EMC Insurance Group (EMCI)

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EMC Insurance Group 10-K 2007

Documents found in this filing:

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K/A

x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the Fiscal Year Ended December 31, 2006

o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from __________ to ___________

Commission File Number: 0-10956

EMC INSURANCE GROUP INC.

(Exact name of registrant as specified in its charter)

Iowa		42-6234555
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

717 Mulberry Street, Des Moines, Iowa		50309
(Address of principal executive office)		(Zip Code)

Registrant’s telephone number, including area code:

(515) - 345 - 2902

Securities registered pursuant to Section 12(b) of the Act:

Common Stock, Par Value $1.00		The NASDAQ Stock Market LLC
(Title of Class)		(Name of each exchange on which registered)

Securities registered pursuant to Section 12(g) of the Act: None

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act				o	Yes	x	No

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act				o	Yes	x	No

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such
reports), and (2) has been subject to such filing requirements for the past 90 days.				x	Yes	o	No

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in
Part III of this Form 10-K or any amendment to this Form 10-K.				x

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer (as defined in Rule 12b-2 of the Exchange Act).
Large accelerated filer o	Accelerated filer x	Non-accelerated filer o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).			o		Yes	x	No

The aggregate market value of the voting stock held by non-affiliates of the registrant as of June 30, 2006 was $170,983,693.

The number of shares outstanding of the registrant’s common stock, $1.00 par value, on February 28, 2007, was 13,757,341.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the registrant’s definitive proxy statement for the Annual Meeting of Stockholders to be held on May 24, 2007, and to be filed pursuant to Regulation 14A within 120 days after the registrant’s fiscal year ended December 31, 2006, are incorporated by reference under Part III.

EXPLANATORY NOTE

EMC Insurance Group Inc. is filing this amendment on Form 10-K/A to correct a document conversion error affecting the Consolidated Statements of Cash Flow included in the original filing’s Part II - Item 8. All information contained in this amendment is as of March 15, 2007, the filing date of the Company’s original Annual Report on Form 10-K.

ITEM 8.

FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.

Management’s Report on Internal Control Over Financial Reporting

The management of EMC Insurance Group Inc. and Subsidiaries is responsible for the preparation, integrity and objectivity of the accompanying Consolidated Financial Statements, as well as all other financial information in this report. The Consolidated Financial Statements and the accompanying notes have been prepared in accordance with U.S. generally accepted accounting principles and include amounts that are based on management’s estimates and judgments where necessary.

Management is responsible for establishing and maintaining adequate internal control over financial reporting, including safeguarding of assets and reliability of financial records. The Company’s internal control structure, designed by or under the supervision of management, includes policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect transactions and dispositions of assets; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of the Consolidated Financial Statements in accordance with generally accepted accounting principles, and that transactions are being made only in accordance with authorizations of management and directors of the Company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the Company’s assets that could have a material effect on the Consolidated Financial Statements. This control structure is further reinforced by a program of internal audits, including audits of the Company’s decentralized branch locations, which requires responsive management action.

There are inherent limitations in the effectiveness of any internal control, including the possibility of human error and the circumvention or overriding of controls. Accordingly, adequate internal controls can provide only reasonable assurance with respect to financial statement preparation. Further, because of changes in conditions, the effectiveness of internal control may vary over time.

Management assessed the effectiveness of the Company’s internal control over financial reporting based on criteria established in “Internal Control – Integrated Framework,” issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based on this assessment, management believes that, as of December 31, 2006, the Company maintained effective internal control over financial reporting.

The Audit Committee of the Board of Directors is comprised of three outside directors who are independent of the Company’s management. The Audit Committee is responsible for the selection of the independent registered public accounting firm. It meets periodically with management, the independent registered public accounting firm, and the internal auditors to ensure that they are carrying out their responsibilities. In addition to reviewing the Company’s financial reports, the Audit Committee is also responsible for performing an oversight role by reviewing and monitoring the financial, accounting and auditing procedures of the Company. The independent registered public accounting firm and the internal auditors have full and free access to the Audit Committee, with or without the presence of management, to discuss the adequacy of internal control over financial reporting and any other matters which they believe should be brought to the attention of the Audit Committee.

The Company’s financial statements and internal control over financial reporting have been audited by Ernst & Young LLP, an independent registered public accounting firm. Management has made available to Ernst & Young LLP all of the Company’s financial records and related data, as well as the minutes of the stockholders’ and directors’ meetings. Furthermore, management believes that all representations made to Ernst & Young LLP during its audit were valid and appropriate. Their reports with respect to the fairness of presentation of the Company’s financial statements and management’s assessment and the effectiveness of the Company’s internal control over financial reporting appear elsewhere in this annual report.

/s/ Bruce G. Kelley		/s/ Mark E. Reese
Bruce G. Kelley		Mark E. Reese
President and Chief Executive Officer		Senior Vice President and Chief Financial Officer

Report of Independent Registered Public Accounting Firm

on Internal Control Over Financial Reporting

The Board of Directors and Stockholders

EMC Insurance Group Inc.

We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control Over Financial Reporting, that EMC Insurance Group Inc. and Subsidiaries maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). The management of EMC Insurance Group Inc. and Subsidiaries is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, management’s assessment that EMC Insurance Group Inc. and Subsidiaries maintained effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, EMC Insurance Group Inc. and Subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on the COSO criteria.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of EMC Insurance Group Inc. and Subsidiaries as of December 31, 2006 and 2005, and the related consolidated statements of income, comprehensive income, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2006 of EMC Insurance Group Inc. and Subsidiaries and our report dated March 13, 2007, expressed an unqualified opinion thereon.

/s/ Ernst & Young LLP

Des Moines, Iowa

March 13, 2007

Report of Independent Registered Public Accounting Firm

The Board of Directors and Stockholders

EMC Insurance Group Inc.

We have audited the accompanying consolidated balance sheets of EMC Insurance Group Inc. and Subsidiaries as of December 31, 2006 and 2005, and the related consolidated statements of income, comprehensive income, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2006. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of EMC Insurance Group Inc. and Subsidiaries at December 31, 2006 and 2005 and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2006, in conformity with U.S. generally accepted accounting principles.

As discussed in Note 1 to the consolidated financial statements, during 2006 the Company changed its method of accounting for the recognition of share-based compensation expense and the recognition of the funded status of its defined benefit pension and postretirement plans.

We also have audited, in accordance with standards of the Public Company Accounting Oversight Board (United States), the effectiveness of EMC Insurance Group Inc. and Subsidiaries’ internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 13, 2007 expressed an unqualified opinion thereon.

/s/ Ernst & Young LLP

Des Moines, Iowa

March 13, 2007

EMC INSURANCE GROUP INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

	December 31,
	2006	2005
ASSETS
Investments:
Fixed maturities:
Securities held-to-maturity, at amortized cost
(fair value $5,768,918 and $18,287,704)	$ 5,679,960	$ 17,927,478
Securities available-for-sale, at fair value
(amortized cost $724,943,182 and $740,845,145)	735,596,894	753,399,943
Fixed maturity securities on loan:
Securities held-to-maturity, at amortized cost
(fair value $0 and $1,891,504)	-	1,866,928
Securities available-for-sale, at fair value
(amortized cost $89,841,454 and $41,922,225)	88,909,477	41,656,150
Equity securities available-for-sale, at fair value
(cost $77,089,044 and $66,115,755)	112,527,480	93,343,172
Other long-term investments, at cost	552,202	4,269,566
Short-term investments, at cost	58,053,337	37,345,456
Total investments	1,001,319,350	949,808,693

Balances resulting from related party transactions with
Employers Mutual:
Reinsurance receivables	37,805,569	46,372,087
Prepaid reinsurance premiums	4,807,822	4,846,084
Deferred policy acquisition costs	33,662,408	34,106,217
Defined benefit retirement plan, prepaid asset	7,836,958	5,633,370
Other assets	2,410,120	2,281,025
Cash	196,274	333,048
Accrued investment income	11,363,814	10,933,046
Accounts receivable (net of allowance for uncollectible
accounts of $0 and $0)	205,046	211,595
Income taxes recoverable	1,888,935	-
Deferred income taxes	12,403,141	13,509,369
Goodwill	941,586	941,586
Securities lending collateral	91,317,719	44,705,501
Total assets	$ 1,206,158,742	$ 1,113,681,621

See accompanying Notes to Consolidated Financial Statements.

EMC INSURANCE GROUP INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

	December 31,
	2006	2005
LIABILITIES
Balances resulting from related party transactions with
Employers Mutual:
Losses and settlement expenses	$ 548,547,982	$ 544,051,061
Unearned premiums	155,653,799	160,693,288
Other policyholders' funds	7,320,536	5,359,116
Surplus notes payable	36,000,000	36,000,000
Indebtedness to related party	18,621,351	19,899,329
Employee retirement plans	17,700,372	13,681,388
Other liabilities	22,702,661	21,764,259

Income taxes payable	-	5,644,516
Securities lending obligation	91,317,719	44,705,501
Total liabilities	897,864,420	851,798,458

STOCKHOLDERS' EQUITY
Common stock, $1 par value, authorized 20,000,000
shares; issued and outstanding, 13,741,663
shares in 2006 and 13,642,705 shares in 2005	13,741,663	13,642,705
Additional paid-in capital	107,016,563	104,800,407
Accumulated other comprehensive income	24,934,903	25,470,039
Retained earnings	162,601,193	117,970,012
Total stockholders' equity	308,294,322	261,883,163
Total liabilities and stockholders' equity	$ 1,206,158,742	$ 1,113,681,621

See accompanying Notes to Consolidated Financial Statements.

EMC INSURANCE GROUP INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

All balances presented below, with the exception of investment income, realized investment gains and income tax expense (benefit), are the result of related party transactions with Employers Mutual.

	Year ended December 31,
	2006	2005	2004
REVENUES
Premiums earned	$ 391,615,441	$ 415,624,746	$ 345,478,461
Investment income, net	46,691,929	40,696,243	29,900,203
Realized investment gains	4,252,289	3,834,165	4,379,314
Other income	526,617	656,846	600,732
	443,086,276	460,812,000	380,358,710
LOSSES AND EXPENSES
Losses and settlement expenses	228,452,492	257,926,493	249,806,210
Dividends to policyholders	8,663,715	7,540,547	4,478,169
Amortization of deferred policy acquisition costs	86,565,031	92,400,893	75,444,837
Other underwriting expenses	40,019,494	40,059,414	32,783,686
Interest expense	1,112,400	1,112,400	1,112,400
Other expenses	1,907,762	1,662,431	1,162,411
	366,720,894	400,702,178	364,787,713

Income before income tax expense (benefit)	76,365,382	60,109,822	15,570,997

INCOME TAX EXPENSE (BENEFIT)
Current	21,423,901	19,782,182	4,583,505
Deferred	1,394,377	(2,681,405)	(2,197,191)
	22,818,278	17,100,777	2,386,314
Net income	$ 53,547,104	$ 43,009,045	$ 13,184,683

Net income per common share
-basic and diluted	$ 3.91	$ 3.16	$ 1.10

Average number of common shares outstanding
-basic and diluted	13,710,953	13,606,203	11,948,710

See accompanying Notes to Consolidated Financial Statements.

EMC INSURANCE GROUP INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

	Year ended December 31,
	2006	2005	2004

Net income	$ 53,547,104	$ 43,009,045	$ 13,184,683

OTHER COMPREHENSIVE INCOME (LOSS)
Change in unrealized holding gains on investment
securities, before deferred income tax expense	9,896,320	383,439	13,051,438
Deferred income tax expense	3,463,712	134,203	4,568,003
	6,432,608	249,236	8,483,435

Reclassification adjustment for realized investment
gains included in net income, before
income tax expense	(4,252,289)	(3,834,165)	(4,370,215)
Income tax expense	(1,488,301)	(1,341,958)	(1,529,575)
	(2,763,988)	(2,492,207)	(2,840,640)

Adjustment for minimum liability associated with
Employers Mutual's supplemental retirement plan,
before deferred income tax expense (benefit)	264,823	(331,468)	-
Deferred income tax expense (benefit)	92,688	(116,015)	-
	172,135	(215,453)	-

Other comprehensive income (loss)	3,840,755	(2,458,424)	5,642,795

Total comprehensive income	$ 57,387,859	$ 40,550,621	$ 18,827,478

See accompanying Notes to Consolidated Financial Statements.

EMC INSURANCE GROUP INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

	Year ended December 31,
	2006	2005	2004
COMMON STOCK
Beginning of year	$ 13,642,705	$ 13,568,945	$ 11,501,065
Issuance of common stock through
Employers Mutual's incentive stock option plans	109,511	73,760	67,880
Redemption of common stock that was
invalidly issued through Employers Mutual's
incentive stock option plans	(10,553)	-	-
Issuance of common stock through
follow-on stock offering	-	-	2,000,000
End of year	13,741,663	13,642,705	13,568,945

ADDITIONAL PAID-IN CAPITAL
Beginning of year	104,800,407	103,467,293	69,113,228
Issuance of common stock through
Employers Mutual's incentive stock option plans	2,243,776	1,333,114	1,463,980
Stock-based compensation expense associated with
Employers Mutual's incentive stock option plans	178,439	-	-
Redemption of common stock that was
invalidly issued through Employers Mutual's
incentive stock option plans	(206,059)	-	-
Issuance of common stock through
follow-on stock offering	-	-	32,890,085
End of year	107,016,563	104,800,407	103,467,293

ACCUMULATED OTHER COMPREHENSIVE INCOME
Beginning of year	25,470,039	27,928,463	22,285,668
Change in unrealized gains (losses) on investment
securities, net of deferred income tax expense	3,668,620	(2,242,971)	5,642,795
Minimum liability associated with Employers Mutual’s
supplemental retirement plan, net of deferred
income tax expense	172,135	(215,453)	-
Adjustment for adoption of SFAS No. 158,
net of deferred income tax expense	(4,375,891)	-	-
End of year	24,934,903	25,470,039	27,928,463

RETAINED EARNINGS
Beginning of year	117,970,012	83,508,331	77,850,590
Net income	53,547,104	43,009,045	13,184,683
Dividends paid to public stockholders ($.65, $.61, $.60
per share in 2006, 2005 and 2004)	(3,857,395)	(3,705,796)	(1,941,181)
Dividends paid to Employers Mutual ($.65, $.61, $.60
per share in 2006, 2005 and 2004)	(5,058,528)	(4,596,127)	(5,292,178)
Dividends paid to Employers Mutual (reimbursement
for non-GAAP expenses)	-	(245,441)	(293,583)
End of year	162,601,193	117,970,012	83,508,331

Total stockholders' equity	$ 308,294,322	$ 261,883,163	$ 228,473,032

See accompanying Notes to Consolidated Financial Statements.

EMC INSURANCE GROUP INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

	Year ended December 31,
	2006	2005	2004
CASH FLOWS FROM OPERATING ACTIVITIES
Net income	$ 53,547,104	$ 43,009,045	$ 13,184,683
Adjustments to reconcile net income to net cash
provided by operating activities:
Balances resulting from related party transactions
with Employers Mutual:
Losses and settlement expenses	4,496,921	28,615,240	55,894,386
Unearned premiums	(5,039,489)	(1,545,302)	6,756,758
Other policyholders' funds	1,961,420	1,751,700	1,435,215
Indebtedness to related party	(1,277,978)	13,840,481	3,883,730
Employee retirement plans	(4,651,920)	(827,923)	(2,885,657)
Reinsurance receivables	8,566,518	(13,115,515)	(4,595,569)
Prepaid reinsurance premiums	38,262	(144,795)	(385,448)
Commission payable	357,467	(4,136,359)	2,594,243
Deferred policy acquisition costs	443,809	353,101	(1,202,799)
Stock-based compensation plans	377,294	-	-
Other, net	252,985	1,567,742	(629,924)

Accrued investment income	(430,768)	(2,206,754)	(904,640)
Accrued income tax:
Current	(7,533,451)	9,044,001	(6,179,985)
Deferred	1,394,377	(2,681,405)	(2,197,191)
Realized investments gains	(4,252,289)	(3,834,165)	(4,379,314)
Accounts receivable	6,549	5,241	162,587
Amortization of premium/discount on
fixed maturity securities	757,287	928,373	243,378
	(4,533,006)	27,613,661	47,609,770
Cash provided by the change in the property
and casualty insurance subsidiaries' aggregate
pool participation percentage	-	107,801,259	-
Net cash provided by operating activities	$ 49,014,098	$ 178,423,965	$ 60,794,453

EMC INSURANCE GROUP INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS, CONTINUED

	Year ended December 31,
	2006	2005	2004
CASH FLOWS FROM INVESTING ACTIVITIES
Maturities of fixed maturity securities
held-to-maturity	$ 14,100,900	$ 9,388,335	$ 20,635,775
Purchases of fixed maturity securities
available-for-sale	(122,681,124)	(581,405,192)	(830,263,629)
Disposals of fixed maturity securities
available-for-sale	90,409,930	394,555,437	737,364,629
Purchases of equity securities
available-for-sale	(58,996,632)	(49,154,777)	(52,518,206)
Disposals of equity securities
available-for-sale	51,785,819	45,430,758	32,685,028
Purchases of other long-term investments	(300,000)	(1,049,129)	(3,078,000)
Disposals of other long-term investments	4,017,364	2,329,656	2,285,926
Net (purchases) sales of short-term investments	(20,707,881)	8,893,397	17,329,211
Net cash used in investing activities	(42,371,624)	(171,011,515)	(75,559,266)

CASH FLOWS FROM FINANCING ACTIVITIES
Balances resulting from related party transactions
with Employers Mutual:
Issuance of common stock through Employers
Mutual's incentive stock option plans	2,353,287	1,406,874	1,531,860
Redemption of common stock that was
invalidly issued through Employers Mutual's
incentive stock option plans	(216,612)	-	-
Dividends paid to Employers Mutual	(5,058,528)	(4,596,127)	(5,292,178)
Dividends paid to Employers Mutual
(reimbursement for non-GAAP expense)	-	(245,441)	(293,583)

Dividends paid to public stockholders	(3,857,395)	(3,705,796)	(1,941,181)
Issuance of common stock through follow-on
stock offering	-	-	34,890,085
Net cash (used in) provided by
financing activities	(6,779,248)	(7,140,490)	28,895,003

NET (DECREASE) INCREASE IN CASH	(136,774)	271,960	14,130,190
Cash at the beginning of the year	333,048	61,088	(14,069,102)

Cash at the end of the year	$ 196,274	$ 333,048	$ 61,088

Income taxes paid	$ 28,957,352	$ 10,738,181	$ 10,957,163
Interest paid	$ 1,119,663	$ 1,118,413	$ 884,310

See accompanying Notes to Consolidated Financial Statements.

EMC INSURANCE GROUP INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1.	SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Principles of Consolidation and Basis of Presentation

EMC Insurance Group Inc., a 56.6 percent owned subsidiary of Employers Mutual Casualty Company (Employers Mutual), is an insurance holding company with operations in property and casualty insurance and reinsurance. Both commercial and personal lines of insurance are written, with a focus on medium-sized commercial accounts. Approximately 36 percent of the premiums written are in Iowa and contiguous states. The term “Company” is used interchangeably to describe EMC Insurance Group Inc. (Parent Company only) and EMC Insurance Group Inc. and its subsidiaries.

The Company’s subsidiaries include EMCASCO Insurance Company, Illinois EMCASCO Insurance Company, Dakota Fire Insurance Company, Farm and City Insurance Company, EMC Reinsurance Company and EMC Underwriters, LLC.

The consolidated financial statements have been prepared on the basis of U.S. generally accepted accounting principles (GAAP), which differ in some respects from those followed in reports to insurance regulatory authorities. All significant inter-company balances and transactions have been eliminated.

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, as well as the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates.

Property and Casualty Insurance and Reinsurance Operations

Property and casualty insurance premiums are recognized as revenue ratably over the terms of the respective policies. Unearned premiums are calculated on the daily pro rata method. Both domestic and foreign assumed reinsurance premiums are recognized as revenues ratably over the terms of the contract period. Amounts paid as ceded reinsurance premiums are reported as prepaid reinsurance premiums and are amortized over the remaining contract period in proportion to the amount of reinsurance protection provided. Reinsurance reinstatement premiums are recognized in the same period as the loss event that gave rise to the reinstatement premiums.

Acquisition costs consisting of commissions, premium taxes and other underwriting expenses that vary with and are directly related to the production of business have been deferred and are being amortized as premium revenue is recognized. The method followed in computing deferred policy acquisition costs limits the amount of such deferred costs to their estimated realizable value, which gives effect to the premium to be earned, related investment income, losses and settlement expenses and certain other costs expected to be incurred as the premium is earned.

Certain commercial lines of business, primarily workers’ compensation, are eligible for policyholder dividends in accordance with provisions of the underlying insurance policies. Net premiums written subject to policyholder dividends represented approximately 60 percent of the Company’s total net premiums written in 2006. Policyholder dividends are accrued over the terms of the underlying policies.

Liabilities for losses are based upon case-basis estimates of reported losses, estimates of unreported losses based upon prior experience adjusted for current trends, and estimates of losses expected to be paid under assumed reinsurance contracts. Liabilities for settlement expenses are provided by estimating expenses expected to be incurred in settling the claims provided for in the loss reserves. Changes in estimates are reflected in current operating results (see note 4).

Ceded reinsurance amounts with nonaffiliated reinsurers relating to reinsurance receivables for paid and unpaid losses and settlement expenses and prepaid reinsurance are reported on the balance sheet on a gross basis. Amounts ceded to Employers Mutual relating to the affiliated reinsurance pooling agreement (see note 2) have not been grossed up because the contracts provide that receivables and payables may be offset upon settlement.

Based on current information, the liabilities for losses and settlement expenses are considered to be adequate. Since the provisions are necessarily based on estimates, the ultimate liability may be more or less than such provisions.

Investments

Securities classified as held-to-maturity are purchased with the intent and ability to be held to maturity and are carried at amortized cost. Unrealized holding gains and losses on securities held-to-maturity are not reflected in the financial statements. All other securities have been classified as securities available-for-sale and are carried at fair value, with unrealized holding gains and losses reported as accumulated other comprehensive income in stockholders’ equity, net of deferred income taxes. Other long-term investments represent minor ownership interests in limited partnerships and limited liability companies and are carried at cost. Short-term investments represent money market funds and are carried at cost, which approximates fair value.

Premiums and discounts on fixed maturity securities are amortized over the life of the security as an adjustment to yield using the effective interest method. Gains and losses realized on the disposition of investments are included in net income. The cost of investments sold is determined on the specific identification method using the highest cost basis first. Included in investments at December 31, 2006 and 2005 are securities on deposit with various regulatory authorities as required by law amounting to $13,093,900 and $12,929,527, respectively.

The Company regularly monitors its investments that have a fair value that is less than the carrying value for indications of “other-than-temporary” impairment. Several factors are used to determine whether the carrying value of an individual security has been “other-than-temporarily” impaired. Such factors include, but are not limited to, the security’s value and performance in the context of the overall markets, length of time and extent the security’s fair value has been below carrying value, key corporate events and collateralization of fixed maturity securities. When a security is deemed “other-than-temporarily” impaired, the carrying value is reduced to fair value and a realized loss is recognized and charged to income.

On November 3, 2005 the FASB issued Staff Position No. FAS 115-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments”, which amended SFAS 115, “Accounting for Certain Investments in Debt and Equity Securities” and nullified certain requirements of EITF Issue 03-1. FAS 115-1 addresses the determination of when an investment is considered impaired, whether that impairment is “other-than-temporary”, and the measurement of an impairment loss. FAS 115-1 also includes accounting considerations subsequent to the recognition of an “other-than-temporary” impairment, and requires certain disclosures about unrealized losses that have not been recognized as “other-than-temporary” impairments. FAS 115-1 was effective for reporting periods beginning after December 15, 2005, with earlier application permitted. The Company adopted FAS 115-1 in the first quarter of 2006 through the addition of various impairment analysis procedures, including inquiry of the Company’s outside equity manager on their intentions regarding securities that are in an unrealized loss position.

The Company participates in a securities lending program whereby certain fixed maturity securities from the investment portfolio are loaned to other institutions for a short period of time. The Company requires initial collateral equal to 102 percent of the market value of the loaned securities. The collateral is invested by the lending agent, in accordance with the Company’s guidelines, and generates fee income for the Company that is recognized ratably over the time period the security is on loan. The securities on loan to others are segregated from the other invested assets on the Company’s balance sheet. In accordance with relevant accounting literature, the collateral held by the Company is accounted for as a secured borrowing and is recorded as an asset on the Company’s balance sheet, with a corresponding liability reflecting the Company’s obligation to return this collateral upon the return of the loaned securities.

Income Taxes

During October 2004, Employers Mutual’s ownership of the Company fell below 80 percent upon successful completion of the follow-on stock offering. Accordingly, the Company was no longer included in Employers Mutual’s consolidated tax return effective October 1, 2004, and the Company filed a short-period tax return for the period October 1, 2004 through December 31, 2004. Consolidated income taxes/benefits are allocated among the entities based upon separate tax liabilities.

Deferred income taxes are provided for temporary differences between the tax basis of assets and liabilities and the reported amounts of those assets and liabilities for financial reporting purposes. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Income tax expense provisions increase or decrease in the same period in which a change in tax rates is enacted. A valuation allowance is established to reduce deferred tax assets to their net realizable value if it is “more likely than not” that a tax benefit will not be realized.

Stock-Based Compensation

The Company has no stock-based compensation plans of its own; however, Employers Mutual has several stock plans that utilize the common stock of the Company. The Company receives the current fair value for all shares issued under these plans. Under the terms of the pooling agreement (see note 2), stock option expense is allocated to the Company’s insurance subsidiaries as determined on a statutory basis of accounting. The Company’s insurance subsidiaries reimburse Employers Mutual for their share of the statutory-basis compensation expense (equal to the excess of the fair value of the stock on the option exercise date over the option’s exercise price) associated with stock option exercises.

In December 2004, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 123 (revised 2004) “Share-Based Payment,” which is a revision of SFAS No. 123 (as amended by SFAS 148) “Accounting for Stock-Based Compensation” and supersedes Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees.” SFAS 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements based on their fair values. Effective January 1, 2006, the Company adopted SFAS 123(R) using the modified prospective method, which requires compensation expense to be recorded for all options granted after the date of adoption as well as for existing options for which the requisite service has not been rendered as of the date of adoption. The modified-prospective method does not require restatement of prior periods to reflect the impact of SFAS 123(R). There was no initial change to net income or stockholders’ equity upon the adoption of SFAS 123(R). Under the provisions of SFAS 123(R), the Company recognized compensation expense of $377,294 (gross and net of tax) during 2006 related to incentive stock options and a stock appreciation rights agreement.

Prior to January 1, 2006, under the provisions of APB 25, the Company did not recognize any compensation expense from the operation of Employers Mutual’s incentive stock option plans since the exercise price of the options was equal to the fair value of the stock on the date of grant. The statutory-basis compensation expense that was paid by the Company’s subsidiaries to Employers Mutual ($245,441 in 2005 and $293,583 in 2004) was reclassified as a dividend payment to Employers Mutual in these GAAP-basis financial statements.

The following table illustrates the effect on net income and net income per share if the Company had applied the fair value recognition provisions of SFAS No. 123 (as amended by SFAS No. 148) “Accounting for Stock-Based Compensation” to Employers Mutual’s incentive stock option plans:

	Year ended December 31,
	2005	2004
Net income, as reported	$ 43,009,045	$ 13,184,683
Deduct: Total stock-based employee compensation expense
determined under the fair value method for all awards
vesting in the current calendar year	117,710	32,373
Pro forma net income	$ 42,891,335	$ 13,152,310

Net income per share:
Basic and diluted -
As reported	$ 3.16	$ 1.10
Pro forma	$ 3.15	$ 1.10

Employee Retirement Plans

In September 2006, the FASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans.” SFAS 158 requires recognition of the funded status of defined benefit retirement or other postretirement plans as a net asset or liability on the balance sheet, the recognition of future changes in the funded status through other comprehensive income, the measurement of the defined benefit plan assets and obligations as of the end of the employer’s fiscal year and enhanced disclosure. The initial recognition of the funded status is reflected as an adjustment to the ending balance of accumulated other comprehensive income. SFAS 158 does not change the method of calculating the net periodic cost that existed under previous guidance. SFAS 158 became effective for the Company on December 31, 2006, except for the requirement to measure assets and obligations as of the end of the Company’s fiscal year, which will be effective at December 31, 2008.

The following table provides a detailed breakdown of the initial adjustment to the Company’s consolidated balance sheet at December 31, 2006, as a result of adopting SFAS 158:

	Before		After
	Application of		Application of
	Statement 158	Adjustments	Statement 158
Defined benefit retirement plan, prepaid asset	$ 11,665,609	$ (3,828,651)	$ 7,836,958
Deferred income taxes	10,046,893	2,356,248	12,403,141
Total assets	1,207,631,145	(1,472,403)	1,206,158,742
Liability for employee retirement plans	14,796,844	2,903,488	17,700,332
Total liabilities	894,960,932	2,903,488	897,864,420
Accumulated other comprehensive income	29,310,794	(4,375,891)	24,934,903
Total stockholders' equity	312,670,213	(4,375,891)	308,294,322

Foreign Currency Transactions

Included in the underlying reinsurance business assumed by Employers Mutual are reinsurance transactions conducted with foreign cedants denominated in their local functional currencies. In accordance with the revised terms of the quota share agreement (see note 2), the reinsurance subsidiary is assuming all foreign currency exchange gains/losses associated with contracts incepting on January 1, 2006 and thereafter that are subject to the quota share agreement. Previously, the foreign currency exchange gains/losses were retained by Employers Mutual. The balances resulting from these foreign reinsurance transactions are reported in the Company’s consolidated balance sheet in U.S. dollars based on the foreign currency exchange rates that existed on December 31, 2006. The balances reported in the Company’s 2006 consolidated statement of income that resulted from these foreign reinsurance transactions are reported in U.S. dollars measured at the foreign currency exchange rates that existed at the inception of each reinsurance contract. The foreign currency exchange rate gains/losses resulting from these re-measurements to U.S. dollars are reported as other income/expense in the consolidated statement of income.

Net Income Per Share - Basic and Diluted

The Company’s basic and diluted net income per share is computed by dividing net income by the weighted average number of common shares outstanding during each period. As previously noted, the Company receives the current fair value for all shares issued under Employers Mutual’s stock plans. As a result, the Company had no potential common shares outstanding during 2006, 2005 and 2004 that would have been dilutive to net income per share.

Goodwill

Goodwill represents the excess of cost over the fair value of net assets of acquired subsidiaries. Goodwill is not amortized, but is subject to annual impairment testing to determine if the carrying value of the goodwill exceeds the estimated fair value of net assets. If the carrying amount of the subsidiary (including goodwill) exceeds the computed fair value, an impairment loss is recognized through earnings equal to the excess amount, but not greater than the balance of the goodwill. An annual impairment test is completed in the fourth quarter of each year and goodwill was not deemed to be impaired in 2006, 2005 or 2004.

New Accounting Pronouncements

In February 2006, the FASB issued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments” – an Amendment of FASB Statement Nos. 133 and 140. SFAS 155 simplifies the accounting for certain hybrid financial instruments by permitting fair value re-measurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation, and eliminates a restriction on passive derivative instruments that a qualifying special-purpose entity may hold. SFAS 155 is effective for all financial instruments acquired, issued, or subject to a re-measurement (new basis) event occurring in fiscal years that begin after September 15, 2006. Adoption of this statement is not expected to have a material effect on the operating results of the Company.

In June 2006, the FASB issued Interpretation No. 48 “Accounting for Uncertainty in Income Taxes.” This interpretation clarifies the accounting for uncertainty in income taxes recognized in an enterprise's financial statements in accordance with SFAS 109 “Accounting for Income Taxes.” This interpretation prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. The interpretation also provides guidance for de-recognition of tax positions, financial statement classification, interest and penalties, accounting in interim periods, disclosure, and transition. This interpretation is effective for fiscal years beginning after December 15, 2006. Adoption of this statement is not expected to have a material effect on the operating results of the Company, as a recently completed assessment of the Company’s current tax positions indicated no uncertainties that would warrant different recognition and valuation from that applied in the Company’s tax returns.

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements,” which defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. The provisions of SFAS 157 are effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The Company is currently evaluating the impact this statement will have on its financial statements.

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities.” SFAS 159 permits reporting entities to choose, at specified election dates, to measure eligible items at fair value (the “fair value option”). The unrealized gains and losses on items for which the fair value option has been elected will be reported in earnings. As it relates to the Company’s financial reporting, the Company would be permitted to elect fair value recognition of fixed maturity and equity investments currently classified as either available-for-sale or held-to-maturity, and report the unrealized gains and losses from these investments in earnings going forward. Electing the fair value option for an existing held-to-maturity security will not call into question the intent of an entity to hold other fixed maturity securities to maturity in the future. The provisions of this statement are effective beginning with the first fiscal year that begins after November 15, 2007. The Company is currently evaluating the alternatives permitted by this statement and the impact those alternatives would have on its financial statements.

2.	AFFILIATION AND TRANSACTIONS WITH AFFILIATES

Property and Casualty Insurance Subsidiaries

The Company’s four property and casualty insurance subsidiaries and two subsidiaries and an affiliate of Employers Mutual are parties to reinsurance pooling agreements with Employers Mutual (collectively the “pooling agreement”). Under the terms of the pooling agreement, each company cedes to Employers Mutual all of its insurance business, with the exception of any voluntary reinsurance business assumed from nonaffiliated insurance companies, and assumes from Employers Mutual an amount equal to its participation in the pool. All premiums, losses, settlement expenses, and other underwriting and administrative expenses, excluding the voluntary reinsurance business assumed by Employers Mutual from nonaffiliated insurance companies, are prorated among the parties on the basis of participation in the pool. Employers Mutual negotiates reinsurance agreements that provide protection to the pool and each of its participants, including protection against losses arising from catastrophic events.

Operations of the pool give rise to inter-company balances with Employers Mutual, which are settled on a quarterly basis. The investment and income tax activities of the pool participants are not subject to the pooling agreement. The pooling agreement provides that Employers Mutual will make up any shortfall or difference resulting from an error in its systems and/or computational processes that would otherwise result in the required restatement of the pool participants’ financial statements.

The purpose of the pooling agreement is to spread the risk of an exposure insured by any of the pool participants among all the companies. The pooling agreement produces a more uniform and stable underwriting result from year to year for all companies in the pool than might be experienced individually. In addition, each company benefits from the capacity of the entire pool, rather than being limited to policy exposures of a size commensurate with its own assets, and from the wide range of policy forms, lines of insurance written, rate filings and commission plans offered by each of the companies.

On October 20, 2004, the Company successfully completed a follow-on stock offering and sold 2.0 million new shares of its common stock to the public at a price of $18.75 per share. Employers Mutual participated in the stock offering as a selling shareholder and sold 2.1 million shares of the Company’s common stock that it previously owned. As a result of these transactions, Employers Mutual’s ownership of the Company was reduced from approximately 80.9 percent to approximately 53.7 percent.

Net proceeds to the Company from the follow-on stock offering totaled $34,890,085. These proceeds were contributed to three of the Company’s property and casualty insurance subsidiaries in December of 2004 to support a 6.5 percentage point increase in the Company’s aggregate participation in the pooling agreement effective January 1, 2005. As a result of this change, the Company’s aggregate participation in the pooling agreement increased from 23.5 percent to 30.0 percent and Employers Mutual’s participation decreased from 65.5 percent to 59.0 percent. In connection with this change in pool participation, the Company’s liabilities increased $115,042,355 and invested assets increased $108,798,583. The Company reimbursed Employers Mutual $6,518,735 for expenses that were incurred to generate the additional business assumed by the Company, but this expense was offset by an increase in deferred policy acquisition costs. The Company also received $274,963 in interest income from Employers Mutual as the actual cash transfer did not occur until February 15, 2005.

In addition to changing the individual pool participation percentages of Employers Mutual and three of the Company’s property and casualty insurance subsidiaries, the pooling agreement was amended effective January 1, 2005 to comply with certain conditions established by the Iowa Insurance Department and A.M. Best Company. These amendments: (1) provide for a fixed term of three years commencing January 1, 2005 and continuing until December 31, 2007, during which period the pooling agreement may not be terminated and the revised participation interests will not be further amended, absent the occurrence of a material event not in the ordinary course of business that could reasonably be expected to impact the appropriateness of the participation interests in the pool; (2) provide that if a pool participant becomes insolvent, or is otherwise subject to liquidation or receivership proceedings, each of the other participants will, on a pro rata basis, adjust their assumed portions of the pool liabilities in order to assume in full the liabilities of the impaired participant, subject to compliance with all regulatory requirements applicable to such adjustment under the laws of all states in which the participants are domiciled; (3) clarify that all development on prior years’ outstanding losses and settlement expenses of the participants will remain in the pool and be pro rated pursuant to the pooling agreement; and (4) clarify that all liabilities incurred prior to a participant withdrawing from the pool, and associated with such withdrawing participant, shall remain a part of the pool and subject to the pooling agreement.

During 2004, the Company’s wholly-owned subsidiary, Farm and City Insurance Company, discontinued writing new nonstandard risk automobile insurance business and began instituting non-renewal procedures on all existing business. The effective dates for these actions were determined by the requirements of the six states in which it conducted business and the terms of the individual policies. Farm and City has completed its non-renewal procedures in all states, with the last policy expiring in January 2006. Farm and City will continue to participate in the pooling agreement even though it no longer writes direct insurance business. Discontinuance of the nonstandard risk automobile insurance business did not have a material impact on the Company’s results of operations.

Reinsurance Subsidiary

The Company’s reinsurance subsidiary assumes a 100 percent quota share portion of Employers Mutual’s assumed reinsurance business, exclusive of certain reinsurance contracts. This includes all premiums and related losses and settlement expenses of this business, subject to a maximum loss of $2,000,000 per event ($1,500,000 in 2005 and 2004). The reinsurance subsidiary does not directly reinsure any of the insurance business written by Employers Mutual; however, the reinsurance subsidiary assumes reinsurance business from the Mutual Reinsurance Bureau (MRB) pool and this pool provides a small amount of reinsurance protection to the EMC Insurance Companies. As a result, the reinsurance subsidiary’s assumed exposures include a small portion of the EMC Insurance Companies’ direct business, after ceded reinsurance protections purchased by the MRB pool are applied. In addition, the reinsurance subsidiary does not reinsure any “involuntary” facility or pool business that Employers Mutual assumes pursuant to state law. Operations of the quota share agreement give rise to inter-company balances with Employers Mutual, which are settled on a quarterly basis. The investment and income tax activities of the reinsurance subsidiary are not subject to the quota share agreement.

Premiums assumed by the reinsurance subsidiary from Employers Mutual amounted to $66,268,178, $92,588,093 and $97,637,066 in 2006, 2005 and 2004, respectively. The large decline in 2006 is primarily attributed to Employers Mutual’s reduced participation in the MRB pool (see note 3). It is customary in the reinsurance business for the assuming company to compensate the ceding company for the acquisition expenses incurred in the generation of the business. Commissions paid by the reinsurance subsidiary to Employers Mutual amounted to $15,650,305, $21,508,620 and $20,621,898 in 2006, 2005 and 2004, respectively.

Effective January 1, 2006, the terms of the quota share agreement between Employers Mutual and the reinsurance subsidiary were revised. The majority of the changes were prompted by the significant amount of hurricane losses retained by Employers Mutual during the severe 2005 hurricane season; however, other changes were made to simplify and clarify the terms and conditions of the quota share agreement. The revised terms of the quota share agreement for 2006 are as follows: (1) the reinsurance subsidiary’s retention, or cap, on losses assumed per event increased from $1,500,000 to $2,000,000; (2) the cost of the $2,000,000 cap on losses assumed per event is treated as a reduction to premiums written rather than commission expense; (3) the reinsurance subsidiary no longer directly pays for the outside reinsurance protection that Employers Mutual purchases to protect itself from catastrophic losses on the assumed reinsurance business it retains in excess of the cap, and instead pays a higher premium rate (previously accounted for as commission); and (4) the reinsurance subsidiary assumes all foreign currency exchange gain/loss associated with contracts incepting on January 1, 2006 and thereafter that are subject to the quota share agreement. For 2006, the premium rate paid by the reinsurance subsidiary to Employers Mutual was 10.50 percent of premiums written. The corresponding rate for 2005 was approximately 8.50 percent (4.50 percent override commission rate plus approximately 4.00 percent for the cost of the outside reinsurance protection). The net foreign currency exchange loss assumed by the reinsurance subsidiary in 2006 was $61,055.

Under the terms of the quota share agreement, the reinsurance subsidiary receives reinstatement premium income that is collected by Employers Mutual from the ceding companies when reinsurance coverage is reinstated after a loss event; however, the cap on losses assumed per event contained in the quota share agreement is automatically reinstated without cost. This arrangement can produce unusual underwriting results for the reinsurance subsidiary when a large event occurs because the reinstatement premium income received by the reinsurance subsidiary may approximate, or exceed, the amount of losses retained.

During 2006, Employers Mutual retained 10.5 percent of the gross assumed premiums written subject to cession to the reinsurance subsidiary ($7,774,480) as compensation for the $2,000,000 cap on losses assumed per event. In 2005 and 2004, the reinsurance subsidiary paid Employers Mutual override commissions of $4,166,464 and $4,393,668 for the $1,500,000 cap per event, and also paid for 100 percent of the outside reinsurance protection Employers Mutual purchased to protect itself from catastrophic losses on the assumed reinsurance business it retained in excess of the cap, excluding reinstatement premiums. This cost was recorded as a reduction to the premiums received by the reinsurance subsidiary and amounted to $3,695,833 and $3,626,833 in 2005 and 2004, respectively. The reinsurance subsidiary’s premiums earned for 2006 reflect a reduction of $508,333 associated with the runoff of the unearned premium from the outside reinsurance protection purchased in 2005, which expired on April 30, 2006. Employers Mutual retained losses and settlement expenses under the quota share agreement totaling $1,029,236 in 2006, $28,682,084 in 2005 and $11,277,246 in 2004.

Services Provided by Employers Mutual

Employers Mutual provides various services to all of its subsidiaries and affiliates. Such services include data processing, claims, financial, actuarial, auditing, marketing and underwriting. Employers Mutual allocates a portion of the cost of these services to the subsidiaries that do not participate in the pooling agreement based upon a number of criteria, including usage and number of transactions. The remaining costs are charged to the pooling agreement and each pool participant shares in the total cost in accordance with its pool participation percentage. Costs allocated to the Company by Employers Mutual for services provided to the holding company and its subsidiaries that do not participate in the pooling agreement amounted to $2,081,688, $1,829,565 and $2,118,411 in 2006, 2005 and 2004, respectively. Costs allocated to the Company through the operation of the pooling agreement amounted to $89,055,823, $82,782,802 and $73,305,162 in 2006, 2005 and 2004, respectively.

Investment expenses are based on actual expenses incurred by the Company plus an allocation of other investment expenses incurred by Employers Mutual, which is based on a weighted average of total invested assets and number of investment transactions. Investment expenses allocated to the Company by Employers Mutual amounted to $1,310,193, $1,011,370 and $699,807 in 2006, 2005 and 2004, respectively.

3.	REINSURANCE

The parties to the pooling agreement cede insurance business to other insurers in the ordinary course of business for the purpose of limiting their maximum loss exposure through diversification of their risks. In its consolidated financial statements, the Company treats risks to the extent they are reinsured as though they were risks for which the Company is not liable. Insurance ceded by the pool participants does not relieve their primary liability as the originating insurers. Employers Mutual evaluates the financial condition of the reinsurers of the parties to the pooling agreement and monitors concentrations of credit risk arising from similar geographic regions, activities or economic characteristics of the reinsurers to minimize exposure to significant losses from reinsurer insolvencies.

As of December 31, 2006, reinsurance ceded to two nonaffiliated reinsurers aggregated $21,088,937, which represents a significant portion of the total prepaid reinsurance premiums and reinsurance receivables for losses and settlement expenses. These amounts reflect the property and casualty insurance subsidiaries’ aggregate pool participation percentage of amounts ceded by Employers Mutual to these organizations on a mandatory basis. Credit risk associated with these amounts is minimal, as all companies participating in these organizations are responsible for the liabilities of such organizations on a pro rata basis.

The effect of reinsurance on premiums written and earned, and losses and settlement expenses incurred, for the three years ended December 31, 2006 is presented below.

	Year ended December 31,
	2006	2005	2004
Premiums written
Direct	$ 191,515,607	$ 187,484,611	$ 191,823,068
Assumed from nonaffiliates	3,414,423	4,537,413	4,125,092
Assumed from affiliates	408,950,067	463,777,028	366,224,505
Ceded to nonaffiliates	(26,112,282)	(25,080,441)	(18,445,768)
Ceded to affiliates	(191,515,607)	(187,484,611)	(191,823,068)
Net premiums written	$ 386,252,208	$ 443,234,000	$ 351,903,829

Premiums earned
Direct	$ 188,426,941	$ 186,933,086	$ 197,051,604
Assumed from nonaffiliates	3,697,564	4,455,928	3,933,665
Assumed from affiliates	414,068,427	435,085,847	359,605,116
Ceded to nonaffiliates	(26,150,550)	(23,917,029)	(18,060,320)
Ceded to affiliates	(188,426,941)	(186,933,086)	(197,051,604)
Net premiums earned	$ 391,615,441	$ 415,624,746	$ 345,478,461

Losses and settlement expenses incurred
Direct	$ 95,639,897	$ 137,398,803	$ 132,616,303
Assumed from nonaffiliates	2,545,606	7,082,993	2,897,364
Assumed from affiliates	233,284,454	280,482,249	258,134,261
Ceded to nonaffiliates	(7,377,568)	(29,638,749)	(11,225,415)
Ceded to affiliates	(95,639,897)	(137,398,803)	(132,616,303)
Net losses and settlement
expenses incurred	$ 228,452,492	$ 257,926,493	$ 249,806,210

For 2006, premiums written and earned assumed from affiliates, and losses and settlement expenses incurred assumed from affiliates, reflect a reduction in Employers Mutual’s participation in the MRB pool. The board of directors of the MRB pool approved the admission of two new assuming companies to the pool effective January 1, 2006. This reduced Employers Mutual’s participation in the pool from a one-third share to an approximate one-fifth share (one company is only assuming property exposures). The premiums written assumed from affiliates and net premiums written amounts for 2006 also include a negative $3,440,024 portfolio adjustment which serves as an offset to the decrease in unearned premiums recognized in connection with this change in participation.

The large increases in net premiums written and earned, and net losses and settlement expenses incurred, in 2005 reflect the increase in the Company’s aggregate participation interest in the pooling agreement. The premiums written assumed from affiliates and net premiums written amounts for 2005 also include a $29,630,612 portfolio adjustment which serves as an offset to the increase in unearned premiums recognized in connection with the change in pool participation (see note 2).

4.	LIABILITY FOR LOSSES AND SETTLEMENT EXPENSES

The following table sets forth a reconciliation of beginning and ending reserves for losses and settlement expenses of the Company. Amounts presented are on a net basis, with a reconciliation of beginning and ending reserves to the gross amounts presented in the consolidated financial statements.

	Year ended December 31,
	2006	2005	2004
Gross reserves at beginning of year	$ 544,051,061	$ 429,677,302	$ 373,782,916
Ceded reserves at beginning of year	(42,650,556)	(25,358,320)	(20,666,429)
Net reserves at beginning of year,
before adjustment	501,400,505	404,318,982	353,116,487

Adjustment to beginning reserves due to
change in pool agreement	-	78,818,305	-
Net reserves at beginning of year,
after adjustment	501,400,505	483,137,287	353,116,487

Incurred losses and settlement expenses
Provision for insured events of the
current year	270,368,747	273,334,396	229,667,776
Increase (decrease) in provision for
insured events of prior years	(41,916,255)	(15,407,903)	20,138,434
Total incurred losses and
settlement expenses	228,452,492	257,926,493	249,806,210

Payments
Losses and settlement expenses
attributable to insured events of the
current year	92,061,399	99,998,372	83,530,727
Losses and settlement expenses
attributable to insured events of
prior years	125,042,454	139,664,903	115,072,988
Total payments	217,103,853	239,663,275	198,603,715

Net reserves at end of year	512,749,144	501,400,505	404,318,982
Ceded reserves at end of year	35,608,811	42,650,556	25,358,320
Gross reserves at end of year, before
foreign currency re-valuation	548,357,955	544,051,061	429,677,302
Re-valuation due to foreign currency exchange rates	190,027	-	-
Gross reserves at end of year	$ 548,547,982	$ 544,051,061	$ 429,677,302

Underwriting results of the Company are significantly influenced by the estimates of loss and settlement expense reserves. Changes in reserve estimates are reflected in operating results in the year such changes are recorded. The property and casualty insurance segment experienced favorable development on prior years’ reserves in 2006 and 2005, but adverse development in 2004, while the reinsurance segment experienced favorable development in all three years presented.

2006 Development

For the property and casualty insurance segment, the December 31, 2006 estimate of loss and settlement expense reserves for accident years 2005 and prior decreased $32,255,312 from the estimate at December 31, 2005. This decrease represents 7.9 percent of the December 31, 2005 carried reserves and is primarily attributed to the final settlement of closed claims.

For the reinsurance segment, the December 31, 2006 estimate of loss and settlement expense reserves for accident years 2005 and prior decreased $9,660,943 from the estimate at December 31, 2005. This decrease represents 7.2 percent of the December 31, 2005 carried reserves and is largely attributed to the 2004 and 2005 accident years in the HORAD book of business.

2005 Development

For the property and casualty insurance segment, the December 31, 2005 estimate of loss and settlement expense reserves for accident years 2004 and prior decreased $14,808,375 from the estimate at December 31, 2004. This decrease represents 4.8 percent of the December 31, 2004 carried reserves and is primarily attributed to downward development of individual case loss reserves and settlement expense reserves. In addition, during the fourth quarter the Company reallocated a portion of a bulk case loss reserve carried in the workers’ compensation line of business to various components of the loss and settlement expense reserve for the other liability line of business (IBNR, asbestos and settlement expense) and eliminated the remainder, resulting in $2,145,000 of favorable development.

For the reinsurance segment, the December 31, 2005 estimate of loss and settlement expense reserves for accident years 2004 and prior decreased $599,528 from the estimate at December 31, 2004. This decrease represents 0.5 percent of the December 31, 2004 carried reserves and is attributed to the HORAD book of business.

2004 Development

For the property and casualty insurance segment, the December 31, 2004 estimate of loss and settlement expense reserves for accident years 2003 and prior increased $23,738,375 from the estimate at December 31, 2003. This increase represents 9.4 percent of the December 31, 2003 carried reserves and is attributed to a combination of newly reported claims in excess of carried IBNR loss reserves ($14,758,000), development on case loss reserves of previously reported claims ($11,037,000), bulk reserve strengthening ($2,350,000), and settlement expense reserve increases resulting from increases in case loss reserves ($6,209,000). This adverse development was partially offset by $10,437,000 of reinsurance recoveries associated with the case loss reserve development and IBNR emergence. Substantial case loss reserve strengthening performed at the Company’s branch offices, primarily in the workers’ compensation and other liability lines of business, is the underlying reason for the adverse reserve development. The economic factors behind this case loss reserve strengthening include, most notably, an increase in workers’ compensation claim severity, increases in construction defect claim activity, the occurrence of several large umbrella claims and increasing legal expenses in the other liability line of business.

For the reinsurance segment, the December 31, 2004 estimate of loss and settlement expense reserves for accident years 2003 and prior decreased $3,599,941 from the estimate at December 31, 2003. This decrease represents 3.1 percent of the December 31, 2003 carried reserves and is primarily from reported policy year 2003 losses for property, casualty and multi-line classes that were below 2003 implicit projections.

5.	ASBESTOS AND ENVIRONMENTAL RELATED CLAIMS

The Company has exposure to asbestos and environmental related claims associated with the insurance business written by the parties to the pooling agreement and the reinsurance business assumed from Employers Mutual by the reinsurance subsidiary. These exposures are not considered to be significant. Asbestos and environmental losses paid by the Company have averaged only $363,986 per year over the past five years. Reserves for asbestos and environmental related claims for direct insurance and assumed reinsurance business totaled $7,288,116 and $6,895,641 at December 31, 2006 and 2005, respectively.

At present, the Company is defending approximately 600 asbestos bodily injury lawsuits, some of which involve multiple plaintiffs. Most of these defenses are subject to express reservation of rights based upon the lack of an injury within the Company’s policy periods, because many asbestos lawsuits do not specifically allege dates of asbestos exposure or dates of injury. During 2003, as a direct result of proposed federal legislation in the areas of asbestos and class action reform, the Company was presented with several hundred additional lawsuits filed against three former policyholders representing approximately 66,500 claims related to exposure to asbestos or products containing asbestos. These claims are based upon nonspecific asbestos exposure and nonspecific injuries. As a result, management did not establish a significant amount of case loss reserves associated with these claims. At December 31, 2006, approximately 25,000 plaintiff cases remain open. Four former policyholders and one current policyholder dominate the Company’s asbestos claims. To date, actual losses paid have been minimal due to the plaintiffs’ failure to identify an exposure to any asbestos-containing product associated with the Company’s policyholders. Defense costs, on the other hand, have increased due to the large number of parties involved in the litigation and the length of time required to obtaining a favorable judgment. The Company believes its settlement expense reserve adequately provides for these increased expenses. Whenever possible, the Company has participated in cost sharing agreements with other insurance companies to reduce overall asbestos claim expenses.

Estimating loss and settlement expense reserves for asbestos and environmental claims is very difficult due to the many uncertainties surrounding these types of claims. These uncertainties exist because the assignment of responsibility varies widely by state and claims often emerge long after a policy has expired, which makes assignment of damages to the appropriate party and to the time period covered by a particular policy difficult. In establishing reserves for these types of claims, management monitors the relevant facts concerning each claim, the current status of the legal environment, social and political conditions, and claim history and trends within the Company and the industry.

6.	STATUTORY INFORMATION AND DIVIDEND RESTRICTIONS

The Company’s insurance subsidiaries are required to file financial statements with state regulatory authorities. The accounting principles used to prepare these statutory financial statements follow prescribed or permitted accounting practices that differ from GAAP. Prescribed statutory accounting principles include state laws, regulations and general administrative rules issued by the state of domicile, as well as a variety of publications and manuals of the National Association of Insurance Commissioners (NAIC). Permitted accounting practices encompass all accounting practices not prescribed, but allowed by the state of domicile. The Company’s insurance subsidiaries had no permitted accounting practices during 2006, 2005 and 2004.

Statutory surplus of the Company’s insurance subsidiaries was $310,279,721 and $259,026,263 at December 31, 2006 and 2005, respectively. Statutory net income of the Company’s insurance subsidiaries was $57,701,796, $40,736,759 and $11,878,844 for 2006, 2005 and 2004, respectively.

The NAIC utilizes a risk-based capital model to help state regulators assess the capital adequacy of insurance companies and identify insurers that are in, or are perceived as approaching, financial difficulty. This model establishes minimum capital needs based on the risks applicable to the operations of the individual insurer. The risk-based capital requirements for property and casualty insurance companies measure three major areas of risk: asset risk, credit risk and underwriting risk. Companies having less statutory surplus than required by the risk-based capital requirements are subject to varying degrees of regulatory scrutiny and intervention, depending on the severity of the inadequacy. At December 31, 2006, the Company’s insurance subsidiaries had total adjusted statutory capital of $310,279,721, which is well in excess of the minimum risk-based capital requirement of $52,753,424.

The amount of retained earnings of the Company’s insurance subsidiaries available for distribution as dividends are limited by law to a percentage of the statutory unassigned surplus of each of the subsidiaries as of the previous December 31, as determined in accordance with accounting practices prescribed by insurance regulatory authorities of the state of domicile of each subsidiary. Subject to this limitation, the maximum dividend that may be paid within a 12 month period without prior approval of the insurance regulatory authorities is generally restricted to the greater of 10 percent of statutory surplus as regards policyholders as of the preceding December 31, or net income of the preceding calendar year on a statutory basis, not greater than earned statutory surplus. At December 31, 2006, $57,701,796 was available for distribution to the Company in 2007 without prior approval.

7.	SEGMENT INFORMATION

The Company’s operations consist of a property and casualty insurance segment and a reinsurance segment. The property and casualty insurance segment writes both commercial and personal lines of insurance, with a focus on medium-sized commercial accounts. The reinsurance segment provides reinsurance for other insurers and reinsurers. The segments are managed separately due to differences in the insurance products sold and the business environment in which they operate. The accounting policies of the segments are described in note 1, Summary of Significant Accounting Policies.

Summarized financial information for the Company’s segments is as follows:

	Property and
Year ended	casualty		Parent
December 31, 2006	insurance	Reinsurance	company	Consolidated
Premiums earned	$ 318,416,718	$ 73,198,723	$ -	$ 391,615,441

Underwriting gain	22,401,468	5,513,241	-	27,914,709
Net investment income	34,310,739	12,116,726	264,464	46,691,929
Realized investment gains	4,026,538	225,751	-	4,252,289
Other income	526,617	-	-	526,617
Interest expense	772,500	339,900	-	1,112,400
Other expenses	1,065,324	61,055	781,383	1,907,762
Income (loss) before income
tax expense (benefit)	$ 59,427,538	$ 17,454,763	$ (516,919)	$ 76,365,382

Assets	$ 925,982,451	$ 274,017,436	$ 308,492,536	$ 1,508,492,423
Eliminations	-	-	(302,723,950)	(302,723,950)
Reclassifications	-	(94,816)	485,085	390,269
Net assets	$ 925,982,451	$ 273,922,620	$ 6,253,671	$ 1,206,158,742

	Property and
Year ended	casualty		Parent
December 31, 2005	insurance	Reinsurance	company	Consolidated
Premiums earned	$ 321,164,542	$ 94,460,204	$ -	$ 415,624,746

Underwriting gain	9,184,117	8,513,282	-	17,697,399
Net investment income	29,694,641	10,783,434	218,168	40,696,243
Realized investment gains (losses)	3,803,585	36,205	(5,625)	3,834,165
Other income	656,846	-	-	656,846
Interest expense	772,500	339,900	-	1,112,400
Other expenses	821,511	-	840,920	1,662,431
Income (loss) before income
tax expense (benefit)	$ 41,745,178	$ 18,993,021	$ (628,377)	$ 60,109,822

Assets	$ 837,933,744	$ 272,388,433	$ 262,099,903	$ 1,372,422,080
Eliminations	-	-	(258,380,998)	(258,380,998)
Reclassifications	(120,633)	-	(238,828)	(359,461)
Net assets	$ 837,813,111	$ 272,388,433	$ 3,480,077	$ 1,113,681,621

	Property and
Year ended	casualty		Parent
December 31, 2004	insurance	Reinsurance	company	Consolidated
Premiums earned	$ 250,034,561	$ 95,443,900	$ -	$ 345,478,461

Underwriting gain (loss)	(32,261,993)	15,227,552	-	(17,034,441)
Net investment income	20,236,342	9,498,925	164,936	29,900,203
Realized investment gains	3,270,862	1,108,452	-	4,379,314
Other income	600,732	-	-	600,732
Interest expense	772,500	339,900	-	1,112,400
Other expenses	495,783	-	666,628	1,162,411
Income (loss) before income
tax expense (benefit)	$ (9,422,340)	$ 25,495,029	$ (501,692)	$ 15,570,997

The following table displays the net premiums earned of the property and casualty insurance segment and the reinsurance segment for the three years ended December 31, 2006, by line of insurance.

	Year ended December 31,
	2006	2005	2004
Property and casualty insurance segment
Commercial lines:
Automobile	$ 71,467,542	$ 72,417,154	$ 56,557,217
Property	61,428,919	60,284,142	45,718,321
Workers' compensation	60,393,515	61,986,051	48,161,493
Liability	69,499,230	66,030,019	49,515,505
Other	8,221,362	7,226,321	4,530,586
Total commercial lines	271,010,568	267,943,687	204,483,122

Personal lines:
Automobile	25,118,055	29,457,545	26,577,794
Property	21,656,438	23,161,197	18,519,312
Liability	631,657	602,113	454,333
Total personal lines	47,406,150	53,220,855	45,551,439
Total property and casualty insurance	$ 318,416,718	$ 321,164,542	$ 250,034,561


Reinsurance segment
Pro rata reinsurance:
Property and casualty	$ 10,900,235	$ 19,156,254	$ 20,949,377
Property	13,087,674	16,620,046	13,613,470
Crop	4,259,551	3,969,105	4,023,854
Casualty	1,435,813	1,001,623	955,605
Marine/Aviation	2,962,231	7,224,739	11,095,736
Total pro rata reinsurance	32,645,504	47,971,767	50,638,042

Excess-of-loss reinsurance:
Property	28,071,206	30,465,005	26,855,018
Casualty	12,452,208	16,069,819	17,356,513
Surety	29,805	(46,387)	594,327
Total excess-of-loss reinsurance	40,553,219	46,488,437	44,805,858
Total reinsurance	$ 73,198,723	$ 94,460,204	$ 95,443,900

Consolidated	$ 391,615,441	$ 415,624,746	$ 345,478,461

8. INVESTMENTS

Investments of the Company’s insurance subsidiaries are subject to the insurance laws of the state of their incorporation. These laws prescribe the kind, quality and concentration of investments that may be made by insurance companies. In general, these laws permit investments, within specified limits and subject to certain qualifications, in federal, state and municipal obligations, corporate bonds, preferred and common stocks and real estate mortgages. The Company believes that it is in compliance with these laws.

The amortized cost and estimated fair value of securities held-to-maturity and available-for-sale as of December 31, 2006 and 2005 are as follows. The estimated fair value is based on quoted market prices, where available, or on values obtained from independent pricing services.

		Gross	Gross
	Amortized	unrealized	unrealized	Estimated
December 31, 2006	cost	gains	losses	fair value
Securities held-to-maturity:
Fixed maturity securities:
U.S. treasury securities and
obligations of U.S. government
corporations and agencies	$ 4,996,845	$ 46,386	$ -	$ 5,043,231
Mortgage-backed securities	683,115	42,572	-	725,687
Total securities held-to-maturity	$ 5,679,960	$ 88,958	$ -	$ 5,768,918

Securities available-for-sale:
Fixed maturity securities:
U.S. treasury securities and
obligations of U.S. government
corporations and agencies	$ 427,412,485	$ 329,948	$ 5,598,414	$ 422,144,019
Obligations of states and
political subdivisions	258,311,579	11,011,346	8,920	269,314,005
Mortgage-backed securities	18,316,236	880,460	93,506	19,103,190
Public utilities	6,003,305	329,532	-

EMC Insurance Group (EMCI)

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