.0 million in excess of a $2.0 million retention, consistent with the prior year treaty;
Consistent with the prior year, the Casualty Treaty excludes nuclear, biological, chemical, and radiological terrorism losses; and
Annual aggregate terrorism limits remain the same as the prior year treaty at $201.0 million.

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Table of Contents



Investments
Our investment philosophy includes certain return and risk objectives for the fixed maturity, equity, and other investment portfolios. The primary fixed maturity portfolio return objective is to maximize after-tax investment yield and income while balancing risk. A secondary objective is to meet or exceed a weighted-average benchmark of public fixed income indices. Within the equity portfolio, the high dividend yield equities strategy is designed to generate consistent dividend income while maintaining a minimal tracking error to the Standard & Poor’s (“S&P”) 500 Index. Additional equity security strategies are focused on meeting or exceeding strategy specific benchmarks of public equity indices. Although yield and income generation remain the key drivers to our investment strategy, our overall philosophy is to invest with a long-term horizon along with predominately a “buy-and-hold” approach. The return objective of the other investment portfolio, which includes alternative investments, is to meet or exceed the S&P 500 Index.
Total Invested Assets
 
 
 
 
 
 
($ in thousands)
 
June 30, 2012
 
December 31,
2011

 
Change %
Total invested assets
 
$
4,175,987

 
4,112,421

 
2
%
Unrealized gain – before tax
 
171,694

 
149,612

 
15

Unrealized gain – after tax
 
111,601

 
97,248

 
15

 
The increase in our investment portfolio compared to year-end 2011 was driven primarily by: (i) operating cash flows generated from Insurance Operations; and (ii) valuation improvements on securities in our available-for-sale (“AFS”) portfolio. The cash generated from our Insurance Operations in Six Months 2012 was used to invest primarily in corporate securities within our fixed maturity securities portfolio.

We structure our portfolio conservatively with a focus on: (i) asset diversification; (ii) investment quality; (iii) liquidity, particularly to meet the cash obligations of our Insurance Operations segment; (iv) consideration of taxes; and (v) preservation of capital. We believe that we have a high quality and liquid investment portfolio. The breakdown of our investment portfolio is as follows:
 
 
 
June 30,
2012

 
December 31,
2010

U.S. government obligations
 
7
%
 
9
%
Foreign government obligations
 
1

 
1

State and municipal obligations
 
31

 
30

Corporate securities
 
34

 
31

Mortgage-backed securities (“MBS”)
 
15

 
15

Asset-backed securities (“ABS”)
 
2

 
2

Total fixed maturity securities
 
90

 
88

Equity securities
 
4

 
4

Short-term investments
 
3

 
5

Other investments
 
3

 
3

Total
 
100
%
 
100
%

Fixed Maturity Securities 
The average duration of the fixed maturity securities portfolio as of June 30, 2012 was 3.4 years compared to the Insurance Subsidiaries’ liability duration of approximately 3.8 years. The current duration of the fixed maturity securities portfolio is within our historical range, and is monitored and managed to maximize yield and limit interest rate risk. We are currently experiencing pressure on our yields within our fixed maturity securities portfolio, as higher yielding bonds that are either maturing or have been sold are being replaced with the lower yielding bonds that are currently available in the marketplace. We manage liquidity with a laddered maturity structure and an appropriate level of short-term investments to avoid liquidation of AFS fixed maturities in the ordinary course of business. We typically have a long investment time horizon, and every purchase or sale is made with the intent of maximizing risk adjusted investment returns in the current market environment while balancing capital preservation. In Second Quarter 2012, we increased purchases of municipal bonds, MBS and investment-grade corporate bonds due to attractive risk/return opportunities in those sectors.
 

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Table of Contents

Our fixed maturity securities portfolio maintains a weighted average credit rating of “AA-” as of June 30, 2012. The following table presents the credit ratings of our fixed maturity securities portfolio:
 
Fixed Maturity Security Rating
 
June 30, 2012
 
December 31, 2011
Aaa/AAA
 
15
%
 
14
%
Aa/AA
 
49

 
52

A/A
 
25

 
24

Baa/BBB
 
9

 
9

Ba/BB or below
 
2

 
1

Total
 
100
%
 
100
%



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Table of Contents

The following table summarizes the fair value, unrealized gain (loss) balances, and the weighted average credit qualities of our AFS fixed maturity securities at June 30, 2012 and December 31, 2011:
 
 
June 30, 2012
 
December 31, 2011
($ in millions)
 
Fair
Value
 
Unrealized
Gain (Loss)
 
Weighted Average Credit Quality
 
Fair
Value
 
Unrealized
Gain (Loss)
 
Weighted Average Credit Quality
AFS Fixed Maturity Portfolio:
 
 

 
 

 
 
 
 

 
 

 
 
U.S. government obligations1
 
$
288.0

 
19.1

 
AA+
 
353.8

 
20.3

 
AA+
Foreign government obligations
 
42.8

 
1.2

 
AA
 
34.2

 
0.5

 
AA
State and municipal obligations
 
736.5

 
41.3

 
AA
 
622.7

 
44.4

 
AA
Corporate securities
 
1,348.7

 
65.6

 
A
 
1,213.3

 
44.9

 
A
MBS
 
612.2

 
19.2

 
AA
 
594.5

 
19.2

 
AA
Asset-backed securities ("ABS")
 
94.8

 
1.8

 
AAA
 
78.9

 
1.2

 
AAA
Total AFS fixed maturity portfolio
 
$
3,123.0

 
148.2

 
AA-
 
2,897.4

 
130.5

 
AA-
State and Municipal Obligations:
 
 

 
 

 
 
 
 

 
 

 
 
General obligations
 
$
327.2

 
20.3

 
AA+
 
282.6

 
22.1

 
AA+
Special revenue obligations
 
409.3

 
21.0

 
AA
 
340.1

 
22.3

 
AA
Total state and municipal obligations
 
$
736.5

 
41.3

 
AA
 
622.7

 
44.4

 
AA
Corporate Securities:
 
 

 
 

 
 
 
 

 
 

 
 
Financial
 
$
430.3

 
13.9

 
A
 
379.0

 
3.7

 
A
Industrials
 
95.9

 
7.3

 
A
 
86.9

 
6.1

 
A-
Utilities
 
89.8

 
4.8

 
A-
 
75.6

 
3.5

 
BBB+
Consumer discretion
 
124.6

 
6.9

 
BBB+
 
104.3

 
4.9

 
BBB+
Consumer staples
 
148.8

 
8.2

 
A
 
137.3

 
6.9

 
A
Healthcare
 
160.3

 
9.7

 
A+
 
145.0

 
8.3

 
AA-
Materials
 
66.7

 
4.0

 
A-
 
66.5

 
2.5

 
A-
Energy
 
88.0

 
3.9

 
A-
 
77.9

 
3.3

 
A-
Information technology
 
81.3

 
3.1

 
A
 
74.3

 
2.6

 
A
Telecommunications services
 
51.6

 
2.4

 
BBB+
 
50.9

 
1.5

 
BBB+
Other
 
11.4

 
1.4

 
AA+
 
15.6

 
1.6

 
AA+
Total corporate securities
 
$
1,348.7

 
65.6

 
A
 
1,213.3

 
44.9

 
A
MBS:
 
 

 
 

 
 
 
 

 
 

 
 
Government guaranteed agency commercial MBS ("CMBS")
 
$
67.0

 
3.5

 
AA+
 
72.9

 
5.0

 
AA+
Non-agency CMBS
 
51.1

 
(1.4
)
 
A+
 
39.7

 
(0.3
)
 
A-
Government guaranteed agency residential MBS ("RMBS")
 
102.6

 
4.8

 
AA+
 
98.2

 
4.7

 
AA+
Other agency RMBS
 
340.1

 
11.8

 
AA+
 
339.1

 
10.8

 
AA+
Non-agency RMBS
 
44.6

 
0.4

 
BBB+
 
37.1

 
(1.0
)
 
BBB
Alternative-A (“Alt-A”) RMBS
 
6.8

 
0.1

 
AA+
 
7.5

 

 
AA+
Total MBS
 
$
612.2

 
19.2

 
AA
 
594.5

 
19.2

 
AA
ABS:
 
 

 
 

 
 
 
 

 
 

 
 
ABS
 
$
93.5

 
1.8

 
AAA
 
77.5

 
1.3

 
AAA
Alt-A ABS3
 
0.7

 

 
D
 
0.7

 

 
D
Sub-prime ABS2, 3
 
0.6

 

 
D
 
0.7

 
(0.1
)
 
D
Total ABS
 
$
94.8

 
1.8

 
AAA
 
78.9

 
1.2

 
AAA
 
1 
U.S. government obligations include corporate securities fully guaranteed by the Federal Deposit Insurance Corporation (“FDIC”).
2 
We define sub-prime exposure as exposure to direct and indirect investments in non-agency residential mortgages with average FICO® scores below 650. 
3 
Alt-A ABS and subprime ABS each consist of one security whose issuer is currently expected by rating agencies to default on its obligations.


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Table of Contents

The following tables provide information regarding our held-to-maturity (“HTM”) fixed maturity securities and their credit qualities at June 30, 2012 and December 31, 2011:
June 30, 2012
 
 
 
 
 
 
 
 
 
 
 
 
 
($ in millions)
 
Fair
Value
 
Carry
Value
 
Unrecognized Holding Gain (Loss)
 
Unrealized Gain (Loss) in Accumulated Other Comprehensive Income
 
Total Unrealized/ Unrecognized Gain (Loss)
 
Weighted Average Credit Quality
HTM Portfolio:
 
 

 
 

 
 

 
 

 
 

 
 
Foreign government obligations
 
$
5.4

 
5.5

 
(0.1
)
 
0.2

 
0.1

 
AA+
State and municipal obligations
 
599.3

 
566.6

 
32.7

 
9.3

 
42.0

 
AA
Corporate securities
 
62.0

 
56.7

 
5.3

 
(1.3
)
 
4.0

 
A
MBS
 
13.8

 
8.4

 
5.4

 
(1.4
)
 
4.0

 
AA-
ABS
 
7.5

 
6.3

 
1.2

 
(1.2
)
 

 
A
Total HTM portfolio
 
$
688.0

 
643.5

 
44.5

 
5.6

 
50.1

 
AA
State and Municipal Obligations:
 
 

 
 

 
 

 
 

 
 

 
 
General obligations
 
$
196.0

 
186.6

 
9.4

 
5.0

 
14.4

 
AA
Special revenue obligations
 
403.3

 
380.0

 
23.3

 
4.3

 
27.6

 
AA
Total state and municipal obligations
 
$
599.3

 
566.6

 
32.7

 
9.3

 
42.0

 
AA
Corporate Securities:
 
 

 
 

 
 

 
 

 
 

 
 
Financial
 
$
15.6

 
14.0

 
1.6

 
(1.0
)
 
0.6

 
BBB+
Industrials
 
19.1

 
17.4

 
1.7

 
(0.3
)
 
1.4

 
A
Utilities
 
15.4

 
13.7

 
1.7

 
(0.1
)
 
1.6

 
A
Consumer discretion
 
4.8

 
4.6

 
0.2

 
0.1

 
0.3

 
AA
Consumer staples
 
5.0

 
5.0

 

 

 

 
A
Materials
 
2.1

 
2.0

 
0.1

 

 
0.1

 
BBB
Total corporate securities
 
$
62.0

 
56.7

 
5.3

 
(1.3
)
 
4.0

 
A
MBS:
 
 

 
 

 
 

 
 

 
 

 
 
Non-agency CMBS
 
$
13.8

 
8.4

 
5.4

 
(1.4
)
 
4.0

 
AA-
Total MBS
 
$
13.8

 
8.4

 
5.4

 
(1.4
)
 
4.0

 
AA-
ABS:
 
 

 
 

 
 

 
 

 
 

 
 
ABS
 
$
5.2

 
4.6

 
0.6

 
(0.4
)
 
0.2

 
BBB+
Alt-A ABS
 
2.3

 
1.7

 
0.6

 
(0.8
)
 
(0.2
)
 
AAA
Total ABS
 
$
7.5

 
6.3

 
1.2

 
(1.2
)
 

 
A
 



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Table of Contents

December 31, 2011
 
 
 
 
 
 
 
 
 
 
 
 

 
($ in millions)
 
Fair
Value
 
Carry
Value
 
Unrecognized Holding Gain (Loss)
 
Unrealized Gain (Loss) in AOCI
 
Total Unrealized/ Unrecognized Gain (Loss)
 
Weighted Average Credit Quality
HTM Portfolio:
 
 

 
 

 
 

 
 

 
 

 
 
Foreign government obligations
 
$
5.5

 
5.6

 
(0.1
)
 
0.3

 
0.2

 
AA+
State and municipal obligations
 
657.4

 
626.0

 
31.4

 
11.9

 
43.3

 
AA
Corporate securities
 
69.5

 
62.6

 
6.9

 
(2.2
)
 
4.7

 
A
MBS
 
17.7

 
11.5

 
6.2

 
(3.0
)
 
3.2

 
AA-
ABS
 
7.9

 
6.6

 
1.3

 
(1.4
)
 
(0.1
)
 
A
Total HTM portfolio
 
$
758.0

 
712.3

 
45.7

 
5.6

 
51.3

 
AA
State and Municipal Obligations:
 
 

 
 

 
 

 
 

 
 

 
 
General obligations
 
$
214.8

 
205.3

 
9.5

 
6.3

 
15.8

 
AA
Special revenue obligations
 
442.6

 
420.7

 
21.9

 
5.6

 
27.5

 
AA
Total state and municipal obligations
 
$
657.4

 
626.0

 
31.4

 
11.9

 
43.3

 
AA
Corporate Securities:
 
 

 
 

 
 

 
 

 
 

 
 
Financial
 
$
20.7

 
18.5

 
2.2

 
(1.5
)
 
0.7

 
A-
Industrials
 
20.3

 
17.8

 
2.5

 
(0.7
)
 
1.8

 
A
Utilities
 
15.4

 
13.7

 
1.7

 
(0.1
)
 
1.6

 
A+
Consumer discretion
 
5.9

 
5.6

 
0.3

 
0.1

 
0.4

 
AA-
Consumer staples
 
5.1

 
5.0

 
0.1

 

 
0.1

 
A
Materials
 
2.1

 
2.0

 
0.1

 

 
0.1

 
BBB
Total corporate securities
 
$
69.5

 
62.6

 
6.9

 
(2.2
)
 
4.7

 
A
MBS:
 
 

 
 

 
 

 
 

 
 

 
 
Non-agency CMBS
 
$
17.7

 
11.5

 
6.2

 
(3.0
)
 
3.2

 
AA-
Total MBS
 
$
17.7

 
11.5

 
6.2

 
(3.0
)
 
3.2

 
AA-
ABS:
 
 

 
 

 
 

 
 

 
 

 
 
ABS
 
$
5.6

 
5.0

 
0.6

 
(0.5
)
 
0.1

 
BBB+
Alt-A ABS
 
2.3

 
1.6

 
0.7

 
(0.9
)
 
(0.2
)
 
AAA
Total ABS
 
$
7.9

 
6.6

 
1.3

 
(1.4
)
 
(0.1
)
 
A
 
A portion of our AFS and HTM municipal bonds contain insurance enhancements. The following table provides information regarding these insurance-enhanced securities as of June 30, 2012:

Insurers of Municipal Bond Securities
 
 
 
 
 
 
($ in thousands)
 
Fair Value
 
Ratings
 With
Insurance
 
Ratings
without
Insurance
National Public Finance Guarantee Corporation, a subsidiary of MBIA, Inc.
 
$
315,753

 
AA-
 
AA-
Assured Guaranty
 
213,425

 
AA
 
AA-
Ambac Financial Group, Inc.
 
89,635

 
AA-
 
AA-
Other
 
15,025

 
AA
 
AA-
Total
 
$
633,838

 
AA-
 
AA-
 
To manage and mitigate exposure, we perform analyses on MBS both at the time of purchase and as part of the ongoing portfolio evaluation. This analysis includes review of average FICO® scores, loan-to-value ratios, geographic spread of the assets securing the bond, delinquencies in payments for the underlying mortgages, gains/losses on sales, evaluations of projected cash flows, as well as other information that aids in determination of the health of the underlying assets. We also consider the overall credit environment, economic conditions, total projected return on the investment, and overall asset allocation of the portfolio in our decisions to purchase or sell structured securities.


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The following table details the top 10 state exposures of the municipal bond portion of our fixed maturity securities portfolio at June 30, 2012:
State Exposures of Municipal Bonds 
 
 
 
 
 
 
 
 
 
 
General Obligation
 
Special
Revenue
 
Fair
Value
 
Weighted Average Credit Quality
($ in thousands)
 
Local
 
State
 
 
 
Texas
 
$
79,433

 
1,120

 
54,345

 
134,898

 
AA+
Washington
 
49,282

 
7,084

 
35,592

 
91,958

 
AA
New York
 
3,564

 

 
81,363

 
84,927

 
AA+
Arizona
 
7,189

 

 
65,353

 
72,542

 
AA
Colorado
 
34,405

 
1,775

 
21,929

 
58,109

 
AA-
Florida
 

 
3,619

 
50,243

 
53,862

 
A+
Illinois
 
20,353

 

 
27,397

 
47,750

 
AA-
Ohio
 
13,398

 
7,133

 
22,818

 
43,349

 
AA
North Carolina
 
13,791

 
3,724

 
24,259

 
41,774

 
AA
Missouri
 
17,017

 

 
21,052

 
38,069

 
AA+
Other
 
118,756

 
105,032

 
357,350

 
581,138

 
AA
 
 
357,188

 
129,487

 
761,701

 
1,248,376

 
AA
Pre-refunded/escrowed to maturity bonds
 
24,340

 
12,170

 
50,901

 
87,411

 
AA
Total
 
$
381,528

 
141,657

 
812,602

 
1,335,787

 
AA
 
There has been recent concern regarding the stress on state and local governments emanating from declining revenues, large unfunded liabilities, and entrenched cost structures. We are comfortable with the quality, composition, and diversification of our $1.3 billion municipal bond portfolio.  Our municipal bond portfolio is very high quality with an average AA rating and is well laddered with 42% maturing within three years, and another 33% maturing between three and five years. The weightings of the municipal bond portfolio are: 61% of high-quality revenue bonds that have dedicated revenue streams, 29% of local general obligation bonds, and 10% of state general obligation bonds. In addition, approximately 7% of the municipal bond portfolio has been pre-refunded, meaning assets have been placed in trust to fund the maturity of the bonds. Our largest state exposure is to Texas, at 10% excluding the impact of pre-refunded bonds.  Of the $79 million in local Texas general obligation bonds, $35 million represents investments in Texas Permanent School Fund bonds, which are considered to be of lower risk.
 
The sector composition and credit quality of our special revenue bonds did not significantly change from December 31, 2011. For details regarding our special revenue bond sectors and additional information regarding credit risk associated with our portfolio, see Item 7A. “Quantitative and Qualitative Disclosures About Market Risk.” of our 2011 Annual Report.
 
Our top Eurozone exposures as of June 30, 2012 were as follows:
 
June 30, 2012
 
 
 
 
 
 
 
 
($ in millions)
 
Corporate Securities
 
Government Securities
 
Equity Securities
 
Total Exposure
Country:
 
 

 
 

 
 

 
 

Netherlands
 
$
22.8

 
1.0

 

 
23.8

Germany
 
5.2

 
11.0

 

 
16.2

France
 
12.9

 

 

 
12.9

Luxembourg
 
8.4

 

 

 
8.4

Spain
 
4.7

 

 

 
4.7

Finland
 

 
3.1

 

 
3.1

Ireland
 

 

 
1.3

 
1.3

Other
 

 
3.2

 

 
3.2

Total
 
$
54.0

 
18.3

 
1.3

 
73.6

Average Credit Rating1
 
A

 
AAA

 
N/A

 
A+

1 
Total credit rating of Eurozone exposure excludes equity securities. 


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Uncertainty about the ability of certain sovereign issuers to fully repay their debt triggered significant turbulence in global financial markets in 2011 and continues to cause market volatility in 2012.  The sovereign debt crisis has been particularly concentrated in the Eurozone and a number of member countries have been repeatedly downgraded by the major ratings agencies.  The crisis has placed strains on the stability of the Euro currency as the European Central Bank struggled to supply liquidity to member nations and their banks.  As of June 30, 2012, we had no direct exposure to issuers domiciled in Italy, Greece, or Portugal, three of the more economically troubled nations in the Eurozone. We do not own any derivative exposures such as credit default swaps.  Of the $54.0 million in Eurozone corporate securities in our portfolio, $33.7 million is in the banking and financial sector and carries an average credit quality of A+.  Outside of the effect foreign currency exchange rates have on the underlying investments, we have minimal exposure to Euro depreciation/appreciation.
 
Equity Securities
Our equity securities portfolio was 4% of invested assets as of June 30, 2012, a consistent level compared to year end 2011. Our 2011 transition into a high-dividend yield equities strategy within this portfolio resulted in dividend income in Six Months 2012 that is more than twice the income that was reported in the same period last year. In Six Months 2012, we rebalanced our holdings within this portfolio, generating net proceeds of $17.8 million with net realized gains of $4.3 million.

Other Investments
As of June 30, 2012, alternative investments represented 3% of our total invested assets.  The following table outlines a summary of our other investment portfolio by strategy and the remaining commitment amount associated with each strategy:
 
Other Investments
 
Carrying Value
 
June 30, 2012 Remaining Commitment
($ in thousands)
 
June 30, 2012
 
December 31, 2011
 
Alternative Investments:
 
 
 
 
 
 
Secondary private equity
 
$
29,596

 
30,114

 
8,651

Private equity
 
23,739

 
21,736

 
3,984

Energy/power generation
 
21,578

 
25,913

 
10,383

Distressed debt
 
14,702

 
16,953

 
2,986

Real estate
 
12,961

 
13,767

 
10,473

Mezzanine financing
 
11,146

 
8,817

 
23,435

Venture capital
 
7,856

 
7,248

 
800

Total alternative investments
 
121,578

 
124,548

 
60,712

Other securities
 
3,962

 
3,753

 
1,494

Total other investments
 
$
125,540

 
128,301

 
62,206


In addition to the capital that we have already invested to date, we are contractually obligated to invest up to an additional $62.2 million in these alternative investments through commitments that currently expire at various dates through 2022. For a description of our seven alternative investment strategies outlined above, as well as redemption, restrictions, and fund liquidations, refer to Note 5. “Investments” in Item 8. “Financial Statements and Supplementary Data.” of our 2011 Annual Report. In addition, for information on current year activity, refer to Note 6. "Investments" of this Form 10-Q.
 

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Table of Contents

Net Investment Income
The components of net investment income earned were as follows:

 
 
Quarter ended June 30,
 
Six Months ended June 30,
($ in thousands)
 
2012
 
2011
 
2012
 
2011
Fixed maturity securities
 
$
31,759

 
32,752

 
63,109

 
65,875

Equity securities
 
1,280

 
785

 
2,517

 
1,102

Short-term investments
 
29

 
33

 
67

 
95

Other investments
 
2,963

 
7,900

 
4,963

 
19,541

Miscellaneous income
 
25

 
22

 
64

 
47

Investment expenses
 
(2,050
)
 
(2,147
)
 
(4,086
)
 
(3,842
)
Net investment income earned – before tax
 
34,006

 
39,345

 
66,634

 
82,818

Net investment income tax expense
 
(8,296
)
 
(9,925
)
 
(16,149
)
 
(21,273
)
Net investment income earned – after tax
 
25,710

 
29,420

 
50,485

 
61,545

Effective tax rate
 
24.4
%
 
25.2
%
 
24.2
%
 
25.7
%
Annual after-tax yield on fixed maturity securities
 
 
 
 

 
2.6

 
2.8

Annual after-tax yield on investment portfolio
 
 
 
 

 
2.4

 
3.1


Net investment income earned, before tax, decreased by $5.3 million for Second Quarter 2012 compared to Second Quarter 2011 and decreased by $16.2 million for Six Months 2012 compared to Six Months 2011. These decreases were primarily driven by lower income from our alternative investments within our investment portfolio of $4.7 million and $14.1 million in Second Quarter 2012 and Six Months 2012, respectively. Our alternative investments, which are accounted for under the equity method, primarily consist of investments in limited partnerships, the majority of which report results to us on a one quarter lag.
 
Realized Gains and Losses
Realized Gains and Losses (excluding OTTI)
Realized gains and losses, by type of security excluding OTTI charges, are determined on the basis of the cost of specific investments sold and are credited or charged to income. The components of net realized gains were as follows:

 
 
Quarter ended
June 30,
 
Six Months ended
June 30,
($ in thousands)
 
2012
 
2011
 
2012
 
2011
HTM fixed maturity securities
 
 
 
 
 
 
 
 
Gains
 
$
2

 
8

 
155

 
9

Losses
 
(25
)
 
(108
)
 
(106
)
 
(322
)
AFS fixed maturity securities
 
 

 
 

 
 

 
 

Gains
 
368

 
1,947

 
773

 
2,354

Losses
 
(74
)
 

 
(117
)
 
(7
)
AFS equity securities
 
 

 
 

 
 

 
 

Gains
 

 
468

 
4,775

 
6,671

Losses
 

 

 
(428
)
 

Short-term investments
 
 

 
 

 
 

 
 

Losses
 

 

 
(2
)
 

Other Investments
 
 
 
 
 
 
 
 
     Gains
 
1

 

 
1

 

Total other net realized investment gains
 
272

 
2,315

 
5,051

 
8,705

Total OTTI charges recognized in earnings
 
(94
)
 
(169
)
 
(515
)
 
(799
)
Total net realized gains
 
178

 
2,146

 
4,536

 
7,906

 
For a discussion of realized gains and losses, see Note 6. “Investments” in Item 1. “Financial Statements” of this Form 10-Q.
 

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Our general philosophy for sales of securities is to reduce our exposure to securities and sectors based upon economic evaluations and when the fundamentals for that security or sector have deteriorated, or to opportunistically trade out of securities to other securities with better economic return characteristics. We typically have a long investment time horizon, and every purchase or sale is made with the intent of maximizing risk adjusted investment returns in the current market environment while balancing capital preservation.
 
There were no securities sold at a loss during Second Quarter 2012.  In Six Months 2012, certain equity securities were sold at a loss that were in a continuous loss position for three months or less prior to their sale. The fair value of these securities as of their sale date was $3.2 million with related realized losses of $0.3 million.
 
Other-than-Temporary Impairments
The following table provides information regarding our OTTI charges recognized in earnings:
 
 
 
Quarter ended
June 30,
 
Six Months ended
June 30,
($ in thousands)
 
2012
 
2011
 
2012
 
2011
AFS securities
 
 
 
 

 
 
 
 

Obligations of state and political subdivisions
 
$

 

 

 
17

Corporate securities
 

 

 

 
244

ABS
 
30

 

 
62

 

CMBS
 

 
142

 
108

 
472

RMBS
 
64

 
27

 
174

 
66

Total AFS securities
 
94

 
169

 
344

 
799

Equity securities
 

 

 
171

 

Total OTTI charges recognized in earnings
 
$
94

 
169

 
515

 
799


We regularly review our entire investment portfolio for declines in fair value. If we believe that a decline in the value of a particular investment is other than temporary, we record it as an OTTI, through realized losses in earnings for the credit-related portion and through unrealized losses in other comprehensive income for the non-credit related portion. If there is a decline in fair value of an equity security that we do not intend to hold, or if we determine the decline is other than temporary, we write down the cost of the investment to fair value and record the charge through earnings as a component of realized losses.
 
For discussion of our OTTI methodology, see Note 2. “Summary of Significant Accounting Policies” in Item 8. “Financial Statements and Supplementary Data.” of our 2011 Annual Report.
 
Unrealized/Unrecognized Losses
As evidenced by the table below, our unrealized/unrecognized loss positions improved by $1.9 million as of June 30, 2012 compared to December 31, 2011 as follows:
($ in thousands)
 
 
June 30, 2012
 
December 31, 2011
Number of Issues
% of Market/Book
Unrealized Unrecognized Loss
 
Number of
Issues
% of Market/Book
Unrealized Unrecognized Loss
80% - 99%
$
6,817

 
80% - 99%
$
10,166

60% - 79%
1,580

 
60% - 79%

40% - 59%
342

 
40% - 59%
469

20% - 39%

 
20% - 39%

0% - 19%

 
0% - 19%

 
 
$
8,739

 
 
 
$
10,635


We have reviewed the securities in the table above in accordance with our OTTI policy, which is discussed in Note 2. “Summary of Significant Accounting Policies” in Item 8. “Financial Statements and Supplementary Data.” of our 2011 Annual Report. We have concluded that these securities are temporarily impaired as of June 30, 2012. For additional information regarding the unrealized/unrecognized losses between our AFS and HTM portfolios, see Note 6. “Investments,” in Item 1. “Financial Statements” of this Form 10-Q.

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Table of Contents


Contractual Maturities
The following table presents amortized cost and fair value information for our AFS fixed maturity securities that were in an unrealized loss position at June 30, 2012 by contractual maturity:

($ in thousands)
 
Amortized
Cost
 
Fair
Value
One year or less
 
$
18,704

 
17,949

Due after one year through five years
 
80,603

 
77,209

Due after five years through ten years
 
59,985

 
58,917

Due after ten years
 
41,413

 
41,032

Total
 
$
200,705

 
195,107

 
The following table presents amortized cost and fair value information for our HTM fixed maturity securities that were in an unrealized/unrecognized loss position at June 30, 2012 by contractual maturity:
 
($ in thousands)
 
Amortized
Cost
 
Fair
Value
One year or less
 
$
6,486

 
6,476

Due after one year through five years
 
8,516

 
8,172

Total
 
$
15,002

 
14,648


Investments Outlook
According to the Bureau of Economic Analysis, real gross domestic product increased at a 1.9% annual rate in the first quarter of 2012 compared to the 1.7% annual increase for 2011. The labor market strength exhibited in the first quarter has weakened in Second Quarter 2012 with the Bureau of Labor Statistics reporting an increase of 80,000 jobs in June and an unemployment rate of 8.2%. The risk factors causing economic concern remain relatively consistent with last year, namely slower global growth rates, domestic housing market overhang, sovereign debt stability, and U.S. fiscal uncertainty in a Presidential election year. Volatility in equity and bond markets returned during Second Quarter 2012. The Federal Reserve continues to maintain an accommodative monetary policy and interest rates remain low. The outlook for 2012 reflects the continuing challenge for the fixed maturity securities portfolio to maintain credit quality while overcoming the spread between maturing assets and the reinvestment rate available.

Our fixed maturity securities strategy remains focused on maintaining sufficient liquidity while maximizing yield within acceptable risk tolerances.  We will continue to invest in high-quality instruments, including additions to investment grade corporate bonds and municipal bonds with diversified maturities to manage incremental interest rate risk. We may opportunistically invest in below investment grade securities to take advantage of risk adjusted return opportunities.

The allocation to a high dividend yield equities strategy is being maintained, and has improved diversification in the equity portfolio while providing additional yield. The strategy is relatively sector-neutral, provides broad based exposure to the domestic equity market, and provides attractive current income yields.

Our current outlook for alternative investments remains positive and private markets continue to offer attractive risk adjusted returns.

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Financial Condition, Liquidity, Short-term Borrowings, and Capital Resources
Capital resources and liquidity reflect our ability to generate cash flows from business operations, borrow funds at competitive rates, and raise new capital to meet operating and growth needs.
 
Liquidity
We manage liquidity with a focus on generating sufficient cash flows to meet both the short-term and long-term cash requirements of our business operations. Our cash and short-term investment position was $136.0 million at June 30, 2012, primarily comprised of $22.3 million at Selective Insurance Group, Inc. (the “Parent”) and $113.7 million at the Insurance Subsidiaries. Short-term investments are generally maintained in AAA-rated money market funds approved by the National Association of Insurance Commissioners.
 
Sources of cash for the Parent have historically consisted of dividends from the Insurance Subsidiaries, borrowings under lines of credit and the Federal Home Loan Bank of Indianapolis (“FHLBI”) through our Indiana-domiciled Insurance Subsidiaries’ (“Indiana Subsidiaries”) loan agreements, and the issuance of stock and debt securities. We continue to monitor these sources, giving consideration to our long-term liquidity and capital preservation strategies.
 
We currently anticipate the Insurance Subsidiaries paying approximately $196 million in total dividends to the Parent in 2012, of which $28.5 million was paid through Second Quarter 2012, compared to our allowable ordinary maximum dividend amount of approximately $108 million. Subsequent to June 30, 2012, an extraordinary cash and property dividend of approximately $139 million was paid to the Parent from Selective Insurance Company of America to capitalize the formation of two additional New Jersey domiciled insurance companies and the re-domestication of Selective Insurance Company of New England from Maine to New Jersey.  

Any dividends to the Parent continue to be subject to the approval and/or review of the insurance regulators in the respective domiciliary states under insurance holding company acts, and are generally payable only from earned surplus as reported in the statutory annual statements of those subsidiaries as of the preceding December 31. Although past dividends have historically been met with regulatory approval, there is no assurance that future dividends that may be declared will be approved. For additional information regarding dividend restrictions, refer to Note 6. “Stockholders' Equity and Other Comprehensive Income (Loss)” in Item 8. “Financial Statements and Supplementary Data.” of our 2011 Annual Report.

The Parent had no private or public issuances of stock or debt during 2012 and there were no borrowings under its $30 million line of credit (“Line of Credit”). The Indiana Subsidiaries’ membership in the FHLBI provides these companies with access to additional liquidity. The Indiana Subsidiaries’ aggregate investment of $2.9 million provides them with the ability to borrow up to 20 times the total amount of the FHLBI common stock purchased, at comparatively low borrowing rates. The Parent’s Line of Credit agreement permits collateralized borrowings by the Indiana Subsidiaries from the FHLBI as long as the aggregate amount borrowed does not exceed 10% of the respective Indiana Subsidiary’s admitted assets from the preceding calendar year. For additional information regarding the Parent’s Line of Credit, refer to the section below entitled “Short-term Borrowings.” All borrowings from the FHLBI are required to be secured by certain investments. For additional information regarding the required collateral, refer to Note 6, “Investments” in Item 1. “Financial Statements” of this Form 10-Q. The Indiana Department of Insurance has approved lending agreements from each of the Indiana Subsidiaries to the Parent for up to 10% of the admitted assets of the respective Indiana Subsidiary. At June 30, 2012, the outstanding borrowings of the Indiana Subsidiaries from the FHLBI were $58 million. The Indiana Subsidiaries have the ability to borrow an aggregate of approximately $26 million more from the FHLBI until the Line of Credit maximum borrowings of 10% of admitted assets is reached. In addition, pursuant to the lending agreements between the Indiana Subsidiaries and the Parent, additional borrowings by the Parent from the Indiana Subsidiaries are limited to approximately $18 million.
 
The Insurance Subsidiaries also generate liquidity through insurance float, which is created by collecting premiums and earning investment income before losses are paid. The period of the float can extend over many years. Our investment portfolio consists of maturity dates that are well-laddered to continually provide a source of cash flows for claims payments in the ordinary course of business. The duration of the fixed maturity securities portfolio, excluding short-term investments, was 3.4 years as of June 30, 2012, while the liabilities of the Insurance Subsidiaries have a duration of approximately 3.8 years. In addition, the Insurance Subsidiaries purchase reinsurance coverage for protection against any significantly large claims or catastrophes that may occur during the year.
 
The liquidity generated from the sources discussed above is used, among other things, to pay dividends to our shareholders. Dividends on shares of the Parent’s common stock are declared and paid at the discretion of the Board of Directors based on our operating results, financial condition, capital requirements, contractual restrictions, and other relevant factors.
 

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Our ability to meet our interest and principal repayment obligations on our debt, as well as our ability to continue to pay dividends to our stockholders is dependent on liquidity at the Parent coupled with the ability of the Insurance Subsidiaries to pay dividends, if necessary, and/or the availability of other sources of liquidity to the Parent. Our next principal repayments of $13 million and $45 million are due in 2014 and 2016, respectively. Subsequent to 2016, our next principal repayment is due in 2034. Restrictions on the ability of the Insurance Subsidiaries to declare and pay dividends, without alternative liquidity options, could materially affect the Parent’s ability to service its debt and pay dividends on common stock.

Short-term Borrowings
Our Line of Credit with Wells Fargo Bank, National Association, as administrative agent, and Branch Banking and Trust Company (BB&T), was renewed effective June 13, 2011 with a borrowing capacity of $30 million, which can be increased to $50 million with the approval of both lending parties. This Line of Credit provides the Parent an additional source of short-term liquidity, if needed. The interest rate on our Line of Credit varies and is based on the Parent’s debt ratings. The Line of Credit expires on June 13, 2014. There were no balances outstanding under this credit facility as of June 30, 2012 or at any time during 2012.
 
The Line of Credit agreement contains representations, warranties, and covenants that are customary for credit facilities of this type, including, without limitation, financial covenants under which we are obligated to maintain a minimum consolidated net worth, minimum combined statutory surplus, and maximum ratio of consolidated debt to total capitalization, as well as covenants limiting our ability to: (i) merge or liquidate; (ii) incur debt or liens; (iii) dispose of assets; (iv) make investments and acquisitions; and (v) engage in transactions with affiliates.

The table below outlines information regarding certain of the covenants in the Line of Credit:
 
 
Required as of
June 30, 2012
Actual as of
June 30, 2012
Consolidated net worth
$803 million
$1.1 billion
Statutory surplus
Not less than $750 million
$1.1 billion
Debt-to-capitalization ratio1
Not to exceed 35%
20.8%
A.M. Best financial strength rating
Minimum of A-
A
1 
Calculated in accordance with the Line of Credit agreement.
 
Capital Resources
Capital resources provide protection for policyholders, furnish the financial strength to support the business of underwriting insurance risks, and facilitate continued business growth. At June 30, 2012, we had statutory surplus and GAAP stockholders’ equity of $1.1 billion. We had total debt of $307.4 million at June 30, 2012, which equates to a debt-to-capital ratio of 22.1%.
 
Our cash requirements include, but are not limited to, principal and interest payments on various notes payable and dividends to stockholders, payment of claims, payment of commitments under limited partnership agreements and capital expenditures, as well as other operating expenses, which include agents’ commissions, labor costs, premium taxes, general and administrative expenses, and income taxes. For further details regarding our cash requirements, refer to the section below entitled “Contractual Obligations, Contingent Liabilities, and Commitments.”
 
We continually monitor our cash requirements and the amount of capital resources that we maintain at the holding company and operating subsidiary levels. As part of our long-term capital strategy, we strive to maintain capital metrics, relative to the macroeconomic environment, that support our targeted financial strength. Based on our analysis and market conditions, we may take a variety of actions, including, but not limited to, contributing capital to our subsidiaries in our Insurance Operations, issuing additional debt and/or equity securities, repurchasing shares of the Parent’s common stock, and increasing stockholders’ dividends.
 
Our capital management strategy is intended to protect the interests of the policyholders of the Insurance Subsidiaries and our stockholders, while enhancing our financial strength and underwriting capacity.
 
Book value per share increased to $19.75 as of June 30, 2012, from $19.45 as of December 31, 2011, primarily driven by: (i) net income, which led to an increase in book value per share of $0.33; and (ii) an increase in unrealized gains on our investment portfolio, which led to an increase in book value per share of $0.26. Partially offsetting these increases were the impact of dividends paid to our shareholders, which resulted in a decrease in book value per share of $0.26.
 

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Ratings
We are rated by major rating agencies that issue opinions on our financial strength, operating performance, strategic position, and ability to meet policyholder obligations. We believe that our ability to write insurance business is most influenced by our rating from A.M. Best and Company ("A.M. Best"). In Second Quarter 2012, A.M. Best lowered our rating to “A (Excellent),” their third highest of 15 ratings, with a “stable” outlook. The change resulted from their assessment of our operating performance over the most recent five-year period relative to the commercial casualty composite index despite recognizing that recent performance has been negatively impacted by record catastrophic and weather-related losses. They cited solid risk-adjusted capitalization, disciplined underwriting focus, increasing use of predictive modeling technology, and our strong independent agency relationships in support of the “A (Excellent)” rating. We have been rated “A” or higher by A.M. Best for the past 82 years. A downgrade from A.M. Best to a rating below “A-” could: (i) affect our ability to write new business with customers and/or agents, some of whom are required (under various third-party agreements) to maintain insurance with a carrier that maintains a specified A.M. Best minimum rating; or (ii) be an event of default under our Line of Credit.

Ratings by other major rating agencies are as follows:

S&P Insurance Rating Services - S&P cites our strong competitive position in Mid-Atlantic markets, effective use of well-developed predictive modeling and agency interface technology, strong financial flexibility, and strong capital adequacy in support of our “A” financial strength rating and outlook of stable.

Moody's Investor Service (“Moody's”) - Moody's cited our strong regional franchise with established independent agency support, along with good risk adjusted capitalization and moderate financial leverage in support of our financial strength rating of “A2” with a stable outlook.  Their outlook reflects the expectation that we will continue to employ our technologically-based risk management process to identify and manage underperforming segments, while maintaining pricing discipline and reserve adequacy.

Fitch Ratings - Our “A+” rating and outlook of stable was reaffirmed in Second Quarter 2012, citing our disciplined underwriting culture, conservative balance sheet with very good capitalization and reserve strength, strong independent agency relationships, and improved diversification through our continued efforts to reduce our concentration in New Jersey.  

Our S&P and Moody's financial strength ratings affect our ability to access capital markets.  There can be no assurance that our ratings will continue for any given period of time or that they will not be changed.  It is possible that positive or negative ratings actions by one or more of the rating agencies may occur in the future.

Off-Balance Sheet Arrangements
At June 30, 2012 and December 31, 2011, we did not have any material relationships with unconsolidated entities or financial partnerships, such entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or for other contractually narrow or limited purposes. As such, we are not exposed to any material financing, liquidity, market, or credit risk that could arise if we had engaged in such relationships.
 
Contractual Obligations, Contingent Liabilities, and Commitments
Our future cash payments associated with loss and loss expense reserves, contractual obligations pursuant to operating leases for office space and equipment, and notes payable have not materially changed since December 31, 2011. We expect to have the capacity to repay and/or refinance these obligations as they come due.
 
At June 30, 2012, we had contractual obligations that expire at various dates through 2022 that may require us to invest up to an additional $62.2 million in alternative and other investments. There is no certainty that any such additional investment will be required. We have issued no material guarantees on behalf of others and have no trading activities involving non-exchange traded contracts accounted for at fair value. We have no material transactions with related parties other than those disclosed in Note 18. “Related Party Transactions” included in Item 8. “Financial Statements and Supplementary Data.” of our 2011 Annual Report.
 
ITEM 3.    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
There have been no material changes in the information about market risk set forth in our 2011 Annual Report.

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ITEM 4.   CONTROLS AND PROCEDURES
Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of our disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (“Exchange Act”)), as of the end of the period covered by this report. Based on such evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of such period, our disclosure controls and procedures are: (i) effective in recording, processing, summarizing, and reporting information on a timely basis that we are required to disclose in the reports that we file or submit under the Exchange Act; and (ii) effective in ensuring that information that we are required to disclose in the reports that we file or submit under the Exchange Act is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. No changes in our internal control over financial reporting (as such term is defined in Rule 13a-15(f) of the Exchange Act) occurred during Second Quarter 2012 that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.



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PART II - OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS
In the ordinary course of conducting business, we are named as defendants in various legal proceedings. Most of these proceedings are claims litigation involving our Insurance Subsidiaries as either: (a) liability insurers defending or providing indemnity for third-party claims brought against insureds; or (b) insurers defending first-party coverage claims brought against them. We account for such activity through the establishment of unpaid loss and loss adjustment expense reserves. We expect that the ultimate liability, if any, with respect to such ordinary course claims litigation, after consideration of provisions made for potential losses and costs of defense, will not be material to our consolidated financial condition, results of operations, or cash flows.
 
Our Insurance Subsidiaries are also from time-to-time involved in other legal actions, some of which assert claims for substantial amounts. These actions include, among others, putative class actions seeking certification of a state or national class. Such putative class actions have alleged, for example, improper reimbursement of medical providers paid under workers compensation and personal and commercial automobile insurance policies. Our Insurance Subsidiaries are also involved from time-to-time in individual actions in which extra-contractual damages, punitive damages, or penalties are sought, such as claims alleging bad faith in the handling of insurance claims. We believe that we have valid defenses to these cases. We expect that the ultimate liability, if any, with respect to such lawsuits, after consideration of provisions made for estimated losses, will not be material to our consolidated financial condition. Nonetheless, given the large or indeterminate amounts sought in certain of these actions, and the inherent unpredictability of litigation, an adverse outcome in certain matters could, from time-to-time, have a material adverse effect on our consolidated results of operations or cash flows in particular quarterly or annual periods.


ITEM 1A. RISK FACTORS
Certain risk factors exist that can have a significant impact on our business, liquidity, capital resources, results of operations, and financial condition. The impact of these risk factors could also impact certain actions that we take as part of our long-term capital strategy including, but not limited to, contributing capital to our subsidiaries in our Insurance Operations, issuing additional debt and/or equity securities, repurchasing shares of our common stock, or changing stockholders’ dividends. We operate in a continually changing business environment and new risk factors emerge from time-to-time. Consequently, we can neither predict such new risk factors nor assess the impact, if any, they might have on our business in the future. There have been no material changes from the risk factors disclosed in Item 1A. “Risk Factors.” in our 2011 Annual Report other than as discussed below.

We face risks regarding our flood business because of uncertainties regarding the funding of the National Flood Insurance Program (“NFIP”).

Selective is the sixth largest insurance group participating in the write-your-own (“WYO”) arrangement of the NFIP, which is managed by the Mitigation Division of the Federal Emergency Management Agency ("FEMA") in the U.S. Department of Homeland Security. For WYO participation, Selective receives an expense allowance, or servicing fee, for policies written and claims serviced. Currently, the expense allowance is 30.4%. The servicing fee is the combination of 1% of direct written premiums and 1.5% of incurred losses.
 
The NFIP is funded by Congress. In the last several years, funding of the program has continued through short extensions as part of continuing resolutions to temporarily maintain current spending. In July 2012, the President signed a law extending the NFIP until September 30, 2017.  The new legislation: (i) increases the limit that the NFIP can raise premiums annually from 10% to 20%; (ii) requires a four-year phase-in to actuarial rates for specific types of pre-FIRM (Flood Insurance Rate Map) properties, specifically non-primary residences, severe repetitive loss properties, properties where flood losses exceed property values, business properties and any property that has sustained substantial damage; (iii) increases the minimum annual deductibles for pre-FIRM properties; and (iv) allows FEMA to accept installment plans to pay premiums.  The legislation directs FEMA to develop a Named Storm Event Model to generate post-event assessments for allocating loss between wind and water for indeterminate claims.  The legislation also directs FEMA to conduct studies on the viability of reinsurance capacity in the market, and clarifies that FEMA is authorized to secure reinsurance in the private market. We will continue monitoring developments in Washington regarding reform proposals to the NFIP, particularly regarding any changes to the fee structure. We cannot predict whether future proposals will be adopted or, if adopted, what impact their adoption could have on our business, financial condition, or results of operations.
 

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As a WYO carrier, we are required to follow certain NFIP procedures when administering flood policies and claims. Some of these requirements may be different from our normal business practices and may present a reputational risk to our brand. Insurance companies are regulated by states, however, NFIP is a federal program and there may be instances where requirements placed on WYO carriers by NFIP are not consistent with the regulations of a particular state. Consequently, we have the risk that our regulator's position may conflict with NFIP's position on the same issue.

A downgrade or a potential downgrade in our financial strength or credit ratings could result in a loss of business and could have a material adverse effect on our financial condition and results of operations.

We are rated on our financial strength, primarily our ability to pay claims, by various Nationally Recognized Statistical Rating Organizations (“NRSROs”). Following the acquisition of MUSIC, the newly-acquired company was included in our Insurance Subsidiaries' intercompany pooling agreement. As a result, the financial strength ratings from A.M. Best and Fitch include MUSIC, while S&P and Moody's Investor Service have not yet taken any rating action on MUSIC. The financial strength ratings are as follows:
 
NRSRO
Financial Strength Rating
Outlook
A.M. Best and Company
“A”
Stable
S&P
“A”
Stable
Moody's Investor Service
“A2”
Stable
Fitch
“A+”
Stable
 
A significant rating downgrade, particularly from A.M. Best, could:  (i) affect our ability to write new business with customers, some of whom are required under various third-party agreements to maintain insurance with a carrier that maintains a specified minimum rating; or (ii) be an event of default under our line of credit with Wachovia Bank, National Association (“Line of Credit”). The Line of Credit requires our Insurance Subsidiaries to maintain an A.M. Best rating of at least “A-” (one level below our current rating) and a default could lead to acceleration of any outstanding principal. Such an event also could trigger default provisions under certain of our other debt instruments and negatively impact our ability to borrow in the future. As a result, any significant downgrade in our financial strength ratings could have a material adverse effect on our results of operations, liquidity, financial condition, financial strength, and debt ratings.
 
NRSROs also rate our long-term debt creditworthiness. Credit ratings indicate the ability of debt issuers to meet debt obligations in a timely manner and are important factors in our overall funding profile and ability to access certain types of liquidity. Our current credit ratings are as follows:
 
NRSRO
Credit Rating
Long Term Credit Outlook
A.M. Best and Company
“bbb+”
Stable
S&P
“BBB”
Stable
Moody's Investor Services
“Baa2”
Stable
Fitch
“A-”
Stable
 
Downgrades in our credit ratings could have a material adverse effect on our financial condition and results of operations in many ways, including making it more expensive to access capital markets.
 
Because of the difficulties experienced by many financial institutions during the recent credit crisis, including insurance companies, and the public criticism of NRSROs, we believe it is possible that the NRSROs:  (i) will heighten their level of scrutiny of financial institutions; (ii) will increase the frequency and scope of their reviews; and (iii) may adjust upward the capital and other requirements employed in their models for maintaining certain rating levels. We cannot predict possible actions NRSROs may take regarding their ratings that could adversely affect our business or the possible actions we may take in response to any such action.

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ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
The following table provides information regarding our purchases of our common stock in Second Quarter 2012:

Period
 
Total Number of
Shares Purchased1
 
Average Price
Paid per Share
 
Total Number of
Shares Purchased
as Part of Publicly
Announced Programs
 
Maximum Number of
Shares that May Yet
Be Purchased Under the Programs
April 1 – 30, 2012
 
4,199

 
$
17.45

 

 

May 1 – 31, 2012
 

 

 

 

June 1 – 30, 2012
 
807

 
17.04

 

 

Total
 
5,006

 
$
17.38

 

 

 
1 
During Second Quarter 2012, 1,009 shares were purchased from employees in connection with the vesting of restricted stock units and 3,997 shares were purchased from employees in connection with stock option exercises. These repurchases were made to satisfy tax withholding obligations and/or option costs with respect to those employees. These shares were not purchased as part of any publicly announced program. The shares that were purchased in connection with the vesting of restricted stock units were purchased at fair market value as defined in the Parent’s 2005 Omnibus Stock Plan. The shares purchased in connection with the option exercises were purchased at the current market prices of our common stock on the dates the options were exercised.



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Item 6. EXHIBITS

(a) Exhibits:

Exhibit No.  
 
 
* 11
 
Statement Re: Computation of Per Share Earnings.
* 31.1
 
Certification of Chief Executive Officer in accordance with Section 302 of the Sarbanes-Oxley Act of 2002.
* 31.2
 
Certification of Chief Financial Officer in accordance with Section 302 of the Sarbanes-Oxley Act of 2002.
* 32.1
 
Certification of Chief Executive Officer in accordance with Section 906 of the Sarbanes-Oxley Act of 2002.
* 32.2
 
Certification of Chief Financial Officer in accordance with Section 906 of the Sarbanes-Oxley Act of 2002.
** 101.INS
 
XBRL Instance Document.
** 101.SCH
 
XBRL Taxonomy Extension Schema Document.
** 101.CAL
 
XBRL Taxonomy Extension Calculation Linkbase Document.
** 101.LAB
 
XBRL Taxonomy Extension Label Linkbase Document.
** 101.PRE
 
XBRL Taxonomy Extension Presentation Linkbase Document.
** 101.DEF
 
XBRL Taxonomy Extension Definition Linkbase Document.
 
* Filed herewith.
** Furnished and not filed herewith.

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SIGNATURES
 
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.
 
SELECTIVE INSURANCE GROUP, INC.
Registrant 
 
By: /s/ Gregory E. Murphy
July 26, 2012
Gregory E. Murphy
 
Chairman of the Board, President and Chief Executive Officer
 
 
 
By: /s/ Dale A. Thatcher
July 26, 2012
Dale A. Thatcher
 
Executive Vice President and Chief Financial Officer
 
(principal accounting officer and principal financial officer)
 
 



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