| OHIO CASUALTY CORP Item 1A Risk Factors 14 ITEM 1A RISK FACTORS RISKS RELATING TO THE PROPERTY AND CASUALTY INDUSTRY o INSURANCE COMPANIES ARE SUBJECT TO EXTENSIVE GOVERNMENTAL REGULATION Our insurance subsidiaries are subject to extensive regulation and supervision in the jurisdictions in which they do business |
| Regulation is generally designed to protect the interests of policyholders, shareholders and non-policyholder creditors |
| Examples of governmental regulation that have adversely affected the operations of our insurance subsidiaries include: o the adoption in several states of legislation and other regulatory action intended to reduce the premiums paid for automobile insurance by residents of those states; and o requirements that insurance companies pay assessments to support associations that fund state-sponsored insurance operations, or involuntarily issue policies for high-risk automobile drivers |
| Regulations that could adversely affect our insurance subsidiaries also include statutory surplus and risk-based capital requirements |
| Maintaining appropriate levels of statutory surplus, as measured by statutory accounting practices and procedures, is considered important by state insurance regulatory authorities and the private agencies that rate insurers &apos claims-paying abilities and financial strength |
| The failure of an insurance subsidiary to maintain levels of statutory surplus that are sufficient for the amount of insurance written by it could result in increased regulatory scrutiny, action by state regulatory authorities or a downgrade by rating agencies |
| Similarly, the NAIC has adopted a system of assessing minimum capital adequacy that is applicable to our insurance subsidiaries |
| This system, known as risk-based capital, is used to identify companies that may merit further regulatory action by analyzing the adequacy of the insurerapstas surplus in relation to statutory requirements |
| Because state legislatures remain concerned about the availability and affordability of property and casualty insurance and the protection of policyholders, the Group expects that they will continue to face efforts to regulate their operations |
| Any one of these efforts could adversely affect the operating results and financial condition of the Group |
| In addition, regulatory authorities have broad discretion to deny or revoke licenses for various reasons, including the violation of regulations |
| In some instances, where there is uncertainty as to applicability, the Group follows practices based on their interpretations of regulations or practices that they believe generally to be followed by the industry |
| These practices may turn out to be different from the interpretations of regulatory authorities |
| If the Group does not have the requisite licenses and approvals or do not comply with applicable regulatory requirements, insurance regulatory authorities could preclude or temporarily suspend them from carrying on some or all of their activities or otherwise penalize them |
| This could adversely affect the Groupapstas ability to operate their businesses |
| Further, changes in the level of regulation of the insurance industry or changes in laws or regulations themselves or interpretations by regulatory authorities could adversely affect the Groupapstas ability to operate its &apos business |
| o INSURANCE COMPANIES ARE SUBJECT TO THE UNPREDICTABILITY OF COURT DECISIONS The financial position of our insurance subsidiaries also may be affected by court decisions that expand insurance coverage beyond the intention of the insurer at the time it originally issued an insurance policy |
| As a result, the full extent of liability under the policy may not be known for many years after a contract is issued |
| 14 ITEM 1A CONTINUED The United States Senate, the Department of Labor, the NAIC, as well as the attorneys general and insurance regulatory officials of various states have and in certain instances are currently investigating the character and extent of certain market practices within the insurance industry |
| These practices include, but may not be limited to, the payment of contingent commissions by insurance companies to insurance brokers and agents and the extent to which compensation to producers has been disclosed to insureds, the solicitation and provision of fictitious or inflated quotes, the illegal tying of insurance contracts to reinsurance placements, the use of improper inducements to employers |
| In addition to these government investigations, class action lawsuits relating to these market practices and specific types of illegal activity have been filed against various members of the insurance industry |
| o EXTERNAL FACTORS IN THE INSURANCE INDUSTRY MAY NEGATIVELY AFFECT OUR BUSINESS External factors beyond our control impacting the insurance industry in general could cause our results of operations to suffer |
| The insurance business is also affected by cost trends that impact profitability |
| Factors which negatively affect cost trends include inflation and increased litigation of claims |
| o NEW CLAIM AND COVERAGE ISSUES IN THE INSURANCE INDUSTRY MAY NEGATIVELY IMPACT OUR INCOME As insurance industry practices and regulatory, judicial, and consumer conditions change, unexpected and unintended issues related to claims and coverage may emerge |
| The issues can have a negative effect on our business by either extending coverage beyond our underwriting intent or by increasing the size of claims |
| Recent examples of emerging claims and coverage issues include: o the use of an applicantapstas credit rating as a factor in making risk selection and pricing decisions; o the availability of coverages which pay different commission levels to agents depending upon premium level; and o a growing trend of plaintiffs targeting automobile insurers in purported class action litigation relating to claims-handling practices |
| The effects of these and other unforeseen emerging claim and coverage issues could negatively impact our revenues or our methods of doing business |
| o THE PROPERTY AND CASUALTY INSURANCE BUSINESS IS HIGHLY CYCLICAL AND INTENSELY COMPETITIVE The Group has experienced, and expects to experience in the future, prolonged periods of intense competition during which they are unable to increase prices sufficiently to cover costs |
| The inability of the Group to compete successfully in the insurance lines in which they participate could adversely affect the Groupapstas operating results and financial condition |
| The Group competes with domestic and foreign insurers, many of which have greater financial resources than the Group |
| Competition involves many factors, including: o the perceived overall financial strength of the insurer; o levels of customer service to agents and policyholders, including the speed with which the insurer issues policies and pays claims; o terms, conditions and prices of products; and o experience in the insurance business |
| A number of new, proposed or potential legislative or industry developments could further increase competition in the property and casualty insurance industry |
| These developments include: o the enactment of the Gramm-Leach-Bliley Act of 1999, which could result in increased competition from new entrants to the market, including banks and other financial service companies; o the implementation of commercial lines deregulation in several states, which could increase competition from standard carriers for excess and surplus lines of business; 15 ITEM 1A CONTINUED o regulation of the use of credit scoring in the underwriting of insurance policies; o programs in which state-sponsored entities provide property insurance in catastrophe prone areas or other alternative market types of coverage; and o changing practices caused by the Internet, which have led to greater competition in the insurance business and, in some cases, greater expectations for customer service |
| New competition as a result of these developments could cause the supply or demand for insurance to change, which could adversely affect our results of operations and financial condition |
| The personal automobile and homeowners &apos insurance businesses are especially competitive and, except for regulatory considerations, there are relatively few barriers to entry |
| We compete with both large national writers and smaller regional companies |
| Some of our competitors have more capital and greater resources than we have, and may offer a broader range of products and lower prices than we offer |
| Some of our competitors that are direct writers, as opposed to agency writers as we are, may have certain competitive advantages, including increased name recognition, direct relationships with policyholders rather than with independent agents and, potentially, lower cost structures |
| All of these factors could potentially negatively impact our revenues |
| o THE THREAT OF TERRORISM, CONTINUED MILITARY ACTIONS AND POLITICAL INSTABILITY MAY ADVERSELY AFFECT THE LEVEL OF CLAIM LOSSES WE INCUR As a property and casualty insurer, we may have substantial exposure to losses resulting from acts of war, acts of terrorism and political instability |
| It is difficult to predict their occurrence with statistical certainty or to estimate the amount of loss an occurrence will generate |
| In addition, on November 26, 2002, Congress enacted the Terrorism Risk Insurance Act of 2002, or TRIA, which requires mandatory offers of terrorism coverage to all commercial policyholders, including workers &apos compensation and surety policyholders |
| TRIA provides that in the event of a terrorist attack on behalf of a foreign interest resulting in insurance industry losses of dlra5 million or greater, the US government will provide funding to the insurance industry on an annual aggregate basis of 90prca of covered losses up to dlra100 billion |
| Each insurance company is subject to a deductible, which is a percentage of that companyapstas direct earned premiums for the prior year, and this percentage increases in each of the three calendar years covered by TRIA, 2003 to 2005 |
| On December 22, 2005, the Terrorism Risk Insurance Extension Act of 2005 was signed into law, which reauthorizes the TRIA program for two years, while expanding the private sector role and reducing the federal share of compensation for insured losses under the program |
| Under TRIA, our deductible is calculated as a percentage of our direct earned premium for covered lines of business |
| We believe that we have reduced our exposure to terrorism risk by focusing our commercial lines business on small-to-medium-sized businesses and monitoring the aggregate exposure in large urban areas with highly visible targets |
| We also believe that we have secured enough reinsurance coverage to cover potential claims |
| Nevertheless, because of the unavailability of, or limitations on, reinsurance for these risks, we will continue to be exposed to commercial losses that arise from terrorism |
| Moreover, any future attacks could have a significant adverse affect on general economic, market and political conditions, potentially increasing other risks in our business |
| We cannot assess the effects of future terrorist attacks and any ensuing responsive actions on our business at this time, but they could be material |
| RISK RELATING TO THE CONSOLIDATED CORPORATION o OUR SUCCESS DEPENDS UPON OUR ABILITY TO UNDERWRITE RISKS ACCURATELY AND TO CHARGE ADEQUATE RATES TO POLICYHOLDERS AND TO SETTLE CLAIMS EXPEDITIOUSLY AND FAIRLY Our operating performance and financial condition depend on our ability to underwrite and set rates accurately for a full spectrum of risks |
| Rate adequacy is necessary to generate sufficient premiums to offset losses, loss adjustment expense and underwriting expenses and to earn a profit |
| If we fail to assess accurately the risks that we assume, we may fail to establish adequate premium rates, which could reduce income and have a material adverse effect on our operating results or financial condition |
| 16 ITEM 1A CONTINUED In order to price accurately, we must collect and properly analyze a substantial volume of data; develop, test and apply appropriate rating formulae; closely monitor and timely recognize changes in trends; and project both severity and frequency of losses with reasonable accuracy |
| Our ability to undertake these efforts successfully, and as a result, to price accurately, is subject to a number of risks and uncertainties, including, without limitation: o availability of sufficient reliable data; o incorrect or incomplete analysis of available data; o uncertainties inherent in estimates and assumptions, generally; o selection and application of appropriate rating formulae or other pricing methodologies; o our ability to innovate in the future as new or improved pricing strategies emerge; o unanticipated court decisions, legislation or regulatory action; o ongoing changes in our claim settlement practices, which can influence the amounts paid on claims; o changes in consumer and claimant behavior, which could adversely affect both frequency and severity of claims; o changing auto driving patterns, which could adversely affect both frequency and severity of claims; o unexpected inflation in the medical sector of the economy, resulting in increased workers &apos compensation, bodily injury and personal injury protection claim severity; and o unanticipated inflation in auto repair costs, auto parts prices and used car prices, adversely affecting auto physical damage claim severity |
| Such risks may result in our pricing being based on inadequate or inaccurate data or inappropriate analyses, assumptions or methodologies, and may cause us to incorrectly estimate future changes in the frequency or severity of claims |
| As a result, we could under price risks, which would negatively affect our margins, or we could overprice risks, which could reduce our volume and competitiveness |
| In either event, our operating results and financial condition could be materially adversely affected |
| o WE MAY FACE SIGNIFICANT LOSSES FROM CATASTROPHES AND SEVERE WEATHER EVENTS The Group has experienced, and is expected in the future to experience, catastrophe losses |
| It is possible that a catastrophic event or a series of catastrophic events could have a material adverse effect on the operating results and financial condition of the Group |
| Various events can cause catastrophes, including hurricanes, windstorms, earthquakes, hail, terrorism, explosions, severe winter weather and fires |
| The frequency and severity of these catastrophes are inherently unpredictable |
| The extent of losses from a catastrophe is a function of both the total amount of insured exposures in the area affected by the event and the severity of the event |
| Although catastrophes can cause losses in a variety of property and casualty lines, most of the catastrophe-related claims of the Group are related to homeowners &apos and commercial property coverages |
| Our insurance subsidiaries seek to reduce their exposure to catastrophe losses through their underwriting strategies and the purchase of catastrophe reinsurance |
| Nevertheless, reinsurance may prove inadequate if: o major catastrophic losses exceed our reinsurance limit; or o the Group incurs a high frequency of smaller catastrophic loss events which, individually, fall below our retention level; or o a reinsurer incurs claims with multiple insurers that may negatively impact surplus and their ability to pay |
| Claims resulting from natural or man-made catastrophic events could cause substantial volatility in our financial results for any fiscal quarter or year and could materially reduce our profitability or harm our financial condition |
| We believe that increases in the value and geographic concentration of insured property and the effects of inflation could increase the severity of claims from 17 ITEM 1A CONTINUED catastrophic events in the future |
| In addition, from time to time, legislation is passed that has the effect of limiting the ability of insurers to manage catastrophe risk, such as legislation prohibiting insurers from adopting terrorism exclusions or withdrawing from catastrophe-prone areas |
| Governmental regulation of this type is discussed above under the risk factors "e Risk Factors--Risks Relating to the Property and Casualty Industry--Insurance companies are subject to extensive governmental regulation and the unpredictability of court decisions "e and "e Risk Factors--Risks Relating to the Consolidated Corporation--War, Terrorism and Political Instability "e |
| o ACTUAL COSTS INCURRED ON CLAIMS MAY EXCEED CURRENT RESERVES ESTABLISHED FOR CLAIMS The Group maintains loss reserves to provide for their estimated ultimate liability for losses and loss adjustment expenses with respect to reported and unreported claims incurred as of the end of each accounting period |
| If these loss reserves prove inadequate, then the Groupapstas operating results and financial condition will be adversely affected |
| Reserves do not represent an exact calculation of liability |
| Instead, reserves represent estimates, generally involving actuarial projections at a given time, of what the Group expects the ultimate settlement and adjustment of claims will cost, net of salvage and subrogation |
| Estimates are based on assessments of known facts and circumstances, estimates of future trends in claims severity and frequency, changing judicial theories of liability and other factors |
| These variables are affected by both internal and external events, including changes in claims handling procedures, economic inflation, unpredictability of court decisions, plaintiffs &apos expanded theories of liability, risks inherent in major litigation and legislative changes |
| Many of these items are not directly quantifiable, particularly on a prospective basis |
| Additionally, significant reporting lags may exist between the occurrence of an insured event and the time it is actually reported |
| The Group adjusts the reserve estimates regularly as experience develops and further claims are reported and settled |
| Because the establishment of reserves is an inherently uncertain process involving estimates of future losses, previously established reserves may prove inadequate in light of actual experience |
| There are several types of insurance coverage provided by our insurance subsidiaries where the establishment of loss reserves is particularly difficult: o umbrella and excess liability losses, which are particularly affected by significant delays in the reporting of claims, relatively large amounts of insurance coverage, unpredictability of court decisions and plaintiffs &apos expanded theories of liability; o asbestos and environmental losses, which are particularly affected by significant delays in the reporting of claims, unpredictability of court decisions, plaintiffs &apos expanded theories of liability, risks of major litigation and legislative developments; and o construction defect losses, which are particularly affected by complexity of multiple party involvement and unpredictability of court decisions and plaintiffs &apos expanded theories of liability |
| o workers &apos compensation losses, which are particularly affected by the relatively long period of time to finalize claims and rising cost of medical benefits on claims providing lifetime coverages |
| The Group reflects adjustments to their reserves in the results of the periods in which their estimates are changed |
| For example, in 2003, the Group added dlra34dtta1 million to reserves for loss development on prior years &apos business on both a GAAP and statutory basis |
| In 2005 and 2004, the Group reduced reserves by dlra20dtta1 and dlra21dtta8 million for favorable development on prior years &apos business on a GAAP basis, or dlra21dtta5 and dlra21dtta7 million on a statutory basis, respectively |
| For additional discussion on the risk factors inherent in the loss and LAE reserves see Item 7, Managementapstas Discussion and Analysis of Financial Condition and Results of Operations - Critical Accounting Policies section on pages 44-52 of this Annual Report on Form 10-K o REINSURANCE SUBJECTS US TO THE CREDIT RISK OF REINSURERS AND MAY BE INADEQUATE TO PROTECT US AGAINST LOSSES ARISING FROM CEDED INSURANCE FURTHER, REINSURANCE MAY NOT BE AVAILABLE AT PRICES WE DEEM REASONABLE WHICH MAY LIMIT OUR ABILITY TO WRITE BUSINESS Reinsurance is a contract by which one insurer, called a reinsurer, agrees to cover a portion of the losses incurred by a second insurer in the event a claim is made under a policy issued by the second insurer |
| The Group obtains reinsurance to help manage its exposure to property and casualty risks |
| Additionally, GAI has agreed to maintain reinsurance on the commercial lines business that we acquired from GAI in 1998 for loss dates prior to December 1, 1998 |
| 18 ITEM 1A CONTINUED Although a reinsurer is liable to the Group according to the terms of the reinsurance policy, the Group remains primarily liable as the direct insurer on all risks reinsured |
| As a result, reinsurance does not eliminate the obligation of the Group to pay all claims, and each insurance subsidiary is subject to the risk that one or more of its reinsurers will be unable or unwilling to honor its obligations |
| The Group, except for OCNJ, pool their underwriting results, including reinsurance, which means that their insurance operations are aggregated and then reallocated among the participating insurers |
| Accordingly, if the reinsurance obtained by one of our insurance subsidiaries, or the reinsurance obtained by GAI related to the acquired commercial lines business, proves uncollectible or inadequate, then the operating results and financial condition of all of our insurance subsidiaries in the reinsurance pool will be adversely affected |
| The reinsurance obtained by GAI relating to the acquired commercial lines business is guaranteed by GAI in the event that the reinsurers are unable to pay |
| The Group cannot guarantee that its reinsurers will pay in a timely fashion, if at all |
| Reinsurers may become financially unsound by the time that they are called upon to pay amounts due, which may not occur for many years |
| Additionally, the availability and cost of reinsurance are subject to prevailing market conditions beyond our control |
| For example, the terrorist attacks of September 11, 2001 and the recent hurricanes had a significant impact on the reinsurance market |
| Some of the reinsurance contracts of the Group include coverage for acts of terrorism |
| Instead of being unlimited as in the past, however, terrorism coverage in 2004 contracts has been modified to exclude or limit coverage |
| If the Group is unable to obtain adequate reinsurance at commercially reasonable rates, then the Group would have to either bear an increased risk in net exposures or reduce the level of its underwriting commitments |
| Either of these potential developments could have a material adverse effect upon the business volume and profitability of the Group |
| For further information on the Consolidated Corporationapstas reinsurance programs see Item 7, Managementapstas Discussion and Analysis of Financial Condition and Results of Operations on page 55 of this Annual Report on Form 10-K o IF THE GROUP IS UNABLE TO MAINTAIN ITS RELATIONSHIP WITH ITS KEY AGENTS OR IS UNABLE TO ATTRACT ADDITIONAL AGENTS, OUR BUSINESS AND RESULTS OF OPERATIONS COULD BE ADVERSELY IMPACTED Our future success will depend, in large part, upon the efforts of our independent agents |
| The Group is represented by approximately 3cmam400 independent insurance agencies with approximately 5cmam500 agency locations, each containing at least one licensed agent of the Group |
| Certain agencies that meet established profitability and production targets are eligible for "e key agent "e status |
| At December 31, 2005 and December 31, 2004, these agencies represented 21dtta5prca and 16dtta2prca, respectively, of the Groupapstas total agency force and wrote 42dtta5prca and 39dtta8prca, respectively, of its book of business |
| The policies placed by key agents have consistently produced a lower loss ratio for the Group than policies placed by other agents |
| In addition, as we expand our business, we may need to expand our network of agencies to successfully market our products |
| We will need to recruit and retain additional independent agents, but we may not be able to do so |
| If the Group was unable to maintain its relationships with its key agents or if certain key agents no longer marketed and sold its products and if they were unsuccessful in recruiting and retaining additional agents, our book of business would likely decline and our results of operations would be adversely affected |
| o OUR INSURANCE SUBSIDIARIES ARE SUBJECT TO MINIMUM CAPITAL AND SURPLUS REQUIREMENTS THAT COULD RESULT IN A REGULATORY ACTION IF WE FAIL TO MEET THESE REQUIREMENTS Our insurance subsidiaries are subject to minimum capital and surplus requirements imposed under the laws of Ohio and Indiana |
| Any failure by one of our insurance subsidiaries to meet the minimum capital and surplus requirements imposed by applicable state law will subject it to corrective action, including requiring the adoption of a comprehensive financial plan, examination and the issuance of a corrective order by the applicable state insurance department, revocation of its license to sell insurance products or placing of the subsidiary under state regulatory control |
| Any new minimum capital and surplus requirements adopted in the future may require us to increase our capital and surplus levels, which we may be unable to do |
| As of December 31, 2005 and December 31, 2004, each of our insurance subsidiaries had capital and surplus in excess of the currently required amounts |
| 19 ITEM 1A CONTINUED o OUR SYSTEM FOR DISTRIBUTING INSURANCE PRODUCTS IS EXTREMELY COMPETITIVE Unlike some of our competitors, we do not distribute our products through agents who sell products exclusively for one insurance company nor do we sell directly to consumers |
| We distribute our products primarily through a network of independent agents |
| These agents may sell our competitors &apos products and may stop selling our products altogether |
| Strong competition exists among insurers for agents with demonstrated ability |
| While we believe that the independent agent distribution system offers service and underwriting advantages, using this system requires us to compete with other insurers for agents, which we do primarily on the basis of our support services, compensation, product features and financial position |
| In addition, we face continued competition from our competitors &apos products within our own distribution channel |
| Although we have undertaken several initiatives to strengthen our relationships with our independent agents and to make it easier and more attractive for them to sell our products, we cannot provide assurance that these initiatives will be successful |
| Sales of our insurance products and our results of operations could be materially adversely affected if we should be unsuccessful in attracting and retaining productive agents to sell our products |
| The Group also competes with other companies that use exclusive agents or salaried employees to sell their insurance products |
| Because these companies generally pay lower commissions or do not pay any commissions, they may be able to obtain business at a lower cost than the Group, which sells its products primarily through independent agents and brokers who typically represent more than one insurance company |
| o OUR GEOGRAPHIC CONCENTRATION TIES OUR PERFORMANCE TO THE ECONOMIC AND REGULATORY CONDITIONS AND WEATHER-RELATED EVENTS IN THE MID-ATLANTIC AND MID-WESTERN STATES Our property and casualty insurance business is concentrated geographically |
| Approximately 56dtta0prca of our net premiums written are for insurance policies written in the Mid-Atlantic and Mid-Western regions |
| We are concentrated in several Mid-Atlantic states, including New Jersey, Maryland, North Carolina and Pennsylvania and several Mid-Western states, including Ohio, Kentucky, Illinois and Indiana |
| Consequently, unusually severe storms or other natural or man-made disasters in the states in which we write insurance could adversely affect our operations |
| Our revenues and profitability are also subject to prevailing economic and regulatory conditions in those states in which we write insurance |
| Because our business is concentrated in a limited number of markets, we may be exposed to risks of adverse developments that are greater than the risks of having business in a greater number of markets |
| o THE ABILITY OF OUR SUBSIDIARIES TO PAY DIVIDENDS MAY AFFECT OUR LIQUIDITY AND ABILITY TO MEET OUR DEBT AND CONTRACTUAL OBLIGATIONS The Corporation is a holding company and a legal entity separate and distinct from our insurance company subsidiaries |
| As a holding company without significant operations of our own, our principal sources of funds are dividends and other distributions from our insurance company subsidiaries |
| State insurance laws limit the ability of our insurance subsidiaries to pay dividends and require our insurance subsidiaries to maintain specified levels of statutory capital and surplus |
| In addition, for competitive reasons, our insurance subsidiaries need to maintain financial strength ratings, which requires us to sustain capital levels in those subsidiaries |
| These restrictions affect the ability of our insurance company subsidiaries to pay dividends and use their capital in other ways |
| Our rights to participate in any distribution of assets of our insurance company subsidiaries are subject to prior claims of policyholders and creditors (except to the extent that our rights, if any, as a creditor are recognized) |
| Further, if our insurance subsidiaries cannot achieve and maintain profitability in the future, then they will need to draw on their surplus in order to pay dividends to enable us to meet our financial obligations |
| As surplus is reduced, the insurance subsidiaries &apos ability to pay additional dividends is also reduced |
| Insurance companies write insurance based, in part, upon a ratio of premiums to surplus |
| As the insurance subsidiaries &apos surplus is reduced by the payment of dividends, continuing losses or both, our insurance subsidiaries &apos ability to write insurance business could also be reduced |
| This could have a material adverse effect upon the business volume and profitability of our insurance subsidiaries |
| Consequently, our ability to repay our indebtedness, as well as our ability to pay expenses and cash dividends to our shareholders, may be limited |
| For further information on the regulation of dividends, refer to Item 1, page 8 of this Annual Report on Form 10-K 20 ITEM 1A CONTINUED o IF OUR NEW TECHNOLOGY FOR ISSUING AND MAINTAINING INSURANCE POLICIES DOES NOT WORK AS INTENDED OR DOES NOT SATISFY THE AGENT &apos S NEEDS, IT COULD DAMAGE OUR RELATIONSHIP WITH OUR AGENT NETWORK Our agents want a cost effective, timely and simple system for issuing and maintaining insurance policies |
| In 2001, we introduced into operation the Policy Administration Rating and Issuance System ( "e PARIS(SM) "e ) which is an internal system used to create and maintain policies |
| PARIS(SM) also provides the platform for a proprietary internet interface called PARIS Express(SM) and a platform for upload and download of information called PARIS Connect(SM) |
| Our agents utilize these interfaces to quote and issue both new business and endorsement business transactions |
| PARIS(SM) is the cornerstone in our strategy of focusing on superior agent service |
| The success of our strategic plan depends in part on our ability to provide our agents with the technological advantages of PARIS(SM) |
| If PARIS(SM) does not continue to work as expected, or if it fails to satisfy agents &apos needs, we may lose agents to insurers with preferred technologies |
| o OUR BUSINESS DEPENDS ON THE UNINTERRUPTED OPERATION OF ITS FACILITIES, SYSTEMS AND BUSINESS FUNCTIONS, INCLUDING ITS INFORMATION TECHNOLOGY AND OTHER BUSINESS SYSTEMS Our business is highly dependent upon its employees &apos ability to perform, in an efficient and uninterrupted fashion, necessary business functions, such as information system support and maintaining disaster recovery procedures, processing new and renewal policies, and processing and paying claims |
| Our inability to access one or more of our systems, a power outage, or a failure of technology, telecommunications or other systems could significantly impair our ability to perform such functions on a timely basis |
| If sustained or repeated, such a business interruption and systems failure could result in a deterioration of our ability to write and process new and renewal business, provide customer service, pay claims in a timely manner or perform other necessary business functions |
| This could result in a materially adverse effect on our operating results and financial condition |
| o ALTHOUGH WE HAVE BEGUN TO PAY CASH DIVIDENDS, WE MAY NOT CONTINUE OR BE ABLE TO PAY CASH DIVIDENDS IN THE FUTURE We have reinstated a cash dividend to our shareholders during 2005 after four years of not paying a dividend |
| However, future cash dividends will depend upon our results of operations, financial condition, cash requirements and other factors, including the ability of our insurance subsidiaries to pay dividends to the Corporation |
| There can also be no assurance that we will continue to pay dividends even if the necessary financial conditions are met and if sufficient cash is available for distribution |
| o A DOWNGRADE BY A RATING AGENCY MAY ADVERSELY IMPACT OUR ABILITY TO OBTAIN FINANCING AND RETAIN AGENTS FURTHER, BECAUSE WE ARE A "e SPLIT-RATED "e BORROWER, IT MAY RESULT IN A HIGHER COST OF BORROWING AS COMPARED TO BORROWERS WITH ONLY INVESTMENT GRADE CREDIT RATINGS Debt and financial strength ratings have become an increasingly important factor in establishing the competitive position of insurance companies |
| Each rating agency reviews its ratings periodically |
| A downgrade in the financial strength rating of our insurance subsidiaries by a recognized rating agency could result in a loss of business if agents or policyholders move to other companies with higher financial strength ratings |
| This loss of business could have a material adverse effect on the results of operations and financial condition of the insurance subsidiaries and the ability of the insurance subsidiaries to pay dividends |
| Generally, credit ratings affect the cost and availability of debt financing |
| Often, borrowers with investment grade credit ratings can borrow at lower rates than those available to similarly situated companies with ratings that are below investment grade, and the availability of certain debt products may be greater for borrowers with investment grade credit ratings |
| The Corporation and the insurance subsidiaries are currently rated by AM Best Company (AM Best), Fitch, Inc |
| AM Bestapstas ratings for insurance companies currently range from "e A++ "e (Superior) to "e F "e (In Liquidation), and include 10 separate rating categories |
| Within these categories, "e A++ "e (Superior) and "e A+ "e (Superior) are the highest, followed by "e A "e (Excellent) and "e A- "e (Excellent) |
| Publications of AM Best indicate that the "e A "e and "e A- "e ratings are assigned to those companies that, in AM Bestapstas opinion, have demonstrated excellent overall performance when compared to the standards established by AM Best and have demonstrated a strong ability to meet their obligations to policyholders over a long period of time |
| The AM Best rating for our insurance subsidiaries moved from "e A+ "e to "e A "e in 2000 and from "e A "e to "e A- "e in 2001 |
| In June 2004, AM Best affirmed our rating of "e A- "e and assigned a stable outlook on the rating |
| 21 ITEM 1A CONTINUED Fitchapstas ratings for insurance companies range from "e AAA "e to "e D, "e and include 12 different rating categories |
| Fitch may apply either a plus (+) or a minus (-) sign in each generic rating classification from "e AA "e to "e CCC "e |
| The plus (+) sign indicates that the obligation ranks in the higher end of its generic rating category; the minus (-) sign indicates a ranking in the lower end of that generic rating category |
| Publications of Fitch indicate that "e A "e ratings are assigned to those companies that have demonstrated strong financial security |
| On January 21, 2004, Fitch assigned a financial strength rating of "e A- "e to the Group and also affirmed its "e BBB- "e senior debt and long term issuer ratings |
| In June 2004, Fitch affirmed its financial strength rating of "e A- "e to the Group and also affirmed its "e BBB- "e senior debt and long term issuer ratings when assigning a rating to our 7dtta30prca Senior Notes due 2014 |
| In September 2005, Fitch affirmed its financial strength rating of "e A- "e and re-affirmed its "e BBB- "e senior debt and long term issuer ratings |
| The rating outlook was upgraded to positive |
| In February 2006 the Corporationapstas long term issuer rating of "e BBB- "e was withdrawn |
| Fitch assigned the Corporation an issuer default rating of "e BBB "e with a positive outlook and maintained the senior debt rating at "e BBB- |
| Moodyapstas ratings for insurance companies range from "e Aaa "e to "e C, "e and include 9 different ratings categories |
| Moodyapstas applies numerical modifiers 1, 2, and 3 in each generic rating classification from "e Aa "e through "e Caa "e |
| The modifier 1 indicates that the obligation ranks in the higher end of its generic rating category; the modifier 2 indicates a mid-range ranking; and the modifier 3 indicates a ranking in the lower end of that generic rating category |
| Publications of Moodyapstas indicate that "e A "e ratings are assigned to those companies that have demonstrated good financial security |
| In 2001, Moodyapstas affirmed its "e A2 "e rating of our insurance subsidiaries and issued a stable outlook |
| In November 2002, Moodyapstas downgraded our insurance subsidiaries &apos "e A2 "e rating to "e A3 "e and issued a stable outlook |
| In June 2003, Moodyapstas affirmed the "e A3 "e rating and issued a stable outlook |
| In June 2004, Moodyapstas assigned a Baa3 rating to our 7dtta30prca Senior Notes due 2014 |
| The financial strength rating and outlook were unaffected |
| In March 2005, Moodyapstas affirmed the A3 and Baa3 ratings with a stable outlook |
| S&Papstas ratings for insurance companies currently range from "e AAA "e (Extremely Strong) to "e R "e (Under Regulatory Supervision), and include 10 different ratings categories |
| S&Papstas may apply either a plus (+) or minus (-) sign in each generic rating classification from "e AA "e to "e CCC "e |
| The plus (+) sign indicates that the obligation ranks in the higher end of its generic rating category; the minus (-) sign indicates a ranking in the lower end of that generic rating category |
| Publications of S&Papstas indicate that an insurer rated "e BBB "e or higher is regarded as having financial security characteristics that outweigh any vulnerabilities, and is highly likely to have the ability to meet financial commitments |
| The S&Papstas rating for our insurance subsidiaries moved from "e A+ "e to "e BBB+ "e in 2000 and from "e BBB+ "e to "e BBB "e in 2001 |
| In October 2002, S&Papstas revised its outlook to negative from stable |
| In the first quarter of 2004 S&Papstas changed its outlook from negative to stable and affirmed the ratings of our insurance subsidiaries |
| In December 2004, S&Papstas revised its outlook to positive from stable, and affirmed its "e BBB "e financial strength rating on the Groupapstas intercompany pool |
| In August 2005, the S&Papstas rating for our insurance subsidiaries moved from "e BBB "e to "e BBB+ "e and the rating for our senior debt moved from "e BB "e to "e BB+ "e while the outlook was changed to stable |
| In February 2006, S&P announced it had revised its outlook from stable to positive |
| We cannot guarantee that future downgrades, if any, will not have a material adverse effect upon our business in the future |
| o FLUCTUATIONS IN THE VALUE OF OUR INVESTMENT PORTFOLIO COULD ADVERSELY AFFECT OUR FINANCIAL POSITION AND RESULTS OF OPERATIONS Our investment portfolio includes equity investments, both common and preferred, that are more volatile than fixed income investments |
| The market value of our equity portfolio was approximately 9dtta0prca (7dtta9prca common, 1dtta1prca preferred) and 8dtta9prca (8dtta7prca common, 0dtta2prca preferred) of total invested assets, excluding cash and cash equivalents, at December 31, 2005 and 2004, respectively |
| The portfolio was diversified across 60 separate entities in all ten major S&P industry sectors at December 31, 2005 |
| As of December 31, in 2005 and 2004, 24dtta2prca and 31dtta2prca, respectively, of our equity portfolio was invested in five companies and the largest single position was 5dtta4prca and 7dtta3prca, respectively, of the equity portfolio |
| Our cost basis in some of our stock holdings is very low, creating a significant unrealized gain in the portfolio, which could lead to a significant cash outflow for income taxes upon disposition |
| Equity securities are marked to fair value on the balance sheet |
| As a result, shareholders &apos equity and statutory surplus fluctuate with changes in the value of the equity portfolio |
| The effects of future stock market volatility are managed by maintaining an appropriate ratio of equity securities to shareholders &apos equity and statutory surplus |
| 22 ITEM 1A CONTINUED Our investment portfolio also includes investments in corporate and municipal bonds, mortgage-backed securities and other fixed income securities |
| The fair market value of these assets generally increases or decreases in an inverse relationship with fluctuations in interest rates |
| The interest income realized from future investments in fixed income securities will increase or decrease directly with fluctuations in interest rates |
| At December 31, 2005 and 2004, approximately 17dtta0prca and 16dtta7prca, respectively, of our total investment portfolio was invested in mortgage-backed securities |
| These investments carry the risk that cash flows from the underlying mortgages will be received faster or slower than originally anticipated |
| Faster repayment creates a risk that we will have to reinvest the repaid funds at a lower interest rate than the original investment |
| Slower repayments, which typically occur when interest rates rise, could decrease the value of the investment as the receipt of anticipated cash flows is delayed |
| At both December 31, 2005 and 2004, approximately 2dtta0prca of our available-for-sale fixed income portfolio was invested in below investment grade securities |
| The risk of default by borrowers which issue below investment grade securities is significantly greater because these borrowers are often highly leveraged and more sensitive to adverse economic conditions, including a recession or a sharp increase in interest rates |
| Additionally, these securities are generally unsecured |
| We also have exposure to losses resulting from potential volatility in interest rates |
| For additional information on investment results and market risk, see Item 7, Investment Results on pages 30-33 and Item 7A, Quantitative and Qualitative Disclosures about Market Risk sections of the Managementapstas Discussion and Analysis of Financial Condition and Results of Operation on pages 58 and 59 of this Annual Report on Form 10-K o WE CANNOT GUARANTEE THAT WE WILL BE ABLE TO MAINTAIN PROFITABILITY IN THE FUTURE Our failure to maintain profitability in the future may adversely affect our ability to meet our financial obligations |
| Although we reported net income of dlra212dtta7 million or dlra3dtta19 per share in 2005, dlra128dtta4 million or dlra1dtta89 per share in 2004 and dlra75dtta8 million or dlra1dtta18 per share in 2003, we cannot guarantee that we will be able to maintain profitability in the future |
| o WE MAY REQUIRE ADDITIONAL CAPITAL IN THE FUTURE, WHICH MAY NOT BE AVAILABLE OR MAY ONLY BE AVAILABLE ON UNFAVORABLE TERMS Our future capital requirements depend on many factors, including our ability to write new business successfully and to establish premium rates and reserves at levels sufficient to cover losses |
| We may need to raise additional funds through financings or curtail our growth and reduce our assets |
| Any equity or debt financing, if available at all, may be on terms that are not favorable to us |
| If we cannot obtain adequate capital on favorable terms or at all, our business, operating results and financial condition could be adversely affected |
| o OUR SHAREHOLDER RIGHTS PLAN MAY HAVE ANTI-TAKEOVER EFFECTS WHICH WILL MAKE AN ACQUISITION OF THE CORPORATION BY ANOTHER COMPANY MORE DIFFICULT We have adopted a shareholders &apos rights plan |
| The rights become exercisable only if a person or group, without the prior approval of our directors, acquires 20prca or more of our outstanding common shares or commences or publicly announces that it intends to commence a tender or exchange offer which, if completed, would result in a person or group owning 20prca or more of our outstanding common shares |
| Under certain circumstances after the rights become exercisable, each right would entitle the holder (other than the 20prca shareholder) to purchase common shares of the Corporation having a value of twice the then exercise price of the rights |
| The rights are intended to discourage a significant share acquisition, merger or tender offer involving our common shares which has not been approved in advance by our directors by increasing the cost of effecting any such transaction and, accordingly, could have an adverse impact on a takeover attempt that a shareholder might consider to be in its best interest |
| 23 ITEM 1A CONTINUED o THE ABILITY TO ATTRACT AND RETAIN TALENTED EMPLOYEES, MANAGERS AND EXECUTIVES IS CRITICAL TO OUR SUCCESS Our ability to remain a competitive force in the marketplace depends, in part, on our ability to hire and train talented new employees to handle work associated with the increase in new inquiries, applications, policies and customers, to respond to the increase in claims that may also result and to build sustainable business relationships with our agents |
| In addition, our ability to maintain appropriate staffing levels is affected by the rate of turnover of existing, more experienced employees |
| Our failure to meet these employment goals could result in our having to slow down growth in the business units or markets that are affected |
| Our success also depends on our ability to attract and retain talented executives and other key managers |
| Our loss of certain key officers and employees or our failure to attract talented new executives and managers could have a material adverse effect on our business |
| We further believe that our success depends upon our ability to maintain and improve our staffing models and employee culture that have been developed over the years |
| Our ability to do so may be impaired as a result of litigation that may be brought against us, new legislation at the state or federal level or other factors in the employment marketplace |
| In such events, the productivity of certain of our employees could be adversely affected, which could lead to a decrease in our operating performance and margins |
| o WE ARE PARTY TO LITIGATION, WHICH, IF DECIDED ADVERSELY TO US, COULD AFFECT OUR BUSINESS, RESULTS OF OPERATIONS OR FINANCIAL CONDITION We are named as a defendant in various legal actions arising out of claims made in connection with our insurance policies, other contracts we have entered into, employment related issues, and other matters including those referenced in Part |