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UNITED STATES Washington, D.C. 20549
FORM 10-Q
Commission File Number: 000-50070
SAFETY INSURANCE GROUP, INC. (Exact name of registrant as specified in its charter)
20 Custom House Street, Boston, Massachusetts 02110 (Address of principal executive offices including zip code)
(617) 951-0600 (Registrant’s telephone number, including area code)
Not Applicable (Former name or former address, 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. Yes x No o
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 (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No o
Indicate by check mark whether the registrant is large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No x
As of May 8, 2012, there were 15,302,108 shares of common stock with a par value of $0.01 per share outstanding.
SAFETY INSURANCE GROUP, INC.
Safety Insurance Group, Inc. and Subsidiaries (Dollars in thousands, except share data)
The accompanying notes are an integral part of these financial statements.
Safety Insurance Group, Inc. and Subsidiaries Consolidated Statements of Operations (Unaudited) (Dollars in thousands, except share data)
The accompanying notes are an integral part of these financial statements.
Safety Insurance Group, Inc. and Subsidiaries Consolidated Statements of Comprehensive Income (Unaudited) (Dollars in thousands)
The accompanying notes are an integral part of these financial statements.
Safety Insurance Group, Inc. and Subsidiaries Consolidated Statements of Changes in Shareholders’ Equity (Unaudited) (Dollars in thousands)
The accompanying notes are an integral part of these financial statements.
Safety Insurance Group, Inc. and Subsidiaries Consolidated Statements of Cash Flows (Unaudited) (Dollars in thousands)
The accompanying notes are an integral part of these financial statements.
Safety Insurance Group, Inc. and Subsidiaries Notes to Unaudited Consolidated Financial Statements (Dollars in thousands except per share and share data)
1. Basis of Presentation
The consolidated financial statements have been prepared on the basis of accounting principles generally accepted in the United States of America (“GAAP”). The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from these estimates.
The consolidated financial statements include Safety Insurance Group, Inc. and its subsidiaries (the “Company”). The subsidiaries consist of Safety Insurance Company, Safety Indemnity Insurance Company, Safety Property and Casualty Insurance Company, Whiteshirts Asset Management Corporation (“WAMC”), and Whiteshirts Management Corporation, which is WAMC’s holding company. All intercompany transactions have been eliminated. Prior period amounts have been reclassified to conform to the current period presentation.
The financial information as of March 31, 2012 and for the three months ended March 31, 2012 and 2011 is unaudited; however, in the opinion of the Company, the information includes all adjustments, consisting only of normal recurring adjustments, necessary for a fair presentation of the financial condition and results of operations for the periods. These unaudited consolidated financial statements may not be indicative of financial results for the full year and should be read in conjunction with the audited financial statements included in the Company’s annual report on Form 10-K filed with the U.S. Securities and Exchange Commission (“SEC”) on March 13, 2012.
The Company is a leading provider of personal lines property and casualty insurance focused primarily on the Massachusetts market. The Company’s principal product line is private passenger automobile insurance, which accounted for 67.2% of its direct written premiums in 2011. The Company operates through its insurance company subsidiaries, Safety Insurance Company, Safety Indemnity Insurance Company, and Safety Property and Casualty Insurance Company (together referred to as the “Insurance Subsidiaries”).
The Insurance Subsidiaries began writing private passenger automobile and homeowners insurance in New Hampshire during 2008, personal umbrella insurance in New Hampshire during 2009, and commercial automobile in New Hampshire insurance during 2011. For the three months ended March 31, 2012 and 2011, the Company wrote $1,663 and $973, respectively, in direct written premiums in New Hampshire.
2. Recent Accounting Pronouncements
In October 2010, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2010-26 (Topic 944), Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts, which updated guidance to address diversity in practice for the accounting of costs associated with acquiring or renewing insurance contracts. This guidance modifies the definition of acquisition costs to specify that a cost be directly related to the successful acquisition of a new or renewal insurance contract in order to be deferred. The guidance also specifies that advertising costs only should be included as deferred acquisition costs if the direct-response advertising accounting criteria are met. The new guidance was effective for reporting periods beginning after December 15, 2011 and was to be applied prospectively, with retrospective application permitted. The adoption of the guidance had no impact on the Company’s consolidated financial condition and results of operations.
In May 2011, the FASB issued ASU No. 2011-04 (Topic 820), Fair Value Measurements, Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and International Financial Reporting Standards (IFRS), which clarifies the application of existing fair value measurement and disclosure requirements and amends certain fair value measurement principles, requirements and disclosures. To improve consistency in global application across jurisdictions, changes in wording were made to ensure that U.S. GAAP and IFRS fair value measurement and disclosure requirements are described in the same way. The guidance was to be applied prospectively for reporting periods beginning after December 15, 2011. The adoption of the guidance had no impact on the Company’s consolidated financial condition and results of operations.
In June 2011, the FASB issued ASU 2011-05 (Topic 220), Presentation of Comprehensive Income, which amends the presentation of comprehensive income and its components. Under the new guidance, an entity has the option to present comprehensive income in a single continuous statement or in two separate but consecutive statements. Both options require an entity to present reclassification adjustments for items reclassified from other comprehensive income to net income in the statement(s) where the components of net income and the components of comprehensive income are presented. The guidance was effective for reporting periods beginning after December 15, 2011 and was to be applied retrospectively. The impact of adoption is related to presentation only and had no impact on the Company’s consolidated financial position and results of operations.
Safety Insurance Group, Inc. and Subsidiaries Notes to Unaudited Consolidated Financial Statements (Dollars in thousands except per share and share data)
In December 2011, the FASB issued ASU 2011-12 (Topic 220), Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in ASU No. 2011-05, which indefinitely defers certain provisions of ASU 2011-05 (Topic 220), Presentation of Comprehensive Income, that revised the manner in which entities present comprehensive income in financial statements. One of ASU 2011-05 provisions would require entities to present reclassification adjustments out of accumulated other comprehensive income by component in both the statement in which net income is presented and the statement in which other comprehensive income is presented. Accordingly, this requirement is indefinitely deferred and will be further deliberated by the FASB at a future date. The amendment was effective for fiscal years and interim periods within those years that begin after December 15, 2011. The adoption of the guidance had no impact on the Company’s consolidated financial condition and results of operations.
3. Earnings (Loss) per Weighted Average Common Share
Basic earnings (loss) per weighted average common share (“EPS”) is calculated by dividing net income by the weighted average number of basic common shares outstanding during the period including unvested restricted shares which are considered participating securities. Diluted earnings (loss) per share amounts are based on the weighted average number of common shares including unvested restricted shares and the net effect of potentially dilutive common shares outstanding. At March 31, 2012 and 2011, the Company’s potentially dilutive instruments were common shares under options of 112,600 and 133,194, respectively.
The following table sets forth the computation of basic and diluted EPS for the periods indicated.
For the three months ended March 31, 2012, there were 82,100 anti-dilutive common shares under options not included in the computation of EPS because their exercise prices were greater than the average market price of common stock for the period. For the three months ended March 31, 2011, all 133,194 common shares under options were not included in the computation of EPS because their inclusion would be anti-dilutive.
4. Stock-Based Compensation
Management Omnibus Incentive Plan
Long-term incentive compensation is provided under the Company’s 2002 Management Omnibus Incentive Plan (“the Incentive Plan”) which provides for a variety of stock-based compensation awards, including nonqualified stock options, incentive stock options, stock appreciation rights and restricted stock (“RS”) awards.
The maximum number of shares of common stock with respect to which awards may be granted is 2,500,000. Shares of stock covered by an award under the Incentive Plan that are forfeited will again be available for issuance in connection with future grants of awards under the plan. At March 31, 2012, there were 617,538 shares available for future grant. The Board of Directors and the Compensation Committee intend to issue more awards under the Incentive Plan in the future.
Safety Insurance Group, Inc. and Subsidiaries Notes to Unaudited Consolidated Financial Statements (Dollars in thousands except per share and share data)
A summary of stock-based awards granted under the Incentive Plan during the three months ended March 31, 2012 is as follows.
(1) The fair value per share of the restricted stock grant is equal to the closing price of the Company’s common stock on the grant date. (2) The shares cannot be sold, assigned, pledged, or otherwise transferred, encumbered or disposed of until the recipient is no longer a member of the Board of Directors.
Accounting and Reporting for Stock-Based Awards
Accounting Standards Codification (“ASC”) 718, Compensation —Stock Compensation requires the Company to measure and recognize the cost of employee services received in exchange for an award of equity instruments. Under the provisions of ASC 718, share-based compensation cost is measured at the grant date, based on the fair value of the award, and is recognized as an expense over the requisite service period (generally the vesting period of the equity grant).
As permitted by ASC 718, the Company elected the modified prospective transition method. Under the modified prospective transition method, (i) compensation expense for share-based awards granted prior to January 1, 2006 is recognized over the remaining service period using the compensation cost calculated for pro forma disclosure purposes under ASC 718 as adjusted to incorporate forfeiture assumptions under ASC 718, and (ii) compensation expense for all share-based awards granted subsequent to December 31, 2005 is based on the grant date fair value estimated in accordance with the provisions of ASC 718.
Stock Options
The fair value of stock options used to compute net income and EPS for the three months ended March 31, 2011 is the estimated fair value at grant date using the Black-Scholes option-pricing model with the following assumptions:
Expected dividend yield is the Company’s dividend yield on the measurement date and is based on the assumption that the current yield will continue in the future. Expected volatility is based on historical volatility of the Company’s common stock as well as the volatility of a peer group of property and casualty insurers measured for a period equal to the expected holding period of the option. The risk-free interest rate is based upon the yield on the measurement date of a zero-coupon U.S. Treasury bond with a maturity period equal to the expected holding period of the option. The expected holding period is based upon the simplified method provided in SEC Staff Accounting Bulletin No. 107, Share-Based Payment, which utilizes the mid-points between the vesting dates and the expiration date of the option award to calculate the overall expected term. There were no stock options granted during the three months ended March 31, 2012 and 2011.
Safety Insurance Group, Inc. and Subsidiaries Notes to Unaudited Consolidated Financial Statements (Dollars in thousands except per share and share data)
The following table summarizes stock option activity under the Incentive Plan for the three months ended March 31, 2012.
The aggregate intrinsic value in the preceding table represents the total pre-tax intrinsic value, based upon the Company’s closing stock price of $41.64 on March 31, 2012, which would have been received by the option holders had all option holders exercised their options as of that date. The range of exercise prices on stock options outstanding under the Incentive Plan was $13.30 to $42.85 at March 31, 2012 and 2011, respectively. The total intrinsic value of options exercised during the three months ended March 31, 2012 and 2011 was $153 and $136, respectively.
As of March 31, 2011, all compensation expense related to non-vested stock option awards was recognized and all outstanding stock options were vested. Cash received from options exercised was $380 and $685 for the three months ended March 31, 2012 and 2011, respectively.
Restricted Stock
Restricted stock awarded to employees in the form of unvested shares is recorded at the market value of the Company’s common stock on the grant date and amortized ratably as expense over the requisite service period.
The following table summarizes restricted stock activity under the Incentive Plan during the three months ended March 31, 2012.
As of March 31, 2012, there was $9,559 of unrecognized compensation expense related to non-vested restricted stock awards that is expected to be recognized over a weighted average period of 1.8 years. The total fair value of the shares that were vested and unrestricted during the three months ended March 31, 2012 and 2011 was $4,278 and $3,953, respectively. For the three months ended March 31, 2012 and 2011, the Company recorded compensation expense related to restricted stock of $794 and $768, net of income tax benefits of $427 and $414, respectively.
Safety Insurance Group, Inc. and Subsidiaries Notes to Unaudited Consolidated Financial Statements (Dollars in thousands except per share and share data)
5. Investments
The gross unrealized gains and losses on investments in fixed maturity securities and equity securities, including interests in mutual funds, were as follows for the periods indicated.
(1) Residential mortgage-backed securities consists of obligations of U.S. Government agencies including collateralized mortgage obligations issued, guaranteed and/or insured by the following issuers: Government National Mortgage Association (GNMA), Federal Home Loan Mortgage Corporation (FHLMC), Federal National Mortgage Association (FNMA) and the Federal Home Loan Bank (FHLB). (2) Other asset-backed securities includes obligations of the U.S. Small Business Administration which totaled $5,719 and $6,054 at amortized cost and $6,214 and $6,584 at estimated fair value at March 31, 2012 and December 31, 2011. (3) Equity securities includes interests in mutual funds of $13,329 and $12,937 at cost and $13,841 and $12,564 at fair value as of March 31, 2012 and December 31, 2011, respectively, held to fund the Company’s executive deferred compensation plan. (4) Our investment portfolio included 43 and 55 securities in an unrealized loss position at March 31, 2012 and December 31, 2011, respectively. (5) Amounts in this column represent other-than-temporary impairment (“OTTI”) recognized in accumulated other comprehensive income.
Safety Insurance Group, Inc. and Subsidiaries Notes to Unaudited Consolidated Financial Statements (Dollars in thousands except per share and share data)
The amortized cost and the estimated fair value of fixed maturity securities, by maturity, are shown below for the period indicated. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
The gross realized gains and losses on sales of investments were as follows for the periods indicated.
In the normal course of business, the Company enters into transactions involving various types of financial instruments, including investments in fixed maturities and equity securities. Investment transactions have credit exposure to the extent that a counter party may default on an obligation to the Company. Credit risk is a consequence of carrying, trading and investing in securities. To manage credit risk, the Company focuses on higher quality fixed income securities, reviews the credit strength of all companies in which it invests, limits its exposure in any one investment and monitors the portfolio quality, taking into account credit ratings assigned by recognized statistical rating organizations.
The following tables as of March 31, 2012 and December 31, 2011 present the gross unrealized losses included in the Company’s investment portfolio and the fair value of those securities aggregated by investment category. The tables also present the length of time that they have been in a continuous unrealized loss position.
Safety Insurance Group, Inc. and Subsidiaries Notes to Unaudited Consolidated Financial Statements (Dollars in thousands except per share and share data)
Other-Than-Temporary Impairments
ASC 320, Investments — Debt and Equity Securities requires entities to separate an OTTI of a debt security into two components when there are credit related losses associated with the impaired debt security for which the Company asserts that it does not have the intent to sell the security, and it is more likely than not that it will not be required to sell the security before recovery of its cost basis. Under ASC 320, the amount of the OTTI related to a credit loss is recognized in earnings, and the amount of the OTTI related to other factors is recorded as a component of other comprehensive income (loss). In instances where no credit loss exists but it is more likely than not that the Company will have to sell the debt security prior to the anticipated recovery, the decline in market value below amortized cost is recognized as an OTTI in earnings. In periods after the recognition of an OTTI on debt securities, the Company accounts for such securities as if they had been purchased on the measurement date of the OTTI at an amortized cost basis equal to the previous amortized cost basis less the OTTI recognized in earnings. For debt securities for which OTTI was recognized in earnings, the difference between the new amortized cost basis and the cash flows expected to be collected will be accreted or amortized into net investment income.
The Company holds no subprime mortgage debt securities. All of the Company’s holdings in mortgage-backed securities are either U.S. Government or Agency guaranteed or are rated investment grade by either Moody’s or Standard & Poor’s.
The unrealized losses in the Company’s fixed income and equity portfolio as of March 31, 2012 were reviewed for potential other-than-temporary asset impairments. The Company held no securities at March 31, 2012 with a material (20% or greater) unrealized loss for four or more consecutive quarters. Specific qualitative analysis was also performed for any additional securities appearing on the Company’s “Watch List,” if any. Qualitative analysis considered such factors as the financial condition and the near term prospects of the issuer, whether the debtor is current on its contractually obligated interest and principal payments, changes to the rating of the security by a rating agency and the historical volatility of the fair value of the security.
The qualitative analysis performed by the Company concluded that the unrealized losses recorded on the investment portfolio at March 31, 2012 resulted from fluctuations in market interest rates and other temporary market conditions as opposed to fundamental changes in the credit quality of the issuers of such securities. Therefore, decreases in fair values of the Company’s securities are viewed as being temporary.
During the three months ended March 31, 2012 and 2011, there was no significant deterioration in the credit quality of any of the Company’s holdings and no OTTI charges were recorded related to the Company’s portfolio of investment securities. At March 31, 2012 and December 31, 2011, there were no amounts included in accumulated other comprehensive income related to securities which were considered by the Company to be other-than-temporarily impaired.
Based upon the qualitative analysis performed, the Company’s decision to hold these securities, the Company’s current level of liquidity and its positive operating cash flows, management believes it is more likely than not that it will not be required to sell any of its securities before the anticipated recovery in the fair value to its amortized cost basis.
Safety Insurance Group, Inc. and Subsidiaries Notes to Unaudited Consolidated Financial Statements (Dollars in thousands except per share and share data)
Net Investment Income
The components of net investment income were as follows:
Fair Value Measurements
ASC 820, Fair Value Measurements and Disclosure provides a revised definition of fair value, establishes a framework for measuring fair value and expands financial statement disclosure requirements for fair value information. Under ASC 820, fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants (an exit price). ASC 820 establishes a fair value hierarchy that distinguishes between inputs based on market data from independent sources (“observable inputs”) and a reporting entity’s internal assumptions based upon the best information available when external market data is limited or unavailable (“unobservable inputs”). The fair value hierarchy in ASC 820 prioritizes fair value measurements into three levels based on the nature of the inputs as follows:
Level 1 — Valuations based on quoted prices in active markets for identical assets and liabilities;
Level 2 — Valuations based on observable inputs that do not meet the criteria for Level 1, including quoted prices in inactive markets and quoted prices in active markets for similar, but not identical instruments; and
Level 3 — Valuations based on unobservable inputs.
The Company is responsible for the determination of the value of the investments carried at fair value and the supporting methodologies and assumptions. Fair values for the Company’s fixed maturity securities are based on prices provided by its custodian bank and its investment manager. Both the Company’s custodian bank and investment manager use a variety of independent, nationally recognized pricing services to determine market valuations. The Company has processes designed to ensure that the values received from third party pricing service are accurately recorded, that the data inputs and valuation techniques utilized are appropriate and consistently applied and that the assumptions are reasonable and consistent with the objective of determining fair value. If the pricing service cannot provide fair value determinations, the Company obtains non-binding price quotes from broker-dealers. A minimum of two quoted prices is obtained for the majority of the Company’s available for sale fixed maturity securities in its investment portfolio. The Company’s custodian bank is its primary provider of quoted prices from third-party pricing services and broker-dealers. To provide reasonable assurance of the validity of each price or quote, a secondary third-party pricing service or broker-dealer quote is obtained from the Company’s investment manager. An examination of the pricing data is then performed for each security. If the variance between the primary and secondary price quotes for a security is within an accepted tolerance level, the quoted price obtained from the Company’s custodian bank is used in the financial statements for the security. If the variance between the primary and secondary price quotes exceeds an accepted tolerance level, the Company obtains a quote from an alternative source, if possible, and documents and resolves any differences between the pricing sources. In addition, the Company may request that its investment manager and its traders provide input as to which vendor is providing prices that its traders believe are reflective of fair value for the security. Following this process, the Company may decide to value the security in its financial statements using the secondary or alternative source if it believes that pricing is more reflective of the security’s value than the primary pricing provided by its custodian bank. The Company analyzes market valuations received to verify reasonableness, to understand the key assumptions used and their sources, and to determine an appropriate ASC 820 fair value hierarchy level based upon trading activity and the observability of market inputs. Based on this evaluation and investment class analysis, each price is classified into Level 1, 2 or 3.
Safety Insurance Group, Inc. and Subsidiaries Notes to Unaudited Consolidated Financial Statements (Dollars in thousands except per share and share data)
Fair values of instruments are based on (i) quoted prices in active markets for identical assets (Level 1), (ii) quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active and model-derived valuations in which all significant inputs are observable in active markets (Level 2) or (iii) valuations derived from valuation techniques in which one or more significant inputs are unobservable in the marketplace (Level 3).
The Company’s Level 1 securities consist of equity securities whose values are based on quoted prices in active markets for identical assets. The Company’s Level 2 securities are comprised of available-for-sale fixed maturity securities whose fair value was determined using observable market inputs and a real estate investment trust equity investment whose fair value was determined using the trust’s net asset value obtained from its audited financial statements. Fair values for securities for which quoted market prices were unavailable were estimated based upon reference to observable inputs such as benchmark interest rates, market comparables, and other relevant inputs. Investments valued using these inputs include U.S. Treasury securities and obligations of U.S. Government agencies, obligations of international government agencies, obligations of states and political subdivisions, corporate securities, commercial and residential mortgage-backed securities, and other asset-backed securities. Inputs into the fair value application that are utilized by asset class include but are not limited to:
· States and political subdivisions: overall credit quality, including assessments of market sectors and the level and variability of sources of payment such as general obligation, revenue or lease; credit support such as insurance, state or local economic and political base, prefunded and escrowed to maturity covenants.
· Corporate fixed maturities: overall credit quality, the establishment of a risk adjusted credit spread over the applicable risk free yield curve for discounted cash flow valuations; assessments of the level of industry economic sensitivity, company financial policies, indenture restrictive covenants, and/or security and collateral.
· Residential mortgage-backed securities, U.S. agency pass-throughs, collateralized mortgage obligations (“CMOs”), non U.S. agency CMOs: estimates of prepayment speeds based upon historical prepayment rate trends, underlying collateral interest rates, original weighted average maturity, vintage year, borrower credit quality characteristics, interest rate and yield curve forecasts, U.S. government support programs, tax policies, and delinquency/default trends.
· Commercial mortgage-backed securities: overall credit quality, including assessments of the level and variability of credit support and collateral type such as office, retail, or lodging, predictability of cash flows for the deal structure, prevailing economic market conditions.
· Other asset-backed securities: overall credit quality, estimates of prepayment speeds based upon historical trends and characteristics of underlying loans, including assessments of the level and variability of collateral, revenue generating agreements, area licenses agreements, product sourcing agreements and equipment and property leases.
· Real estate investment trust (“REIT”): net asset value per share derived from member ownership in capital venture to which a proportionate share of independently appraised net assets is attributed.
All unadjusted estimates of fair value for our fixed maturities priced by the pricing services as described above are included in the amounts disclosed in Level 2.
In order to ensure the fair value determination is representative of an exit price (consistent with ASC 820), the Company’s procedures for validating quotes or prices obtained from third-parties include, but are not limited to, obtaining a minimum of two price quotes for each fixed maturity security if possible, as discussed above, the periodic testing of sales activity to determine if there are any significant differences between the market price used to value the security as of the balance sheet date and the sales price of the security for sales that occurred around the balance sheet date, and the periodic review of reports provided by its investment manager regarding those securities with ratings changes and securities placed on its “Watch List.” In addition, valuation techniques utilized by pricing services and prices obtained from external sources are reviewed by the Company’s external investment manager, whose investment professionals are familiar with the securities being priced and the markets in which they trade, to ensure the fair value determination is representative of an exit price (consistent with ASC 820).
The Company’s entire available-for-sale portfolio was priced based upon quoted market prices or other observable inputs as of March 31, 2012. There were no significant changes to the valuation process during the three months ending March 31, 2012. As of March 31, 2012 and December 31, 2011, no quotes or prices obtained were adjusted by management. All broker quotes obtained were non-binding.
Safety Insurance Group, Inc. and Subsidiaries Notes to Unaudited Consolidated Financial Statements (Dollars in thousands except per share and share data)
The following tables summarize the Company’s total fair value measurements for available-for-sale investments for the periods indicated.
There were no transfers between Level 1 and Level 2 during the three months ended March 31, 2012 and 2011.
Transfers in and out of Level 3 are attributable to changes in the ability to observe significant inputs in determining fair value exit pricing. The Company held no Level 3 securities at March 31, 2012 and 2011 and no transfers were made in or out of Level 3 during the three months ended March 31, 2012 and 2011.
Safety Insurance Group, Inc. and Subsidiaries Notes to Unaudited Consolidated Financial Statements (Dollars in thousands except per share and share data)
6. Loss and Loss Adjustment Expense Reserves
The following table sets forth a reconciliation of beginning and ending reserves for losses and loss adjustment expenses (“LAE”), as shown in the Company’s consolidated financial statements for the periods indicated.
At the end of each period, the reserves were re-estimated for all prior accident years. The Company’s prior year reserves decreased by $3,987 and $9,662 for the three months ended March 31, 2012 and 2011, respectively, and resulted from re-estimations of prior years ultimate loss and LAE liabilities. The decrease in prior years reserves during the 2012 period is primarily composed of a reduction of $4,726 in the Company’s retained automobile reserves, partially offset by an increase of $1,286 in the prior year reserves of all other than automobile and homeowners lines. The decrease in prior year reserves during the 2011 period is primarily composed of reductions of $7,298 in the Company’s retained automobile reserves and $1,250 in the Company’s retained homeowners reserves.
The Company’s private passenger automobile line of business prior year reserves decreased by $4,489 for the three months ended March 31, 2012. The decrease was primarily due to improved retained private passenger results of $3,528 for the accident years 2005 through 2011. The Company’s private passenger automobile line of business prior year reserves decreased by $6,292 for the three months ended March 31, 2011. The decrease was primarily due to improved retained private passenger results of $5,121 for the accident years 2006 through 2009. The improved retained private passenger results were primarily due to fewer incurred but not yet reported claims than previously estimated and better than previously estimated severity on the Company’s established bodily injury and property damage case reserves.
Due to the nature of the risks that the Company underwrites and has historically underwritten, management does not believe that it has an exposure to asbestos or environmental pollution liabilities.
7. Commitments and Contingencies
Various claims, generally incidental to the conduct of normal business, are pending or alleged against the Company from time to time. In the opinion of management, based in part on the advice of legal counsel, the ultimate resolution of such claims will not have a material adverse effect on the Company’s consolidated financial statements. However, if estimates of the ultimate resolutions of those proceedings are revised, liabilities related to those proceedings could be adjusted in the near term.
Massachusetts law requires that insurers licensed to do business in Massachusetts participate in the Massachusetts Insurers Insolvency Fund (“Insolvency Fund”). Members of the Insolvency Fund are assessed a proportionate share of the obligations and expenses of the Insolvency Fund in connection with an insolvent insurer. It is anticipated that there will be additional assessments from time to time relating to various insolvencies. Although the timing and amounts of any future assessments are not known, based upon
Safety Insurance Group, Inc. and Subsidiaries Notes to Unaudited Consolidated Financial Statements (Dollars in thousands except per share and share data)
existing knowledge, management’s opinion is that such future assessments will not have a material effect upon the financial position of the Company.
8. Debt
The Company has a Revolving Credit Agreement (the “Credit Agreement”) with RBS Citizens, NA (“RBS Citizens”). The Credit Agreement provides a $30,000 revolving credit facility with an accordion feature allowing for future expansion of the committed amount up to $50,000. Loans under the credit facility bear interest at the Company’s option at either (i) the LIBOR rate plus 1.25% per annum or (ii) the higher of RBS Citizens prime rate or 0.5% above the federal funds rate plus 1.25% per annum. Interest only is payable prior to maturity. The Credit Agreement has a maturity date of August 14, 2013.
The Company’s obligations under the credit facility are secured by pledges of its assets and the capital stock of its operating subsidiaries. The credit facility is guaranteed by the Company’s non-insurance company subsidiaries. The credit facility contains covenants including requirements to maintain minimum risk-based capital ratios and statutory surplus of Safety Insurance Company as well as limitations or restrictions on indebtedness, liens, and other matters. Among other covenants, the credit facility restricts the Company’s payment of dividends (i) if a default under the credit facility is continuing or would result therefrom or (ii) in an amount in excess of 50% of the Company’s prior year’s net income, as determined in accordance with GAAP. As of March 31, 2012, the Company was in compliance with all such covenants. In addition, the credit facility includes customary events of default, including a cross-default provision permitting the lenders to accelerate the facility if the Company (i) defaults in any payment obligation under debt having a principal amount in excess of $10,000 or (ii) fails to perform any other covenant permitting acceleration of all such debt.
The Company had no amounts outstanding on its credit facility at March 31, 2012 and December 31, 2011. The credit facility commitment fee included in interest expense was computed at a rate of 0.25% per annum on the $30,000 commitment at March 31, 2012 and 2011.
9. Income Taxes
Federal income tax expense for the three months ended March 31, 2012 and 2011 has been computed using estimated effective tax rates. These rates are revised, if necessary, at the end of each successive interim period to reflect the current estimates of the annual effective tax rates.
The Company believes that the positions taken on its income tax returns for open tax years will be sustained upon examination by the Internal Revenue Service (“IRS”). Therefore, the Company has not recorded a liability under ASC 740, Income Taxes.
During the three months ended March 31, 2012, there were no material changes to the amount of the Company’s unrecognized tax benefits or to any assumptions regarding the amount of its ASC 740 liability.
As of March 31, 2012 and December 31, 2011, the Company was no longer subject to examination of its U.S. federal tax returns for years prior to 2008. The Company is not currently under examination by the IRS.
10. Share Repurchase Program
On August 3, 2007, the Board of Directors approved a share repurchase program of up to $30,000 of the Company’s outstanding common shares. On March 19, 2009, the Board of Directors increased this existing share repurchase program by authorizing repurchase of up to $60,000 of the Company’s outstanding common shares. On August 4, 2010, the Board of Directors again increased the existing share repurchase program by authorizing repurchase of up to $90,000 of the Company’s outstanding common shares. Under the program, the Company may repurchase shares of its common stock for cash in public or private transactions, in the open market or otherwise. The timing of such repurchases and actual number of shares repurchased will depend on a variety of factors including price, market conditions and applicable regulatory and corporate requirements. The program does not require the Company to repurchase any specific number of shares and it may be modified, suspended or terminated at any time without prior notice.
No share purchases were made by the Company under the program during the quarters ending March 31, 2012 and 2011. As of March 31, 2012 and December 31, 2011, the Company had purchased 1,728,645 shares on the open market at a cost of $55,569.
Safety Insurance Group, Inc. and Subsidiaries Notes to Unaudited Consolidated Financial Statements (Dollars in thousands except per share and share data)
11. Related Party Transactions
Mr. A. Richard Caputo, Jr., a member of the Company’s Board of Directors and the Chairman of its Investment Committee, is a principal of The Jordan Company, LP (“Jordan”). In February 2012, the Company participated as a lender in a loan made by syndicates of lenders to a portfolio company in which funds managed by Jordan are controlling or a significant investor. The loan, made to Vantage Specialties, Inc., currently bears interest at a rate of 7.0% per annum and matures on February 10, 2018. The loan amortizes in equal quarterly installments of 0.25% of the principal amount per quarter. The Company’s participation in the loan was $2,500. The Company made the loan on the same terms as the other lenders participating in the syndicate. The loan was subject to the approval of the Company’s full Investment Committee.
12. Subsequent Events
The Company has evaluated subsequent events for recognition or disclosure in the consolidated financial statements filed on this Form 10-Q with the SEC and no events have occurred that require recognition or disclosure.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion should be read in conjunction with our accompanying consolidated financial statements and notes thereto, which appear elsewhere in this document. In this discussion, all dollar amounts are presented in thousands, except share and per share data.
The following discussion contains forward-looking statements. We intend statements which are not historical in nature to be, and are hereby identified as “forward-looking statements” to be covered by the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. In addition, the Company’s senior management may make forward-looking statements orally to analysts, investors, the media and others. This safe harbor requires that we specify important factors that could cause actual results to differ materially from those contained in forward-looking statements made by or on behalf of us. We cannot promise that our expectations in such forward-looking statements will turn out to be correct. Our actual results could be materially different from and worse than our expectations. See “Forward-Looking Statements” below for specific important factors that could cause actual results to differ materially from those contained in forward-looking statements.
Executive Summary and Overview
In this discussion, “Safety” refers to Safety Insurance Group, Inc. and “our Company,” “we,” “us” and “our” refer to Safety Insurance Group, Inc. and its consolidated subsidiaries. Our subsidiaries consist of Safety Insurance Company (“Safety Insurance”), Safety Indemnity Insurance Company (“Safety Indemnity”), Safety Property and Casualty Insurance Company (“Safety P&C”), Whiteshirts Asset Management Corporation (“WAMC”), and Whiteshirts Management Corporation, which is WAMC’s holding company.
We are a leading provider of private passenger automobile insurance in Massachusetts. In addition to private passenger automobile insurance (which represented 67.2% of our direct written premiums in 2011), we offer a portfolio of other insurance products, including commercial automobile (10.5% of 2011 direct written premiums), homeowners (18.1% of 2011 direct written premiums), dwelling fire, umbrella and business owner policies (totaling 4.2% of 2011 direct written premiums). Operating exclusively in Massachusetts and New Hampshire through our insurance company subsidiaries, Safety Insurance, Safety Indemnity, and Safety P&C (together referred to as the “Insurance Subsidiaries”), we have established strong relationships with independent insurance agents, who numbered 852 in 987 locations throughout Massachusetts and New Hampshire during 2011. We have used these relationships and our extensive knowledge of the Massachusetts market to become the third largest private passenger automobile and the third largest commercial automobile insurance carrier in Massachusetts, capturing an approximate 11.8% and 13.0% share, respectively, of the Massachusetts private passenger and commercial automobile markets in 2012 according to the Commonwealth Automobile Reinsurers (“CAR”) Cession Volume Analysis Report of April 25, 2012, based on automobile exposures. These statistics total, for each vehicle insured, the number of months during the year insurance for that vehicle is in effect, to arrive at an aggregate number of car-months for each insurer; this aggregate number divided by 12 equals the insurer’s number of car-years, a measure we refer to in this report as automobile exposures.
The Insurance Subsidiaries began writing private passenger automobile and homeowners insurance in New Hampshire during 2008, personal umbrella insurance in New Hampshire during 2009, and commercial automobile insurance in New Hampshire during 2011. During the three months ended March 31, 2012 and 2011, we wrote $1,663 and $973, respectively, in direct written premiums in New Hampshire.
Recent Trends and Events
· For the quarter ended March 31, 2012, loss and loss adjustment expenses incurred decreased by $23,586, or 19.4%, to $98,044 from $121,630 for the comparable 2011 period. The decrease was primarily due to the absence of catastrophe losses during the quarter ended March 31, 2012, compared to $19,902 in pre-tax catastrophic weather event losses during the comparable 2011 quarter.
· We filed and were approved for a private passenger automobile rate increase of 3.6% to be effective May 15, 2012.
Massachusetts Automobile Insurance Market
We have been subject to extensive regulation in the private passenger automobile insurance industry in Massachusetts, which represented 67.2% of our direct written premiums in 2011. Private passenger automobile insurance has been heavily regulated in Massachusetts. In many respects, the private passenger automobile insurance market in Massachusetts prior to 2008 was unique, in comparison to other states. This was due to a number of factors, including unusual regulatory conditions, the market dominance of domestic companies, the relative absence of large national companies, and the heavy reliance on independent insurance agents as the market’s principal distribution channel. Perhaps most significantly, prior to 2008, the Massachusetts Commissioner of Insurance (the “Commissioner”) fixed and established the premium rates and the rating plan to be used by all insurance companies doing business in the private passenger automobile insurance market and the Massachusetts private passenger automobile insurance residual market mechanism featured a reinsurance program run by CAR in which companies were assigned producers.
In 2008, the Commissioner issued a series of decisions to introduce what she termed “managed competition” to Massachusetts automobile insurance premium rates and in doing so replaced the fixed and established regime with a prior approval rate review process, governed by regulations that set certain terms and conditions that insurers must comply with in establishing their rates. The Commissioner also replaced the former reinsurance program with an assigned risk plan.
These decisions removed many of the factors that had historically distinguished the Massachusetts private passenger automobile insurance market from the market in other states. However, certain of the historically unique factors have not been eliminated, including compulsory insurance, affinity group marketing, and the prominence of independent agents.
CAR runs a reinsurance pool for commercial automobile policies and, beginning January 1, 2006, CAR implemented a Limited Servicing Carrier Program (“LSC”) for ceded commercial automobile policies. CAR approved Safety Insurance and five other servicing carriers through a Request for Proposal to process ceded commercial automobile business, which was spread equitably among the six servicing carriers. In 2010, CAR reduced the number of servicing carriers to four, and CAR approved Safety Insurance and three other servicing carriers effective July 1, 2011 to continue the program. Subject to the Commissioner’s review, CAR sets the premium rates for commercial automobile policies reinsured through CAR and this reinsurance pool can generate an underwriting result that is a profit or deficit based upon CAR’s rate level. This underwriting result is allocated among every Massachusetts commercial automobile insurance company, including us, based on a company’s commercial automobile voluntary market share.
CAR also runs a reinsurance pool for Taxi, Limousine and Car Service risks (the “Taxi/Limo Program”). On April 25, 2007, Safety Insurance submitted through a Request for Proposal a bid to process a portion of the Taxi/Limo Program. CAR approved Safety Insurance as one of the two servicing carriers for this program beginning January 1, 2008, and CAR again approved Safety Insurance beginning January 1, 2011 as one of the two servicing carriers.
During 2011, we increased our rates approximately 3.7%, and on March 1, 2012, we began using 17 rating tiers which resulted in a rate increase of 0.7%. Our rates include a 13.0% commission rate for agents. Our direct automobile written premiums increased by 5.5% in 2011 with increased exposures and average written premium per exposure in our private passenger and commercial automobile lines of business.
Insurance Ratios
The property and casualty insurance industry uses the combined ratio as a measure of underwriting profitability. The combined ratio is the sum of the loss ratio (losses and loss adjustment expenses incurred as a percent of net earned premiums) plus the expense ratio (underwriting and other expenses as a percent of net earned premiums, calculated on a GAAP basis). The combined ratio reflects only underwriting results and does not include income from investments or finance and other service income. Underwriting profitability is subject to significant fluctuations due to competition, catastrophic events, weather, economic and social conditions, and other factors.
Our GAAP insurance ratios are outlined in the following table.
Stock-Based Compensation
Long-term incentive compensation is provided under the our 2002 Management Omnibus Incentive Plan (the “Incentive Plan”) which provides for a variety of stock-based compensation awards, including nonqualified stock options, incentive stock options, stock appreciation rights and restricted stock (“RS”) awards.
The maximum number of shares of common stock with respect to which awards may be granted is 2,500,000. Shares of stock covered by an award under the Incentive Plan that are forfeited will again be available for issuance in connection with future grants of awards under the plan. At March 31, 2012, there were 617,538 shares available for future grant. The Board of Directors and the Compensation Committee intend to issue more awards under the Incentive Plan in the future.
A summary of stock-based awards granted under the Incentive Plan during the three months ended March 31, 2012 is as follows.
(1) The fair value per share of the restricted stock grant is equal to the closing price of our common stock on the grant date. (2) The shares cannot be sold, assigned, pledged, or otherwise transferred, encumbered or disposed of until the recipient is no longer a member of the Board of Directors.
Reinsurance
We reinsure with other insurance companies a portion of our potential liability under the policies we have underwritten, thereby protecting us against an unexpectedly large loss or a catastrophic occurrence that could produce large losses, primarily in our homeowners line of business. We use various software products to measure our exposure to catastrophe losses and the probable maximum loss to us for catastrophe losses such as hurricanes. The models include estimates for our share of the catastrophe losses generated in the residual market for property insurance by the Massachusetts Property Insurance Underwriting Association (“FAIR Plan”). The reinsurance market has seen from the various software modelers, increases in the estimate of damage from hurricanes in the southern and northeast portions of the United States due to revised estimations of increased hurricane activity and increases in the estimation of demand surge in the periods following a significant event. We continue to manage and model our exposure and adjust our reinsurance programs as a result of the changes to the models. As of January 1, 2012, we have purchased four layers of excess catastrophe reinsurance providing $485,000 of coverage for property losses in excess of $50,000 up to a maximum of $535,000. Our reinsurers’ co-participation is 50.0% of $30,000 for the 1st layer, 80.0% of $90,000 for the 2nd layer, 80.0% of $200,000 for the 3rd layer, and 80.0% of $165,000 for the 4th layer. As a result of the changes to the models and our revised reinsurance program, our catastrophe reinsurance in 2012 protects us in the event of a “140-year storm” (that is, a storm of a severity expected to occur once in a 140-year period). Swiss Re, our primary reinsurer, maintains an A.M. Best rating of “A” (Excellent). Most of our other reinsurers have an A.M. Best rating of “A” (Excellent) however in no case is a reinsurer rated below “A-” (Excellent). Our losses from the individual catastrophe events of 2011 were less than our reinsurance retention.
We are a participant in CAR, a state-established body that runs the residual market reinsurance programs for commercial automobile insurance in Massachusetts under which premiums, expenses, losses and loss adjustment expenses on ceded business are
shared by all insurers writing automobile insurance in Massachusetts. We also participate in the FAIR Plan in which premiums, expenses, losses and loss adjustment expenses on homeowners business that cannot be placed in the voluntary market are shared by all insurers writing homeowners insurance in Massachusetts. The FAIR Plan has grown dramatically over the past few years as insurance carriers have reduced their exposure to coastal property. The FAIR Plan’s exposure to catastrophe losses increased and as a result, the FAIR Plan decided to buy reinsurance to reduce their exposure to catastrophe losses. On July 1, 2011, the FAIR Plan purchased $1,000,000 of catastrophe reinsurance for property losses in excess of $200,000. At March 31, 2012, we had no material amounts recoverable from any reinsurer, excluding $37,839 recoverable from CAR.
On March 10, 2005, our Board of Directors adopted a resolution that prohibits Safety from purchasing finite reinsurance (reinsurance that transfers only a finite or limited amount of risk to the reinsurer) without approval by the Board. To date, the Company has never purchased a finite reinsurance contract.
Effects of Inflation
We do not believe that inflation has had a material effect on our consolidated results of operations, except insofar as inflation may affect interest rates.
Three Months Ended March 31, 2012 Compared to Three Months Ended March 31, 2011
The following table shows certain of our selected financial results.
Direct Written Premiums. Direct written premiums for the three months ended March 31, 2012 increased by $12,169, or 7.4%, to $176,253 from $164,084 for the comparable 2011 period. The 2012 increase occurred primarily in our personal automobile and homeowners lines, which experienced increases of 5.4% and 3.6%, respectively, in average written premium per exposure and increases of 0.5% and 10.9%, respectively, in written exposures for the three months ended March 31, 2012 from the comparable 2011 period. The increase in homeowners exposures is primarily the result of our pricing strategy of offering account discounts to policyholders who insure both an automobile and home with us.
Net Written Premiums. Net written premiums for the three months ended March 31, 2012 increased by $11,779, or 7.5%, to $169,298 from $157,519 for the comparable 2011 period. The 2012 increase was primarily due to the factors that increased direct written premiums.
Net Earned Premiums. Net earned premiums for the three months ended March 31, 2012 increased by $10,890, or 7.5% to $155,536 from $144,646 for the comparable 2011 period. The 2012 increase was primarily due to the factors that increased direct written premiums.
The effect of reinsurance on net written and net earned premiums is presented in the following table.
Net Investment Income. Net investment income for the three months ended March 31, 2012 decreased by $256, or 2.5%, to $9,909 from $10,165 for the comparable 2011 period. The 2012 decrease primarily resulted from lower short-term interest rates and ongoing maintenance of short duration to protect the portfolio from rising interest rates. Net effective annualized yield on the investment portfolio decreased to 3.6% for the three months ended March 31, 2012 from 3.7%, for the comparable 2011 period. Our portfolio duration was 3.8 years at March 31, 2012, up from 3.7 years at December 31, 2011.
Net Realized Gains (Losses) on Investments. Net realized gains on investments were $456 for the three months ended March 31, 2012 compared to net realized losses of $419 for the comparable 2011 period.
The gross unrealized gains and losses on investments in fixed maturity securities, equity securities, including interests in mutual funds, and other invested assets were as follows.
(1) Residential mortgage-backed securities consists of obligations of U.S. Government agencies including collateralized mortgage obligations and mortgage-backed securities guaranteed and/or insured by the following issuers: Government National Mortgage Association (GNMA), Federal Home Loan Mortgage Corporation (FHLMC), Federal National Mortgage Association (FNMA) and the Federal Home Loan Bank (FHLB). (2) Other asset-backed securities includes obligations of the U.S. Small Business Administration which totaled $5,719 at amortized cost and $6,214 at estimated fair value at March 31, 2012.
(3) Equity securities includes interests in mutual funds of $13,329 at cost and $13,841 at fair value as of March 31, 2012 held to fund the Company’s executive deferred compensation plan. (4) Our investment portfolio included 43 securities in an unrealized loss position at March 31, 2012. (5) Amounts in this column represent other-than-temporary impairments recognized in accumulated other comprehensive income.
The composition of our fixed income security portfolio by Moody’s rating was as follows.
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