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Executives

Jennifer DiBerardino – VP, IR

Greg Murphy – Chairman, President and CEO

Dale Thatcher – EVP and CFO

John Marchioni – EVP, Chief Underwriting and Field Operations Officer

Ron Zaleski – EVP and Chief Actuary

Analysts

Amit Kumar – Fox-Pitt Kelton

Mike Grasher – Piper Jaffray

Sam Hoffman – Lincoln Square

Doug Mewhirter – RBC Capital Markets

Bob Farnam – KBW

Selective Insurance Group, Inc. (SIGI) Q3 2009 Earnings Call Transcript October 29, 2009 8:30 AM ET

Operator

Good day, everyone. Welcome to the Selective Insurance Group's third quarter 2009 earnings release conference call. At this time, for opening remarks and introductions, I would like to turn the call over to Vice President, Investor Relations, Ms. Jennifer DiBerardino.

Jennifer DiBerardino

Thank you. Good morning. And welcome to Selective Insurance Group's third quarter 2009 conference call. This call is being simulcast on our Web site, and the replay will be available through November 30th, 2009. A supplemental investor package, which includes GAAP reconciliations of non-GAAP financial measures referred to on this call is available on the Investors page of our Web site at www.selective.com.

Selective uses operating income, a non-GAAP measure, to analyze trends in operations. Operating income is net income excluding the after tax impact of net realized investment gains or losses as well as the after tax results of discontinued operations. We believe that providing this non-GAAP measure makes it easier for investors to evaluate our insurance business.

As a reminder, some of the statements and projections that will be made during this call are forward-looking statements as defined by the Private Securities Litigation Reform Act of 1995. Forward-looking statements are not guarantees of future performance and are subject to risks and uncertainties.

We refer you to Selective’s Annual Report on Form 10-K and subsequent Form 10-Q filed with the US Securities and Exchange Commission for a detailed discussion of these risks and uncertainties. Please note that Selective undertakes no obligation to update or revise any forward-looking statements.

Joining me today on the call are the following members of Selective’s executive management team, Greg Murphy, CEO; Dale Thatcher, CFO; John Marchioni, Chief Underwriting and Field Operations Officer; Ron Zaleski, Chief Actuary; and, Kerry Guthrie, Chief Investment Officer.

Now, I’ll turn the call over to Dale to review the quarter results.

Dale Thatcher

Good morning. We are pleased to report solid insurance results with a statutory combined ratio of 99.8% in the third quarter. Commercial lines renewal pure pricing continuous its positive trend with a 1.5% increase in the quarter, up from a positive 0.6% in the second quarter. We are very encouraged by the positive pricing trend, and believe it reflects our dedicated field underwriting team, leveraging excellent agency relationships and predictive modeling capabilities in the face of what still can be characterized as a very competitive commercial lines marketplace and a difficult economy.

For the third quarter, we reported strong operating income per diluted share of $0.44, essentially flat with the year-ago. Earnings were driven by better property results, lower catastrophe losses, and improved investment income. As announced in our press release yesterday, we've entered into an agreement to sell our HR outsourcing business to AlphaStaff of Fort Lauderdale, Florida. The transaction is expected to close by year-end.

While we strongly believe in HR outsourcing services as a natural complement to our distribution force and business model, it made more sense to find the quality partner who could focus on those efforts as we devote our full time resources to profitable growth opportunities in our insurance operations. We will continue to support AlphaStaff's business growth through our agency plant as part of the agreement. Note that Selective HR financial results have been moved into discontinued operations, including an after tax $7.9 million goodwill impairment charge in the quarter.

Alternative investments generated a pre-tax gain in the quarter of $2.7 million, compared to a $3.2 million gain in the same period in 2008. Five of our seven strategies generated positive results in the quarter. Real estate continues to be a drag on the overall alternative investment performance. And we would expect this to continue until the commercial real state market stabilizes. As our alternatives largely report on a one-quarter lag, the $11.5 million improvement in the third quarter from the previous quarter reflects second quarter market conditions.

Investment assets were up 6% at September 30th, 2009, compared to December 31st, 2008, reflecting an unrealized gain during the period of $137 million pre-tax on our available for sale portfolio. The financial market's recovery from its lows earlier this year is the driver of this gain.

Market to amortized costs on the whole bond portfolio improved in the quarter to 102.3% from 99.5 % at June 30. For the nine months, our available for sale unrealized loss improved from $57 million to an unrealized gain of $31 million after tax, driven largely by fixed maturity securities.

The net overall improvement increased book value for outstanding share by $1.67. The valuation improvement, along with higher net income, contributed to the increase in book value from $16.84 at December 31st, 2008 to $18.58 at September 30, 2009.

Other than temporary impairments, or OTTI, in the quarter were recorded at $2.8 million after tax, primarily reflecting our intent to sell two securities that are currently in an unrealized loss position. This is a substantial improvement from the prior three quarters and reflects the stabilizing financial markets.

Insurance operations performed well in the quarter. Our 99.8% overall statutory combined ratio was up from the 97.6% reported a year ago. Despite lower catastrophe losses and favorable reserve development, the combined ratio was negatively impacted by increased loss costs and a reduction in earned premium, mainly due to audit and endorsement return premium. Pre-tax catastrophe losses for the quarter were $1.9 million or 0.5 points on the combined ratio, compared to catastrophes a year ago that were $12.8 million or 3.4 points.

Overall, casualty prior year’s statutory loss and LAE favorable reserve development on a pre-tax basis for the quarter was approximately $8 million or 2.2 points on the combined ratio, compared to $5 million or 1.3 points in the third quarter of 2008.

Commercial lines premium growth continues to be a challenge given the tough economic and competitive conditions. Commercial lines premium declined 9% in the quarter, half of which was driven by the impact of audit and endorsement return premium of approximately $18 million, compared to about $1 million a year ago. This continues to hit the workers' compensation and general liability lines of business the hardest. New business declined 13% in the quarter, renewal premium declined 2%, while retention end of the quarter at 75%.

Personal lines results improved 1.6 points in the quarter to a statutory combined ratio of 101.8% from 103.4% a year ago. The improvement was driven by a decrease in total property losses and a decrease in loss costs in the casualty lines. Personal lines and net premium written grew 11% in the quarter to $62 million. The price increases that we have achieved over the past two years and our expansion efforts outside New Jersey are reflected in the premium growth.

At September 30th, the premiums to surplus ratio was 1.6:1.0, down from 1.7 at June 30. Surplus increased $30 million in the quarter to $903 million, while stockholders' equity increased $40 million to $986 million.

Now, I’ll turn the call over to John Marchioni to review the insurance operations.

John Marchioni

Thanks, Dale. Good morning. Insurance operation is focused on growing profitably. The decline in commercial lines premium this quarter reflects not only a tough economy, but more importantly, underwriting and pricing discipline. Pricing and retention are the two levers that underwriters monitor carefully. Our inside renewal underwriting teams are working hard to balance price increases with retention levels. With the success we’ve had in driving overall price, there was a two-point drop in commercial lines retention to 75% in the quarter.

On a point of renewal basis, overall retention in the quarter was 88%, essentially flat with a year-ago. When we look further into our retention, it’s clear that we are driving improvement in our overall mix. At September 30th, retention at the point of renewal for the lower quality, one and two diamond business was 80%, while our best performing four and five diamond business retained at 90%.

We believe this demonstrates that our underwriting expertise and predictive modeling tools are working as intended. Given current economic conditions and a continued presence of some undisciplined competition for new business, we believe that 75% total retention and 88% point of renewal retention are good results in today’s markets.

Our field underwriters are writing the majority of new business in the highest quality four and five diamond range. The shift in quality of new business versus pre-modeling is no worry. Four and five diamond business now represents 67% of new business versus 53% pre-modeling. While the other end of the spectrum, one and two diamond business now represents only 7% of new business versus 17% pre-modeling.

We believe our strong relationship with this -- with our 960 agents provides our AMSs with the best new business opportunities. While the third quarter was the toughest so far this year for new business growth, we are confident that the business we are putting on the books has the best opportunity for profitability given the underwriting information and granular pricing capabilities our underwriters have at their fingertips.

New business pricing was down a modest 0.9% in the quarter, unchanged from the second quarter. In addition, we've seen submission activity from our agents remain very strong, while hit ratios are down from last year. Together, these factors demonstrate the discipline we've instilled in our operations.

Year-to-date, commercial lines new business was up 3%. By segment, One and Done automated small business was up 8% to $56 million; middle market or AMS generated business was up 1% to $133 million; selective risk managers, our large account business, was down 1% to $16 million as this segment of the market continues to experience the most competition. We continue to see the shift in our commercial lines book of business away from contractors to our other more profitable classes.

At September 30th, our contractors' mix stands at 40% of commercial lines premium, down from 43% at year-end 2008. Our new business success in these classes is demonstrated by the following statistics for the first nine months of 2009. New manufacturer and wholesaler business was up $8.5 million or 27%. New specialty business, which includes social service, golf courses, and public entities, was up $6.3 million or 27%. New mercantile and service business was up $1 million or 2%. The non-contractor classes of business performed, on average, about six points better on a combined ratio than the contractors' classes.

As we grow these classes faster than contractors, our profitability will improve. To that end, we have provided our agents with a variety of programs, such as sales developmental training and active leads for writing good business within our appetite, which support our commercial lines diversification efforts. These leads have been pre-scored through our models and target pricing is provided to best ensure profitability.

For personal lines, market pricing moved much sooner than for commercial lines. We began increasing rates in 2008. Through September of this year, we have implemented 21 rate increases of 3% or more. We are expecting to implement another six before the end of the year. Together, 2008 and 2009 increases equate to $26 million in additional premium opportunity our in-force book of business.

Our matrix homeowner and automobile models, with their precision pricing capabilities create organic growth opportunities. In personal lines, total new business increased 43% in the quarter from a year ago, while outside of New Jersey, new business increased 57%. This demonstrates our diversification efforts are working.

We are also seeing significant improvement in the quality of both homeowner and automobile business into higher-scored sectors that have better claim experience. We believe that predictive modeling through matrix, along with $26 million of additional rate on this $216 million book of business, will allow us to achieve our goal of being profitable on a run rate basis in the third or fourth quarter of 2010.

Now, I will turn the call over to Greg.

Greg Murphy

Thank you, John, and good morning. I'm pleased with our third quarter results. Recovery in the financial markets moved our alternative investment portfolio back into positive territory for the third quarter. We are seeing fundamental improvement in personal lines, and as a result of the numerous rate increases we've implemented and the predictive modeling capabilities we have through our matrix system.

In commercial lines, we have achieved renewal price increases ahead of our competitors. We are benefiting greatly from predictive modeling and our other knowledge management initiatives. We believe that if you cannot deliver granular price changes, you're going to get killed in this market.

Our knowledge management tools were key in our ability to deliver positive pure pricing. For commercial lines, renewal pure pricing increased 1.5% for the quarter, up from 0.6% in the second quarter. For the third quarter, commercial lines renewal pure pricing outside of New Jersey is even stronger and a positive 2.l%. Through November 23rd, total commercial lines renewal pure pricing was up a positive 2.6%, which was up 0.4 points over the month of September, and is now very close to covering our loss trends.

Our commercial lines pricing strategy is very targeted. We focus most aggressively on increasing price in the least profitable one and two diamond sectors. While this does negatively impact retention rates, we are comfortably -- we are comfortable shrinking in the short term to preserve long term profitability.

We believe there will be a change in industry behavior in 2010. And companies will raise prices to improve underwriting results for the following reasons, loss trends continue to move higher, particularly for medical expenses. Five years of commercial lines pure price reductions, interest rates remain low, and a recognition of more volatile financial markets, and as reserve releases start to diminish and calendar year loss ratios move higher.

The past year has been challenging on many fronts. But we've seen significant recovery and progress. Book value is up 10% since December 2008 for the five-year compounded annual growth rate of 4.4%. We've made significant progress in our personal lines profit improvement plan, with 21 filed rate increases of 3% of more to date, and another six anticipated for the fourth quarter.

Investment income has stabilized as alternative investment income turned positive in this quarter. Commercial lines pure pricing turned positive, and the run rate is getting close to covering loss trends. When we exceed loss trends and written policy increases start to make their way into earned premiums, profitability should improve.

The economic effect of audit and endorsement return premium comparisons should improve in the fourth quarter. As we move into 2010, we'll begin to show growth in commercial lines unless the competition ignores technical underwriting requirement and remains reckless.

We have a number of claims initiatives underway to even more vigorously manage loss and loss adjustment expenses, such as litigation management; ongoing vendor management to get the best quality at the best price; more effective integrated outcomes in the resolution of claims in workers' compensation and other casualty lines; and, we've diligently managed our expenses, maintaining about a 31.5% year-to-date expense ratio in spite of top line premium declines.

We are positively revising our full year 2009 combined ratio guidance to approximately 101% on both a GAAP and statutory basis. This change reflects the improved profitability we've seen year-to-date, and includes a fourth quarter assumption of one point of catastrophe losses. It does not assume any reserve development, favorable or unfavorable.

Now, I'll turn the call to the operator for your questions.

Question-and-Answer Session

Operator

(Operator instructions) We'll pause for just a moment to compile the Q&A roster. And your first question is on the line of Amit Kumar of Fox-Pitt Kelton.

Amit Kumar – Fox-Pitt Kelton

Thanks. That's Amit Kumar from Fox-Pitt.

Greg Murphy

Hi, Amit.

Amit Kumar – Fox-Pitt Kelton

Hey. I was just going back to your comments regarding the change in industry behavior in 2010. Would you hazard a guess as to -- do you -- are you bill (inaudible) there? You see this in the first half. Or are you talking more so about maybe Q3 or Q4 of 2010?

Greg Murphy

I've got to tell you, for us to be able to achieve -- I got to tell you, we've got a pretty clear plan laid out for 2010. And our ability to stand behind that plan is now based on our very granular pricing capabilities. Obviously, if the market moves, it needs to move in the first quarter of 2010 to exceed that plan. And we believe that because of investment returns, because of loss cost trends, because of five years of ongoing premium reductions, that that price trend needs to move and it needs to start in the first part of 2010.

Amit Kumar – Fox-Pitt Kelton

Okay. That's a good plan. I think, as I look at your rate changes, and I know you guys talked about CLIPs the day before yesterday, CIAB numbers came out, which I think talked about a 6% rate decrease in Q3. And if you look at the comments from some of the brokers, essentially it's a buyer's market. Can you just help me reconcile this delta where you are able to generate these price increases while some of the peers and the brokers are still talking about it being very easy simply based on the current economy?

Greg Murphy

Yes. I think there -- let's take that in its pieces, and I'll let John comment on this as well. But let's first understand that the market scout on CIAB are not really that scientific or actuarially sound methods. But they are an indication directionally of what you can see in the marketplace.

I think these are generally in the larger accounts sector where you could be seeing more reckless pricing. So that could be one reason. You got to understand that if you're talking to a large broker about segmentation and pricing changes, and then you come and look at our book for instance, our average account is more in the 10,000 range.

And the other element of that I think is when you start to look at our book, there is about maybe 30% that we're really focusing on price increases. So there's 70% of the book that really hasn't gotten much of any price increases as a result of our very, very granular targeted rate increases. So I think part of it is you've got to look at it more in the account-by-account basis. You also have to segment the sizes of the accounts. And that's why we believe that we track more closely to advising or CLIPs than when you look at the CLIPs surveys, they have moved positive and it does corroborate our position about what we're doing in the marketplace. John, what--?

John Marchioni

Yes. The only other thing I would add is we certainly saw the markets start to get more disciplined in the second quarter and then things turned back to aggressive from a new business perspective in the third quarter. And just to reiterate what Greg had said, when you look at how we're achieving our rate changes the business that we're pushing out to the market based on applying rate increases tends to be the lower quality business. And I think that's what a lot of the competition is really starting to see out there and starting to pursue with rate levels that, quite honestly, are inadequate.

So you combine that with the fact that many companies -- and we reported to you in our prepared comments the new business pure price number, many companies don't aggressively measure new business pure price. And I think as they start to realize the pricing levels are putting this business on the books, that's going to pour some discipline as well as they start to earn that through their renewal inventory.

Greg Murphy

And part of the comment that I just -- the consumer. And I think that is -- will be a critical part in maybe maintaining a softer market for a longer duration of time. Consumers are very -- price increases, the business is very difficult today. So in some cases they could sit there and say -- they could tell their agent to move them at any cost to another carrier just to get a cheaper price.

So those are -- those are legitimate head winds out there and I hope you get the message from us with the 2.6% price increases through October 23rd, we're very close to covering our loss trend at that point. And we feel good about that. But we're also -- understand that we are out there ahead of the market.

I read most other commentary. No one else is really getting price increases, particularly in the regional space. So we understand that we are a little bit -- we are ahead of the market. But until the market gets those kind of price increases, their combined ratio is going to be under pressure for another 6, or 9, or 12 months more than our will be under pressure. And I just think that's a part of the reality of loss trends and price changes as we move forward.

Amit Kumar – Fox-Pitt Kelton

Those are good points. I guess just talking about your premium to surplus levels being at 1.6, obviously you've talked about -- you've seen that slide in other -- you talked about the new business opportunities and how much you can expand. How far can you go on that premium to surplus level before you hit a ceiling?

Dale Thatcher

I'd say we're very comfortable at our current 1.6:1 premiums to surplus. Obviously in this economy and with the pressures we're having, we're actually seeing some decline in premium which moves that ratio downward. But I'd say that we're comfortable with our capital levels. The one thing that we said publicly is if you did have a very rapid hardening of the pricing out there, there may be some need to do something differently. But quite frankly, we just don’t foresee that you are going to see that kind of a rapid hardening. So we're very comfortable where we are.

Amit Kumar – Fox-Pitt Kelton

Okay. And then final question, in terms of the reserve for leases, I might have missed it. Can you give some more color as to what lines did they come from, specific lines?

Ron Zaleski

Actually, reserve releases came from both workers' comp, general liability, and commercial liability, all about the same amount.

Greg Murphy

That was Ron Zaleski, our Chief Actuary, by the way.

Amit Kumar – Fox-Pitt Kelton

Oh. Yes. Thanks. Okay. Thanks so much, and congrats on the quarter.

Greg Murphy

Thank you.

Operator

And your next question is from the line of Mike Grasher of Piper Jaffray.

Greg Murphy

Hey, Mike.

John Marchioni

Mike.

Mike Grasher – Piper Jaffray

Good morning, everyone. Just more question around that risk to capital and how it has improved dramatically here over the course of the first three quarters in '09. What level or what's it going to take from A.M. Best's perspective to remove that negative outlook that they have placed? Granted you still have the A plus rating, but I'm just curious as to what they look at or what they're looking for?

Greg Murphy

Basically, what they're looking for is improvements in the operating earnings which, basically, the pressure was on the investment side of things. And obviously, with the alternatives moving back into positive territory, that's a very favorable thing. And then, to see us begin to generate capital organically, which that's exactly what you're seeing here. So I think beyond that, it becomes -- we've got to demonstrate a few quarters of that so that they feel comfortable that it's definitely the new current state.

Mike Grasher – Piper Jaffray

Okay. And then do they come back to you once a year or is that -- it can occur at any time? How do you think about that?

Greg Murphy

Well, ratings agencies reserve the right to do whatever they want, at any time. But we do have a regularly schedule annual meeting with them. Which generally, the meeting occurs in late February and they release their results in late April or early May. That's been the tradition. But they are not locked in to that.

Mike Grasher – Piper Jaffray

Okay. So they'll basically get one more look before they come in February.

Greg Murphy

And Mike, they also have their own model. They have the BCAR model. And that's a measurement that we closely follow. And we saw quite an improvement in our -- in those results in the third quarter as our surplus topped over $903 million.

Mike Grasher – Piper Jaffray

Sure. And then I wanted to ask about the workers' comp just to confirm. It looks like the deterioration in the combined ratio and the loss ratio was entirely related to the amount of premium.

Greg Murphy

Yes. That--

Mike Grasher – Piper Jaffray

Numerator-denominator effect more so than deterioration on--

Greg Murphy

Yes. There's a little bit of movement in the 2009 year. But most of that is, like you say, there's a lot of gyrations happening there in the audit and endorsement -- from an audit and endorsement standpoint. And as Dale mentioned, we had about $18 million of negative audit and endorsement premium in the third quarter. That substantially lands in two lines, the biggest one is the workers compensation line and the next one is the GL line, as those are exposure base lines. So let's make sure that we understand that that is less exposure on the books--

Mike Grasher – Piper Jaffray

Right.

Greg Murphy

--and has pushed around both our underwriting expense ratio in that line, our loss adjustment expense ratio in that line as well as a little bit on the loss ratio as a result of that huge fluctuation.

And just to get this point out there, we only had a $1 million of positive audit endorsement in the third Q of '08. As we move into the fourth quarter of '09 we'll be comparing it to a fourth quarter of '08 that's got about $13 million -- $13.5 million of negative premiums. So that's what we started to mean that the comps will start to level out a lot more as we move into the fourth quarter of this year.

Mike Grasher – Piper Jaffray

Okay. And then the change in the premium from workers' comp, is -- year-over-year, how much was related to the negative audit versus how much on the retention aspect?

Greg Murphy

Fine. Dale's looking -- we're looking for that exact split right now. I only have it in total but I don't have it by line. But we'll get that for you in a second. Any other questions that you have while we extract that information?

Mike Grasher – Piper Jaffray

No. I'll come back to you a little bit later. That was it for now. Thanks very much.

Greg Murphy

Thanks.

Operator

And your next question is from the line of Sam Hoffman of Lincoln Square.

Sam Hoffman – Lincoln Square

Yes. I just wanted to follow up on that question because it seems that your loss ratio, excluding caps and excluding development, increased to 69.7% for the quarter, from 66.9% in the second quarter. And it sound like some of that was due to the workers' compensation one time item. But I just want to clarify, how much of that increase -- what do you attribute that increase to and how much of it was one time versus a run rate going forward.

Greg Murphy

There's a lot of moving parts in our loss ratio so it's hard to just succinctly answer that question. But I'll just tell you, the overarching issue is you're still earning in negative rate, you still have positive loss trend. So obviously, as you move forward you're going to see the ramifications of the negative rate and the trend impact your loss ratio on a quarter-to-quarter basis.

So last quarter was the first quarter we rode at positive rate. This quarter we rode at even more positive rate level. So you're going to see that kind of effect to liability lines as you move out into the fourth, and first, and second quarters of '10. And the other thing that popped the number around a fair amount is your performance in the property lines.

But it's hard to sit there and disaggregate that number into it's pieces. There was some reserves that were moved into the current year. But most of that was due to the audit and endorsement situation.

Sam Hoffman – Lincoln Square

Okay. Just seeing the -- a 2.8% increase is quite significant, one quarter to the next. And so, maybe we could follow up offline in terms of--

Greg Murphy

There's a lot of factors that push those numbers around.

Sam Hoffman – Lincoln Square

What do you see the run rate going forward as you--

Greg Murphy

We don't prognosticate future run rates in terms of individual loss ratios. What we will tell you, obviously is we could only expect the combined ratio for the year to be 101. So you can back into that by you know what our expense ratio looks like in the fourth quarter. You know that always tracks higher because our premium on a net premium written basis is always down in the fourth quarter. And then you can just work your model backward and you can play with that.

Sam Hoffman – Lincoln Square

And the 101 excluded reserve releases?

Greg Murphy

There is no contemplation of either favorable or unfavorable development in that number. Correct.

Sam Hoffman – Lincoln Square

Okay.

Greg Murphy

And has one point of catastrophe losses in there as well.

Sam Hoffman – Lincoln Square

So implicitly, what you're saying is that the 69.7% was unusually high for the quarter?

Greg Murphy

I didn't say that. I said that there are a number of factors that push that around. And some of them could be the audit premium or other issues. And it's very hard to just sit there and disaggregate that number any other way than that.

Sam Hoffman – Lincoln Square

Okay. Just quickly, there were two other items. Your yield on fixed income securities dropped to 4.35% from 4.6%. Can you explain that and is that one time as well?

Greg Murphy

That's a reflection of the lowering yields that are available in the marketplace in some of the trades that we put on our portfolio that have de-risked it in terms of some of the -- you also see at the same time, we shortened up duration a little bit as a results of that. But, yes. The yields that we bought on versus the yields that came off, you are seeing a separation of that.

And that's one of the main theses for why price increases need to go up in the industry, because absolute yields are lower. And there's a recognition of more volatility in the investment world. So as you deal with both of those issues on the investment side, your underwriting results need to improve to offset that. Which means that your price increases need to move higher because loss trends are loss trends.

Sam Hoffman – Lincoln Square

Okay. Third thing is your other operating income line and other operating expense line decreased dramatically in the quarter, and the spread got worst for you guys. Can you just talk about the implications of the divestiture or were any other factors for that line because it did -- that adversely impacted you guys in the quarter?

Dale Thatcher

That is the major impact in the quarter is the fact that we sold SHRS. So that's now moved to a discontinued operations line. So their income and their expenses are pulled out of those other categories on the face of the income statement, and moved to the discontinued operations line. I know that several other analysts have asked the question about that. We're going to try and put together a little bit of a schedule and post it out on the Web later today within our investor packet.

Sam Hoffman – Lincoln Square

Would you expect anything to be less than that line after the divestiture?

Jennifer DiBerardino

Yes.

Dale Thatcher

Yes.

Greg Murphy

Basically, yes. Both of those will permanently be lower now because they won't contain the SHRS activity.

Sam Hoffman – Lincoln Square

That's similar to the third quarter?

Greg Murphy

We're not making any prognostications with regards to the individual components that remain there.

Sam Hoffman – Lincoln Square

Okay. And finally, on the tax rate. Maybe you could just briefly discuss that?

Greg Murphy

Sure. And basically, it's a tradition. It's been there since APB 28 came out. But you have to prognosticate what you're expected tax rate is going to be for the full year and book your taxes on an individual quarter basis to that rate, so the difference between looking at the quarter on a cut-off basis and what your expectation for the full year gets booked as an effective tax rate adjustment within the quarter. So you can see -- you can particularly tell, I guess, when you go to the year-to-date number that the effective tax rate adjustment is pretty small at this point, and therefore -- which is exactly what you would expect that by the fourth quarter you get to your full year run rate.

Analyst

Okay. Thanks again.

Dale Thatcher

So that means -- what all that means is, obviously, the taxes that will incur in the fourth quarter will be pretty true to the taxable at 35 and a tax exempt -- at the tax exempt rate.

Analyst

Okay.

Greg Murphy

And another thing, I got some information to Mike Grasher's previous question, basically on the audit side of things, is about two-thirds of the audit premium comes from the workers' comp line of business. So out of the $18 million, it's a little over $11 million.

Operator

And your next question is from the line of Doug Mewhirter of RBC Capital Market.

Greg Murphy

Hey, Doug.

Doug Mewhirter – RBC Capital Markets

Hi. Good morning. Just have one market-related question, I guess John or Greg, maybe you could answer it. It's more of hypothetical. So you've been talking, actually, for the last couple of quarters about -- a lot of times a competitor will come in and take away a long time account, maybe 20% off of it is expiring. Would you describe that typical competitor as a -- as more in the category of a national carrier or more in the category of a regional carrier, without getting too specific of course?

Greg Murphy

The answer is yes.

Dale Thatcher

It's regional, national, and in certain cases, a combination of the two.

Doug Mewhirter – RBC Capital Markets

Okay. And I would assume that she -- would they be large versus small? I guess it would be more regional in the smaller and national in the larger. Or is that--?

Greg Murphy

Not necessarily. We compete against both national and regional players in our small markets and in the middle market business, all the way up to the line in terms of size of business. So you do see them. It varies more geographically and more by segment. So your contractors' competitor status, in certain cases, is slightly different than the competitors that you'll see in manufacturing or specialty.

Doug Mewhirter – RBC Capital Markets

Okay.

Greg Murphy

I have to tell you, Doug, that has a big impact on our ability to move pricing. And I would tell you, if that -- that really curtails your ability to move more and get a larger basket of policy in the price increase area. And that's where our struggle is in terms of how we look at 2010, and how hard we want to push, and how big we want that inventory to include, how much we want those rate increases to be. That's where we have spent as a management time -- management team spend an amount of time on it will continue to as we set our pricing strategy for 2010, which theoretically will be done in the next few weeks.

You got January pricing that'll be -- that is going to be put out in the street in another few weeks. So you need to be way ahead of this curb. You miss January, you miss the whole month. That needs to be decided pretty soon.

Doug Mewhirter – RBC Capital Markets

All right, understood. Thanks. Thanks for your answers. Those are all my questions.

Operator

And you do have a follow up question from the line of Mike Grasher of Piper Jaffray.

Mike Grasher – Piper Jaffray

Thanks. Just a quick question on the changing goodwill, the -- I think the discontinued operation, impairment charges, $7.9 million after tax. I'm just trying to figure out -- I think we ended last quarter at $29 million in goodwill, $29.6 million. And now it's dropped to $7.8 million. Can you reconcile the change, that $7.9 million? I'm assuming a 35% tax rate would be $12 million?

Greg Murphy

I'm sorry. I'm trying to figure out where you're trying to go exactly with that, Mike.

Mike Grasher – Piper Jaffray

So the $12 million plus what's remained -- what's being recorded now at $7.8 million--

Greg Murphy

Right.

Mike Grasher – Piper Jaffray

--to $19 million, and $19 million compared to $29 million. Where did the--?

Greg Murphy

Right, yes. So take the $8 million, you use the 35% tax rate. That grosses it up to the $12 million for the number that you need there, I think is what you're looking for. Right?

Mike Grasher – Piper Jaffray

I'm still $10 million short.

Greg Murphy

Well, the overall goodwill that gets eliminated there is about $21 million. Obviously, there is -- the difference in the loss relates to the fact that we did sell it for $13 million.

Mike Grasher – Piper Jaffray

Okay. I see now. Thanks very much.

Greg Murphy

You got it?

Mike Grasher – Piper Jaffray

Yes.

Operator

And you do have a follow up question from the line Amit Kumar or Fox-Pitt Kelton.

Amit Kumar – Fox-Pitt Kelton

Amit Kumar from Fox-Pitt. Two follow ups, in terms of the discussion on competition. Can you isolate how much of that impacted your top line decline in commercial line space, maybe an approximate number?

Greg Murphy

It's hard to define that. As John articulated in his comments, we're getting as many ad backs from our agents in terms of being able to put pricing out on the street. And our hit ratio is down.

John Marchioni

And in terms of the slowdown and the overall 9% decline, it's roughly two, two-and-a-half points are benign or driven by new business. Now that's not all competition related, but you look at that as the subset of the 9%. And then as we said, managing new pure price and managing mix the way we have has resulted in a lower hit ratio on the similar number of opportunities versus prior year.

Amit Kumar – Fox-Pitt Kelton

Okay. That's very helpful. And I guess my only other question is in terms of your rate change of 2.6%. Can you just briefly touch upon some of the lines where you're seeing the greatest traction.

Greg Murphy

Yes. I don't have the line breakout on the 2.6%. I can just tell you, geographically, we now have two of our regions on over 4% in price increases, so.

John Marchioni

Yes, yes. I've got the quarterly numbers by line. But the 2.6% -- you'll be trying to get your arms behind the 2.6%. I will tell you that it's pretty spread throughout many of our geo locations. We have two over four. We've got one of two-nine. And the other region at two-six And we still have one region that's having -- struggle getting any price increases at all.

And I'll tell you that clearly falls into the super competitive market that they're in right now in terms of our business. It kind of gives you the best sense that I have because that's a quick draw of our mid term pricing increases. And as we roll through the month of October, then we'll have everything by line and all the other aspects of it.

Amit Kumar – Fox-Pitt Kelton

And then, what region is that, which is super competitive?

John Marchioni

Right now, the most difficult market right now is New Jersey.

Amit Kumar – Fox-Pitt Kelton

Okay. That's all for now. Thanks so much, guys.

Operator

And your next question is from the line of Bob Farnam of KBW.

Bob Farnam – KBW

Hi. Good morning. I have just a couple of questions. (inaudible) to the reserve, your favorable reserve development. Can you give us an idea what you're act in years, like in the workers' comp and general liability those were coming from?

Greg Murphy

Ron will answer that for you.

Ron Zaleski

Yes. For the most part, it's 2007 prior for all lines.

Bob Farnam – KBW

For all lines, okay. And you sound like you were raising your estimates the current accident year. Can you quantify that?

Greg Murphy

Well, we said that we're raising our -- I mean, it's two-part. One, it's the audit premium impact and the fact that that was extraordinarily at the level of audit premium. That kind of pushed the numbers around. And then, what I mentioned earlier is the natural progression throughout the quarter where we're still earning in minus rate and we still have positive loss trends. And that does move your loss ratios higher on a quarter-over-quarter basis.

Bob Farnam – KBW

Okay. And I think you've indicated before you thought that the rates needed to get 3% or so to start offsetting losses.

Greg Murphy

That's a close number, yes.

Bob Farnam – KBW

Okay. All right. Thanks.

Operator

And you do have a follow-up question from the line of Sam Hoffman of Lincoln Square.

Sam Hoffman – Lincoln Square

Sorry, just one other follow up. You had commented that your real estate alternative investments would be a continued headwind on results. But yet that portfolio, I believe, was only $21 million at the beginning of the year. And I think you took significant rights on it on the first quarter. And so, is it -- how much of that is actually left? And how significant can that be going forward?

Greg Murphy

Sure. There are three different investments in the real estate sector. It represents approximately 13% of our overall alternative investment portfolio. In terms of dollars, that's approximately $19 million. And as you can see in the package that we disseminated, the loss in the quarter was $1.2 million in that sector.

Sam Hoffman – Lincoln Square

Okay. Thank you.

Operator

And I show no further questions at this time.

Dale Thatcher

I do have -- before Greg closes up. I kind of figured out what Mike Grasher's question was here. Actually, Tony Harnett figured it out. Is that where that extra piece of goodwill is, is it's been relocated into the assets of discontinued operations line. So the goodwill was not written off entirely. It was just written down to reflect the selling price. So that remaining chunk of goodwill, about $9.5 million, resides in the assets of discontinued operation line on the balance sheet.

With that, I'll toss it over to Greg to close it up.

Greg Murphy

Well, thank you then. Underwriting and reserve discipline, coupled with a conservative, well-positioned investment portfolio, will be the foundation for our long term performance. If you've got any other follow up questions, please contact Jennifer and Dale. Thank you very much.

Operator

And this does conclude today's conference call. You may now disconnect.

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Source: Selective Insurance Group, Inc. Q3 2009 Earnings Call Transcript
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