Ohio Casualty Cp (OCAS) - Description of business


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Company Description
Segment Description

      Commercial Lines Segment

The Group’s Commercial Lines segment accounted for 58.7%, 56.8% and 57.0% of net premiums written in 2006, 2005 and 2004, respectively, consisting of the following product lines:

                         
(in millions)   2006     2005     2004  
 
Workers’ compensation
  $ 137.5     $ 138.6     $ 132.9  
Commercial automobile
    223.4       227.7       233.5  
General liability
    101.1       95.7       89.5  
CMP, fire and inland marine
    367.7       361.5       372.3  
 
                 
Total Commercial Lines
  $ 829.7     $ 823.5     $ 828.2  
 
                 


These product lines include:


  Workers’ compensation insurance — insures employers for their obligations to provide workers’ compensation benefits as required by applicable statutes, including medical payments, rehabilitation costs, lost wages, and disability and death benefits. These policies also provide coverage to employers for their liability exposures under the common law;


  Commercial automobile insurance — insures policyholders against first and third party liability related to the ownership and operation of motor vehicles used in the course of business and property damage to insured vehicles. These policies may provide uninsured motorist coverage, which provides coverage to insureds and their employees for bodily injury and property damage caused by an uninsured party;


  General liability insurance — insures policyholders against third party liability for bodily injury and property damage, including liability for products sold and covers the cost of the defense of claims alleging such damages; and


  Commercial multi-peril insurance (CMP) fire and inland marine — insures a business against risks from property, liability, crime and boiler and machinery explosion losses.

      Specialty Lines Segment

The Group’s Specialty Lines segment accounted for 10.3%, 10.4% and 9.3% of net premiums written in 2006, 2005 and 2004, respectively, consisting of the following product lines:

                         
(in millions)   2006     2005     2004  
 
Commercial umbrella/other
  $ 85.6     $ 97.2     $ 87.1  
Fidelity and surety
    59.7       53.2       48.4  
 
                 
Total Specialty Lines
  $ 145.3     $ 150.4     $ 135.5  
 
                 


These product lines include:


  Commercial umbrella — indemnifies policyholders for liability and defense costs which exceed coverage provided by the underlying primary policies, typically commercial automobile and general liability policies, and provides coverage for some items not covered by underlying policies;


  Fidelity and surety — insures against dishonest acts of bonded employees and the non-performance of parties under contracts, respectively.

      Personal Lines Segment

The Group’s Personal Lines segment accounted for the remaining 31.0%, 32.8% and 33.7% of net premiums written in 2006, 2005 and 2004, respectively, consisting of the following product lines:

Item 1. Continued

                         
(in millions)   2006     2005     2004  
 
Personal auto including personal umbrella
  $ 259.6     $ 283.7     $ 294.1  
Personal property
    177.6       191.8       196.1  
 
                 
Total Personal Lines
  $ 437.2     $ 475.5     $ 490.2  
 
                 


These product lines include personal automobile and homeowners insurance sold to individuals and provide property and liability coverage.

Marketing and Distribution

The Group is represented by approximately 3,350 independent insurance agencies (for this purpose considered the Group’s Agency Force) with approximately 5,700 agency locations, each containing at least one licensed agent of the Group. These agents also represent other unaffiliated companies which may compete with the Group. In addition to its home office facility, the Group operates in multiple claim, underwriting, bond and service offices to assist these independent agents in producing and servicing the Group’s business.

Certain agencies that meet established profitability and production targets are eligible for “key producer” status. At December 31, 2006, these agencies represented 16.4% of the Group’s total Agency Force and wrote 48.5% 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.

The Commercial Lines customer group, categorized by commercial liability coverage premium volume, included approximately 51% contractors/artisans, 18% mercantile, 19% service, 7% manufacturers and 5% other. The Group targets small and medium-sized commercial accounts that range in size, with average premium of $5 thousand — $7 thousand. The Group believes this small to medium size business customer group offers an opportunity to achieve superior underwriting results through development and maintenance of strong agent and customer relationships and application of the Group’s underwriting, loss control, pricing and claims expertise.

The Group markets its Specialty Lines segment predominately to policyholders who have purchased commercial automobile and general liability policies and have a need for additional coverage under umbrella policies to cover costs which might exceed the underlying policies limits or are not covered under such policies. Specialty Lines also includes the marketing of the fidelity and surety products to employers and other parties in need of insurance against dishonest acts of bonded employees as well as the non-performance of parties under contractual agreements.

The Group markets personal automobile insurance primarily to standard and preferred risk drivers. Standard and preferred risk drivers are those who have met certain criteria, including a driving record which reflects a low historical incidence of at-fault accidents and moving violations of traffic laws. The Group also markets the homeowners insurance product to individuals to provide coverage for damage to their home and/or personal property.

Competition

The property and casualty insurance industry is highly competitive. The Group competes on the basis of service, price and coverage. According to A.M. Best, based on net insurance premiums written in 2005, the latest year for which industry-wide comparison statistics are available:


  more than $437 billion of net premiums were written by property and casualty insurance companies in the United States and no one company or company group had a market share greater than approximately 10.9%; and


  the Group ranked as the fiftieth largest property and casualty insurance group in the United States.

Item 1. Continued

Regulation

      State Regulation

The Corporation’s insurance subsidiaries are subject to regulation and supervision in the states in which they are domiciled and in which they are licensed to transact business. The Company, American Fire, Ohio Security and OCNJ are all domiciled in Ohio. West American and Avomark are domiciled in Indiana. Collectively, the Corporation’s subsidiaries are licensed to transact business in 49 states and the District of Columbia, actively writing in approximately 40 states. Although the federal government does not directly regulate the insurance industry, federal initiatives can impact the industry.

The authority of state insurance departments extends to various matters, including:


  the establishment of standards of solvency, which must be met and maintained by insurers;


  the licensing of insurers and agents;


  the imposition of restrictions on investments;


  approval and regulation of premium rates and policy forms for property and casualty insurance;


  the payment of dividends and distributions;


  the provisions which insurers must make for current losses and future liabilities; and


  the deposit of securities for the benefit of policyholders.

State insurance departments also conduct periodic examinations of the financial and business affairs of insurance companies and require the filing of annual and other reports relating to the financial condition of insurance companies. Regulatory agencies require that premium rates not be excessive, inadequate or unfairly discriminatory. In general, the Corporation’s insurance subsidiaries must file all rates for personal and commercial insurance with the insurance department of each state in which they operate.

State laws also regulate insurance holding company systems. Each insurance holding company in a holding company system is required to register with the insurance supervisory agency of its state of domicile and furnish information concerning the operations of companies within the holding company system that may materially affect the operations, management or financial condition of the insurers. Pursuant to these laws, the respective departments may examine the parent and the insurance subsidiaries at any time and require prior approval or notice of various transactions including dividends or distributions to the parent from the subsidiary domiciled in that state.

These state laws also require prior notice or regulatory agency approval of changes in control of an insurer or its holding company and of other material transfers of assets within the holding company structure. Under applicable provisions of Indiana and Ohio insurance statutes, the states in which the members of the Group are domiciled, a person would not be permitted to acquire direct or indirect control of the Corporation or any of its insurance subsidiaries, unless that person had obtained prior approval of the Indiana Insurance Commissioner and the Ohio Superintendent of Insurance. For the purposes of Indiana and Ohio insurance laws, any person acquiring more than 10% of the voting securities of a company is presumed to have acquired “control” of that company.

      National Association of Insurance Commissioners (NAIC)

The Corporation’s insurance subsidiaries are subject to the general statutory accounting practices and reporting formats established by the NAIC. The NAIC also promulgates model insurance laws and regulations relating to the financial condition and operations of insurance companies, including the Insurance Regulating Information System.

NAIC model laws and rules are not usually applicable unless enacted into law or promulgated into regulation by the individual states. The adoption of NAIC model laws and regulations is a key aspect of the NAIC Financial Regulations Standards and Accreditation Program, which also sets forth minimum staffing and resource levels for all state insurance departments. Ohio and Indiana are accredited.

Item 1. Continued

The NAIC has developed a “Risk-Based Capital” model for property and casualty insurers. The model is used to establish standards, which relate insurance company statutory surplus to risks of operations and assist regulators in determining solvency requirements. The standards are designed to assess capital adequacy and to raise the level of protection that statutory surplus provides for policyholders. The Risk-Based Capital model measures the following four major areas of risk to which property and casualty insurers are exposed:


  asset and liability risk;


  credit risk;


  underwriting risk; and


  off-balance sheet risk.

The Risk-Based Capital model law requires the calculation of a ratio of total adjusted capital to Authorized Control Level (ACL) risk-based capital. Based upon the unaudited 2006 statutory financial statements, all insurance companies in the Group significantly exceeded 200% of the ACL, which represents the level below which there could be regulatory intervention and corrective action.

      Regulations on Dividends

The Corporation is dependent on dividend payments from its insurance subsidiaries in order to meet or fund operating expenses, debt obligations, common stock repurchases and shareholder dividend payments. Insurance regulatory authorities impose various restrictions and prior approval requirements on the payment of dividends by insurance companies and holding companies. This regulation allows dividends to equal the greater of (1) 10% of policyholders’ surplus or (2) 100% of the insurer’s net income, each determined as of the preceding year end, without prior approval of the insurance department.

Dividend payments to the Corporation from the Company are limited to approximately $206.0 million during 2007 without prior approval of the Ohio insurance department based on 100% of the Company’s net income for the year ending December 31, 2006. Additional restrictions limiting the amount of dividends paid by the Company to the Corporation may result from the minimum risk-based capital requirements in the Corporation’s revolving credit agreement as disclosed in Item 15, Note 15 - Debt, in the Notes to the Consolidated Financial Statements on pages 87 and 88 of this Annual Report on Form 10-K.

Pooling Agreement

All of the Company’s insurance subsidiaries, except OCNJ, have entered into an intercompany reinsurance pooling agreement with the Company. As of January 1, 2005, the Company, the lead company of the pool, assumes and retains 100% of the pool’s underwriting experience. There are no retrocessions to the Company’s insurance subsidiaries.

Prior to January 1, 2005, under the terms of the previous intercompany reinsurance pooling agreement, all of the participants’ outstanding underwriting liabilities as of January 1, 1984, and all subsequent insurance transactions were pooled. The participating insurance subsidiaries shared in underwriting activity in 2004 based on the following percentages:

         
Insurance Subsidiary   Percentage of Losses
The Company
    46.75 %
West American
    46.75  
American Fire
    5.00  
Ohio Security
    1.00  
Avomark
    0.50  


Item 1. Continued

Investments

The distribution of the Consolidated Corporation’s invested assets is determined by a number of factors, including:


  rates of return;


  investment risks;


  insurance law requirements;


  diversification;


  liquidity needs;


  tax planning;


  general market conditions; and


  business mix and liability payout patterns.

Periodically, the investment portfolios are reallocated subject to the parameters set by management, under the direction of the Finance Committee of the Board of Directors. Management evaluates the investment portfolio on a regular basis to determine the optimal investment strategy based upon the factors mentioned above.

Assets relating to property and casualty insurance operations are invested to maximize after-tax returns with appropriate diversification of risk. As a result of improved underwriting profitability, the Consolidated Corporation began to increase funds invested in tax-exempt securities which resulted in enhanced after-tax investment income yields due to the tax-exempt status of the securities.

Equity and available-for-sale fixed income securities are marked to fair value on the consolidated balance sheets. As a result, shareholders’ equity fluctuates with changes in the value of these portfolios. The effect of future market volatility is managed through investment diversification, credit and asset duration management and by maintaining an appropriate ratio of equity securities to shareholders’ equity and statutory surplus.

See further detailed information and discussion on the results of operations and liquidity of the Consolidated Corporation’s investment portfolio in the “Investment Results” section on pages 41-45 and the “Investment Portfolio” section on pages 60-62 of Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operation, of this Annual Report on Form 10-K.

Liabilities for Unpaid Losses and Loss Adjustment Expenses

Liabilities for losses and loss adjustment expenses (LAE) are established for the estimated ultimate cost of settling claims for an insured event, both reported claims and incurred but not reported claims, based on information known as of the evaluation date. The estimated liabilities include the direct cost of the loss under terms of insurance policies, as well as legal fees and general expenses of administering the claims adjustment process. Because of the inherent future uncertainties in estimating ultimate costs of settling claims, actual losses and LAE may deviate substantially from the amounts recorded in the Consolidated Corporation’s financial statements. Furthermore, the timing, frequency and extent of adjustments to the estimated liabilities cannot be accurately predicted since conditions, events and trends which led to historical loss and LAE development and which serve as the basis for estimating ultimate claims cost may not occur in the future in exactly the same manner, if at all. As more information becomes available and claims are settled, the estimated liabilities are adjusted upward or downward with the effect of increasing or decreasing net income at the time of the adjustments. The effect of these adjustments may have a material adverse impact on the results of operations of the Group.

Item 1. Continued

The following tables present an analysis of losses and LAE and related liabilities for the periods indicated. The first table represents the impact of loss and LAE activity for current and prior accident year claims on calendar year incurred and paid losses and LAE. The second table displays the development of losses and LAE liabilities as of successive year-end evaluations for each of the past ten years.

Reconciliation of Liabilities for Losses and Loss Adjustment Expenses
(in millions)

                         
    2006     2005     2004  
Net liabilities, balance as of January 1
  $ 2,262.2     $ 2,186.1     $ 2,131.3  
Incurred related to:
                       
Current year
    945.7       927.4       958.1  
Prior years
    (52.2 )     (20.1 )     (21.8 )
 
                 
Total incurred
    893.5       907.3       936.3  
 
                       
Paid related to:
                       
Current year
    339.8       327.9       354.1  
Prior years
    489.3       503.3       527.4  
 
                 
Total paid
    829.1       831.2       881.5  
 
                       
Net liabilities, balance as of December 31
    2,326.6       2,262.2       2,186.1  
Reinsurance recoverable
    585.7       684.6       570.3  
 
                 
Gross liabilities, balance as of December 31
  $ 2,912.3     $ 2,946.8     $ 2,756.4  
 
                 


The accounting policies used to estimate liabilities for losses and LAE are considered critical accounting policies and are further discussed in the “Reserves for Losses and LAE Adjustment Expenses” sub-section in the “Critical Accounting Policies” section of Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operation, on pages 48-56 in this Annual Report on Form 10-K. In addition loss and LAE liabilities are further discussed in Note 1J - Summary of Significant Accounting Policies and Note 8 — Losses and Loss Reserves, in the Notes to the Consolidated Financial Statements on page 72 and pages 84 and 85 of this Annual Report on Form 10-K.

Item 1. Continued

Analysis of Development of Loss and Loss Adjustment Expense Liabilities
(In millions)

                                                                                         
Year Ended December 31   1996   1997   1998   1999   2000   2001   2002   2003   2004   2005   2006
Net liability as originally estimated:
  $ 1,486.6     $ 1,421.8     $ 1,865.6     $ 1,823.3     $ 1,907.3     $ 1,982.0     $ 2,079.3     $ 2,131.3     $ 2,186.1     $ 2,262.2     $ 2,326.6  
 
                                                                                       
Life Operations Liability
    3.7       0.1       0.1                                                  
 
                                                                                       
P&C Operations Liability
  $ 1,482.9     $ 1,421.7     $ 1,865.5     $ 1,823.3     $ 1,907.3     $ 1,982.0     $ 2,079.3     $ 2,131.3     $ 2,186.1     $ 2,262.2     $ 2,326.6  
 
                                                                                       
Net cumulative payments as of:
                                                                                       
One year later
    483.6       449.8       640.2       614.0       609.1       608.9       586.7       527.4       503.3       489.3          
Two years later
    747.4       751.2       999.1       960.5       1,002.7       1,015.2       951.5       865.8       837.0                  
Three years later
    950.1       919.3       1,223.3       1,226.2       1,290.4       1,281.9       1,212.9       1,111.3                          
Four years later
    1,058.3       1,016.9       1,385.2       1,399.5       1,465.9       1,457.6       1,382.7                                  
Five years later
    1,121.3       1,088.8       1,485.7       1,504.1       1,584.1       1,576.0                                          
Six years later
    1,171.2       1,137.6       1,548.2       1,578.6       1,669.1                                                  
Seven years later
    1,207.0       1,171.3       1,601.1       1,641.1                                                          
Eight years later
    1,233.5       1,205.2       1,646.9                                                                  
Nine years later
    1,263.1       1,228.9                                                                          
Ten years later
    1,284.1                                                                                  
 
                                                                                       
Gross cumulative payments as of:
                                                                                       
One year later
    498.3       469.9       654.2       636.5       647.1       636.8       674.9       609.9       578.4       576.3          
Two years later
    781.9       775.4       1,022.2       1,007.1       1,060.6       1,122.7       1,111.6       1,012.1       994.4                  
Three years later
    983.4       950.4       1,261.1       1,281.4       1,404.5       1,455.5       1,427.0       1,325.7                          
Four years later
    1,098.7       1,057.5       1,426.5       1,492.0       1,620.5       1,659.0       1,637.0                                  
Five years later
    1,171.2       1,131.5       1,532.4       1,616.7       1,763.7       1,806.8                                          
Six years later
    1,223.2       1,187.0       1,601.0       1,706.8       1,874.3                                                  
Seven years later
    1,265.3       1,226.7       1,666.6       1,787.7                                                          
Eight years later
    1,297.2       1,272.0       1,725.0                                                                  
Nine years later
    1,338.3       1,307.2                                                                          
Ten years later
    1,370.8                                                                                  


Item 1. Continued

Analysis of Development of Loss and Loss Adjustment Expense Liabilities (continued)
(In millions)

                                                                                         
Year Ended December 31   1996   1997   1998   1999   2000   2001   2002   2003   2004   2005   2006
Net liability re-estimated as of:
                                                                                       
 
                                                                                       
One year later
    1,428.0       1,355.6       1,888.4       1,880.2       1,965.8       2,066.4       2,113.3       2,109.5       2,166.0       2,210.0          
Two years later
    1,403.1       1,386.4       1,885.2       1,907.6       2,066.1       2,139.5       2,128.5       2,120.2       2,135.0                  
Three years later
    1,439.0       1,400.7       1,901.8       1,997.6       2,131.1       2,165.1       2,171.1       2,114.5                          
Four years later
    1,456.9       1,392.0       1,975.8       2,032.9       2,157.5       2,235.9       2,189.7                                  
Five years later
    1,448.0       1,441.7       1,993.4       2,058.9       2,236.0       2,263.1                                          
Six years later
    1,489.8       1,459.7       2,018.0       2,128.3       2,265.3                                                  
Seven years later
    1,504.2       1,469.1       2,073.5       2,152.6                                                          
Eight years later
    1,510.7       1,502.6       2,092.0                                                                  
Nine years later
    1,543.1       1,500.3                                                                          
Ten years later
    1,540.1                                                                                  
 
                                                                                       
Decrease (increase) in original estimates:
  $ (57.2 )   $ (78.6 )   $ (226.4 )   $ (329.2 )   $ (358.0 )   $ (281.1 )   $ (110.5 )   $ 16.8     $ 51.1     $ 52.2          
 
                                                                                       
Net liability as originally estimated:
  $ 1,482.9     $ 1,421.7     $ 1,865.5     $ 1,823.3     $ 1,907.3     $ 1,982.0     $ 2,079.3     $ 2,131.3     $ 2,186.1     $ 2,262.2     $ 2,326.6  
 
                                                                                       
Net Liability Percent (deficient) / redundant:
    -3.9 %     -5.5 %     -12.1 %     -18.1 %     -18.8 %     -14.2 %     -5.3 %     0.8 %     2.3 %     2.3 %        
 
                                                                                       
Reinsurance recoverable on unpaid losses and LAE
    64.7       60.0       80.2       85.1       96.2       168.7       354.4       496.5       570.3       684.6       585.7  
 
                                                                                       
Gross liability as originally estimated:
  $ 1,556.7     $ 1,483.8     $ 1,956.9     $ 1,908.5     $ 2,003.5     $ 2,150.7     $ 2,433.6     $ 2,627.9     $ 2,756.4     $ 2,946.8     $ 2,912.3  
 
                                                                                       
Life Operations Liability
    9.1       2.2       11.2                                                    
 
                                                                                       
P&C Operations Liability
    1,547.6       1,481.7       1,945.8       1,908.5       2,003.5       2,150.7       2,433.6       2,627.9       2,756.4       2,946.8       2,912.3  
 
                                                                                       
One year later
    1,496.1       1,447.0       1,972.9       1,981.1       2,129.9       2,346.9       2,558.2       2,615.5       2,836.1       2,834.3          
Two years later
    1,507.4       1,477.9       1,975.7       2,041.7       2,310.6       2,502.4       2,576.1       2,724.9       2,756.6                  
Three years later
    1,537.4       1,495.8       2,006.1       2,189.9       2,432.4       2,536.2       2,717.7       2,702.6                          
Four years later
    1,559.5       1,495.6       2,114.3       2,261.6       2,465.3       2,700.8       2,747.5                                  
Five years later
    1,558.2       1,571.1       2,155.4       2,291.8       2,632.0       2,743.8                                          
Six years later
    1,623.2       1,618.8       2,175.4       2,425.1       2,690.3                                                  
Seven years later
    1,667.9       1,624.6       2,287.3       2,471.6                                                          
Eight years later
    1,672.6       1,710.9       2,324.3                                                                  
Nine years later
    1,755.7       1,726.1                                                                          
Ten years later
    1,770.9                                                                                  
 
                                                                                       
Decrease (increase) in original estimates:
    (223.3 )     (244.4 )     (378.5 )     (563.2 )     (686.8 )     (593.0 )     (313.8 )     (74.8 )     (0.3 )     112.5          
 
                                                                                       
Gross liability as originally estimated:
  $ 1,556.7     $ 1,483.8     $ 1,956.9     $ 1,908.5     $ 2,003.5     $ 2,150.7     $ 2,433.6     $ 2,627.9     $ 2,756.4     $ 2,946.8     $ 2,912.3  
Gross Liability Percent (deficient) / redundant:
    -14.3 %     -16.5 %     -19.3 %     -29.5 %     -34.3 %     -27.6 %     -12.9 %     -2.8 %     0.0 %     3.8 %        


Item 1. Continued

Reinsurance

Reinsurance is a contract by which one insurer, called a reinsurer, agrees to cover, under certain defined circumstances, a portion of the losses incurred by a primary insurer in the event a claim is made under a policy issued by the primary insurer. The Group purchases reinsurance to protect against large or catastrophic losses. Reinsurance contracts do not relieve the Group of their obligations to policyholders. The collectibility of reinsurance depends on the solvency of the reinsurers at the time any claims are presented. The Group monitors each reinsurer’s financial health and claims settlement performance because reinsurance protection is an important component of the Consolidated Corporation’s financial plan. There are several programs that provide reinsurance coverage and the programs in effect for 2006 are discussed in the “Reinsurance Programs” section of Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operation, on page 59 and 60 of this Annual Report on Form 10-K. Additionally, reinsurance is further discussed in Item 7, “Critical Accounting Policies” section on page 45 and 46 and Item 15, Note 1K — Summary of Significant Accounting Policies on page 72 and Note 6 - Reinsurance, in the Notes to the Consolidated Financial Statements on page 82 and 83 of this Annual Report on Form 10-K.

Seasonality

The Group’s insurance business experiences modest seasonality with regard to premiums written, which are usually highest in January and July and lowest during the fourth quarter. Although written premium experiences modest seasonality, premiums are earned ratably over the period of coverage. Losses and LAE incurred tend to remain consistent throughout the year, unless a catastrophe occurs. Catastrophes can occur at any time during the year from weather-related events that include, but are not limited to, hail, tornadoes, hurricanes and windstorms.

Employees

At December 31, 2006, the Company had 2,114 employees of which approximately 1,300 were located in the Fairfield and Hamilton, Ohio offices.

(d) Financial Information about Geographic Areas

The Group’s business is geographically concentrated in the Mid-Atlantic and Mid-West regions. The following table shows consolidated direct premiums written for the Group’s ten largest states for the last three years:

Ten Largest States
Direct Premiums Written
($ in millions)

                                                         
            Percent                 Percent                 Percent  
    2006     of Total         2005     of Total         2004     of Total  
New Jersey
  $ 148.4       10.1     New Jersey   $ 156.0       10.4     New Jersey   $ 168.5       10.7  
Pennsylvania
    143.0       9.7     Pennsylvania     139.2       9.3     Pennsylvania     139.6       8.8  
Kentucky
    123.4       8.4     Kentucky     128.1       8.5     Ohio     135.7       8.6  
Ohio
    116.9       7.9     Ohio     127.8       8.5     Kentucky     131.5       8.3  
North Carolina
    73.0       5.0     North Carolina     74.8       5.0     Illinois     75.6       4.8  
Maryland
    71.0       4.8     Maryland     73.8       4.9     North Carolina     75.5       4.8  
Texas
    67.7       4.6     Illinois     68.8       4.6     Maryland     73.2       4.6  
Illinois
    62.3       4.2     Texas     64.5       4.3     Texas     70.2       4.4  
Oklahoma
    53.6       3.6     Oklahoma     54.5       3.6     Indiana     56.6       3.6  
Washington
    46.8       3.2     Indiana     48.3       3.2     New York     54.9       3.5  
 
                                           
 
  $ 906.1       61.5         $ 935.8       62.3         $ 981.3       62.1  
 
                                           


New Jersey remains the Group’s largest state, with 10.1% of the total direct premiums written during 2006, even after the Group ceased writing in the New Jersey private passenger auto and personal umbrella markets in early 2002. The Group continues to underwrite other product lines in the New Jersey market. No other state exceeds 10.0% of the Group’s consolidated direct premiums written.

Item 1. Continued

(e) Available Information

The Corporation’s internet website is www.ocas.com. The Corporation provides a hyperlink to the website of the Securities and Exchange Commission (SEC), www.sec.gov, where the Corporation’s Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and all amendments to these reports (SEC Reports) are available as soon as reasonably practicable after the Corporation has electronically filed or furnished them to the SEC. The information contained on the Corporation’s website is not incorporated by reference into this Annual Report on Form 10-K and should not be considered part of this report except as stated in Part III, Item 10.

Item 1A. Risk Factors

Risks Relating to the Property and Casualty insurance industry


  Insurance companies are subject to extensive governmental regulation, including minimum capital and surplus requirements, that could result in increased costs or decreased premium if companies fail to meet these regulations

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:

    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
 
    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’ 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 and/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 insurer’s 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 and we may incur significant costs to comply with these regulations.

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 Group’s ability to operate their businesses and may result in decreased premium. 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 Group’s ability to operate its’ business.

Item 1A. Continued


  Insurance companies are subject to the unpredictability of court decisions and regulatory investigations which may lead to fines, settlements, or new regulations and could negatively affect business operations

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. 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 property and casualty 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 and 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.


  External factors in the property and casualty insurance industry may negatively affect our business

External factors beyond our control impacting the property and casualty insurance industry in general could cause our results of operations to suffer. Our industry is exposed to the risks of severe weather conditions, such as rainstorms, snowstorms, hail and ice storms, hurricanes, tornadoes, earthquakes, explosions, terrorist attacks and riots. The insurance business is also affected by cost trends that impact profitability. Factors which negatively affect cost trends include inflation (including increasing medical costs) and increased litigation of claims.


  New claim coverages and business issues in the property and casualty 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:

    the use of an applicant’s credit rating as a factor in making risk selection and pricing decisions;
 
    recent court decisions in certain Gulf Coastal states interpretating flood damage to be included in homeowner’s policies; and
 
    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.


  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 Group’s 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:

    the perceived overall financial strength of the insurer;
 
    levels of customer service to agents and policyholders, including the speed with which the insurer issues policies and pays claims;
 
    differing commission levels to agents depending upon coverage availability and premium levels;
 
    terms, conditions and prices of products; and
 
    experience in the insurance business.


Item 1A. Continued

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:

    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;
 
    the implementation of commercial lines deregulation in several states, which could increase competition from standard carriers for excess and surplus lines of business;
 
    regulation of the use of credit scoring in the underwriting of insurance policies;
 
    programs in which state-sponsored entities provide property insurance in catastrophe prone areas or other alternative market types of coverage; and
 
    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’ 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.


  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. These risks are inherently unpredictable, although recent events may lead to increased frequency and severity. 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’ compensation and surety policyholders. 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. The 2005 extension excludes coverage on the following lines of business: commercial automobile, burglary and theft, surety, professional liability (other than directors and officers liability) and farm owners multiple perils. TRIA provides that in the event of a terrorist attack on behalf of a foreign interest resulting in insurance industry losses of $50 million or greater occurring after March 31, 2006 and $100 million or greater occurring after January 1, 2007, the U.S. government will provide funding to the insurance industry on an annual aggregate basis of 90% of covered losses up to $100 billion. Each insurance company is subject to a deductible, which is a percentage of that company’s direct earned premiums for the prior year, and this percentage increases in each year covered by the TRIA. The TRIA is currently scheduled to expire on December 31, 2007. In 2006, 2005 and 2004, our deductible totaled $137.0 million, $161.3 million and $104.5 million. 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.

Item 1A. Continued

Risk Relating to the Consolidated Corporation


  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, LAE 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.

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:

    availability of sufficient reliable data;
 
    incorrect or incomplete analysis of available data;
 
    uncertainties inherent in estimates and assumptions, generally;
 
    selection and application of appropriate rating formulae or other pricing methodologies;
 
    our ability to innovate in the future as new or improved pricing strategies emerge;
 
    unanticipated court decisions, legislation or regulatory action;
 
    ongoing changes in our claim settlement practices, which can influence the amounts paid on claims;
 
    changes in consumer and claimant behavior, which could adversely affect both frequency and severity of claims;
 
    changing auto driving patterns, which could adversely affect both frequency and severity of claims;
 
    unexpected inflation in the medical sector of the economy, resulting in increased workers’ compensation, bodily injury and personal injury protection claim severity; and
 
    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.


  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 natural and man-made events can cause catastrophes, including, but not limited to, 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’ and commercial property coverages.

Item 1A. Continued

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:

    major catastrophic losses exceed our reinsurance limit; or
 
    the Group incurs a high frequency of smaller catastrophic loss events which, individually, fall below our retention level; or
 
    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. Our ability to write new business also could be affected. 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 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 “Risk Factors—Risks Relating to the Property and Casualty Insurance Industry—Insurance companies are subject to extensive governmental regulation and the unpredictability of court decisionsand “Risk Factors—Risks Relating to the Consolidated Corporation—War, Terrorism and Political Instability.”


  Actual costs incurred on claims may exceed current reserves established for claims

The Group is required to maintain loss reserves to provide for its estimated ultimate liability for losses and LAE with respect to reported and unreported insurance claims incurred as of the end of each accounting period. If these loss reserves prove inadequate, then the Group’s 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’ 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:

    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’ expanded theories of liability;
 
    asbestos and environmental losses, which are particularly affected by significant delays in the reporting of claims, unpredictability of court decisions, plaintiffs’ expanded theories of liability, risks of major litigation and legislative developments; and
 
    workers’ compensation losses, which are particularly affected by the relatively long period of time to finalize claims and the rising cost of medical benefits on claims providing lifetime coverages.


The Group reflects adjustments to their reserves in the results of operations of the periods in which their estimates are changed. In 2006, 2005 and 2004, the Group reduced reserves by $52.2 million, $20.1 million and $21.8 million for favorable development on prior accident years’ loss and LAE reserves on a GAAP basis, or

Item 1A. Continued

$52.2 million, $21.5 million and $21.7 million on a statutory basis, respectively. For additional discussion on the risk factors inherent in the loss and LAE reserves see Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations – Critical Accounting Policies section on pages 48-56 of this Annual Report on Form 10-K.


  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.

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 pursuant to the allocation percentages outlined in the pooling agreement. 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 the Group 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 hurricanes of 2005 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, terrorism coverage in contracts entered into since 2004 have 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 Corporation’s reinsurance programs see Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations on pages 59 and 60 of this Annual Report on Form 10-K.


  If the Group is unable to maintain its relationship with its key agencies or is unable to attract additional agencies, our business and results of operations could be adversely impacted

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’ 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’ 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.

Item 1A. Continued

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.

The Group is represented by approximately 3,350 independent insurance agencies with approximately 5,700 agency locations, each containing at least one licensed agent of the Group. These agencies also represent other unaffiliated companies which may compete with the Group. Our future success will depend, in large part, upon the efforts of our independent agents. Certain agencies that meet established profitability and production targets are eligible for “key producer” status. At December 31, 2006 and 2005, these agencies represented 16.4% and 14.4%, respectively, of the Group’s total Agency Force (as previously defined) and wrote 48.5% and 42.5%, 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 agencies or if certain key agencies no longer marketed and sold its products and if the agencies were unsuccessful in recruiting and retaining additional agents, our book of business would likely decline and our results of operations would be adversely affected.


  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, 2006 and December 31, 2005, each of our insurance subsidiaries had capital and surplus in excess of the currently required amounts.


  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 54.0% 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.


  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’ ability to pay additional dividends is also reduced.

Item 1A. Continued

Insurance companies write insurance based, in part, upon a ratio of premiums to surplus. As the insurance subsidiaries’ surplus is reduced by the payment of dividends, continuing losses or both, our insurance subsidiaries’ 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.


  If our new technology for issuing and maintaining insurance policies does not work as intended or does not satisfy the agent’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 (“P.A.R.I.S. SM ”) which is an internal system used to create and maintain policies. P.A.R.I.S. SM also provides the platform for a proprietary internet interface called P.A.R.I.S. Express SM and a platform for upload and download of information called P.A.R.I.S. Connect SM . Our agents utilize these interfaces to quote and issue both new business transactions and endorsement processing. P.A.R.I.S. 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 P.A.R.I.S. SM . If P.A.R.I.S. SM does not continue to work as expected, or if it fails to satisfy agents’ needs, we may lose agents to insurers with preferred technologies. See Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operation for information on rollout dates.


  Our business depends on the uninterrupted operation of our facilities, systems and business functions, including our information technology and other business systems

Our business is highly dependent upon our employees’ 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.


  Although we have begun to pay cash dividends, we may not continue or be able to pay cash dividends in the future

We 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.


  A downgrade by a rating agency may adversely impact our ability to obtain financing and retain agents

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 A.M Best Company (A.M. Best), Fitch, Inc. (Fitch), Moody’s Investor Service (Moody’s) and Standard & Poor’s (S&P).

A.M. Best’s ratings for insurance companies currently range from “A++” (Superior) to “F” (In Liquidation), and include 10 separate rating categories. Within these categories, “A++” (Superior) and “A+” (Superior) are the highest, followed by “A” (Excellent) and “A-” (Excellent). Publications of A.M. Best indicate that the “A” and “A-”

Item 1A. Continued

ratings are assigned to those companies that, in A.M. Best’s opinion, have demonstrated excellent overall performance when compared to the standards established by A.M. Best and have demonstrated a strong ability to meet their obligations to policyholders over a long period of time. In April 2006, A.M. Best affirmed our rating of “A-” and assigned a positive outlook on the rating.

Fitch’s ratings for insurance companies range from “AAA” to “D,” and include 12 different rating categories. Fitch may apply either a plus (+) or a minus (-) sign in each generic rating classification from “AA” to “CCC.” 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 “A” ratings are assigned to those companies that have demonstrated strong financial security. In September 2006, Fitch upgraded its financial strength rating from “A-” to “A” for the Group and upgraded its “BBB-” senior debt and long term issuer ratings to “BBB”. The rating outlook was revised to stable.

Moody’s ratings for insurance companies range from “Aaa” to “C,” and include 9 different ratings categories. Moody’s applies numerical modifiers 1, 2, and 3 in each generic rating classification from “Aa” through “Caa.” 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 Moody’s indicate that “A” ratings are assigned to those companies that have demonstrated good financial security. In June 2004, Moody’s assigned a Baa3 rating to our 7.30% Senior Notes due 2014. The financial strength rating and outlook were unaffected. In May 2006, Moody’s affirmed the A3 financial strength rating of the Group and Baa3 rating on the senior debt and upgraded the outlook to positive.

S&P’s ratings for insurance companies currently range from “AAA” (Extremely Strong) to “R” (Under Regulatory Supervision), and include 10 different ratings categories. S&P may apply either a plus (+) or minus (-) sign in each generic rating classification from “AA” to “CCC.” 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&P indicate that an insurer rated “BBB” 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. In July 2006, the S&P ratings for the senior debt moved from “BB+” to “BBB-“ and the financial strength rating changed from “BBB+” to “A-“ and S&P also revised its outlook from positive to stable.

The above ratings do not include OCNJ, which is unrated. We cannot guarantee that future downgrades, if any, will not have a material adverse effect upon our business in the future.


  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, and fixed income investments. The market value of our equity portfolio was approximately 10.9% (8.6% common, 2.3% preferred) and 9.0% (7.9% common, 1.1% preferred) of total invested assets, excluding cash and cash equivalents, at December 31, 2006 and 2005, respectively. The portfolio was diversified across 83 separate entities in all ten major S&P industry sectors at December 31, 2006. As of December 31, 2006 and 2005, 19.0% and 24.2%, respectively, of our equity portfolio was invested in five companies and the largest single position was 4.9% and 5.4%, 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’ 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’ equity and statutory surplus and an appropriate level of portfolio diversification.

Our investment portfolio also includes investments in corporate and municipal bonds, mortgage and asset-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. We manage exposure to significant fluctuations in the market value of our fixed income portfolio from changes in interest rates by managing the duration of our fixed income portfolio.

Item 1A. Continued

At December 31, 2006 and 2005, approximately 15.3% and 17.0%, respectively, of our total investment portfolio was invested in mortgage and asset-backed securities. These investments carry the risk that cash flows from the underlying assets 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. Additionally, within the mortgage and asset-backed security portfolio, we maintain a small allocation to securitizations backed by sub-prime mortgages. Although the loans within these pools have a higher probability of default in comparison to prime quality mortgages, this risk is mitigated by higher levels of credit enhancement and/or financial guaranty insurance within these sub-prime securitizations and also by our decision to invest in the most highly rated tranches of these securities.

At December 31, 2006 and 2005, approximately 2.1% and 1.9%, respectively, 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 have exposure to market risk, equity price risk, credit risk, reinvestment risk and liquidity risk. For additional information on investment results and these risks, see Item 7, Investment Results on pages 41-45, Investment Portfolio on pages 60-62 and Item 7A, Quantitative and Qualitative Disclosures about Market Risk sections of the Management’s Discussion and Analysis of Financial Condition and Results of Operation on pages 62 and 63 of this Annual Report on Form 10-K.


  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.


  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’ rights plan. Under the shareholders’ rights plan, each outstanding common share has associated with it one-half of one common share purchase right. The rights become exercisable only if a person or group, without the prior approval of our directors, acquires 20% 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 20% or more of our outstanding common shares. Under certain circumstances after the rights become exercisable, each right would entitle the holder (other than the 20% shareholder) to purchase common shares of the Corporation having a value of twice the then exercise price of the rights. We may redeem 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.


  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.

Item 1A.Continued


  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 I, Item 3, Legal Proceedings of this Annual Report on Form 10-K. Other legal and regulatory proceedings are also currently pending that involve us and specific aspects of the conduct of our business.

Like other members of the property and casualty insurance industry, we are occasionally the target of a class action proceeding or other type of litigation which may involve claims for substantial or indeterminable amounts. These actions are based on a variety of issues such as insurance billing practices, premium calculations, and claim settlement practices. These proceedings are defended vigorously. However, all litigation is unpredictable and the ultimate outcome is uncertain.


  New or changes in existing accounting standards issued by the Financial Accounting Standards Board (FASB), SEC or other standard-setting bodies may adversely affect our financial statements and could entail significant expenditures. Additionally, changes in our estimates and assumptions may adversely affect our financial statements.

Our financial statements are subject to the application of U.S. Generally Accepted Accounting Principles (GAAP), which is periodically revised and/or expanded. Accordingly, we are required to adopt new or revised accounting standards from time to time issued by recognized authoritative bodies, including the FASB. It is possible that future changes we are required to adopt could change the current accounting treatment that we apply to our consolidated financial statements and that such changes could have a material adverse effect on our results of operation and financial condition. For a description of current Critical Accounting Policies, see that section of Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operation on pages 45-55 of this Annual Report on Form 10-K. Additionally, for a summary of Significant Accounting Policies of the Consolidated Corporation, see Item 15, Note 1 of the Notes to Consolidated Financial Statements on pages 71-73 of the Annual Report on Form 10-K. The Sarbanes-Oxley Act of 2002 that became law in July 2002, as well as new rules subsequently implemented by the SEC, and the NASDAQ, have required, and will require, changes to some of our accounting and corporate governance practices, including the requirement that we issue a report on our internal controls as required by Section 404 of the Sarbanes-Oxley Act. We expect these new rules and regulations to continue to increase our accounting, legal and other costs, and to make some activities more difficult, time consuming and/or costly. Initial compliance with Section 404 of the Sarbanes-Oxley Act was required for the year ended December 31, 2004. In the event that we are unable to maintain compliance with the Sarbanes-Oxley Act and related rules, it may have a material adverse effect on us.

The preparation of our financial statements require management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of our financial statements, and the reported amount of revenues and expenses during the reporting period. Actual results could differ from those estimates and adversely effect our financial position and results of operations.

Item 1B. Unresolved Staff Comments

None


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