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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
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
Securities registered pursuant to Section 12(b) of the Act:
Securities registered pursuant to Section 12(g) of the Act: None
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.
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PART I
GENERAL
EMC Insurance Group Inc. is an insurance holding company that was incorporated in Iowa in 1974 by Employers Mutual Casualty Company (Employers Mutual) and became a public company in 1982 following the initial public offering of its common stock. EMC Insurance Group Inc. is 56.6 percent owned by Employers Mutual, a multiple-line property and casualty insurance company organized as an Iowa mutual insurance company in 1911 that is licensed in all 50 states and the District of Columbia. The term “Company” is used interchangeably to describe EMC Insurance Group Inc. (Parent Company only) and EMC Insurance Group Inc. and its subsidiaries. Employers Mutual and all of its subsidiaries (including the Company) and an affiliate, are referred to as the “EMC Insurance Companies.”
The Company conducts operations in property and casualty insurance and reinsurance through its subsidiaries. The Company primarily focuses on the sale of commercial lines of property and casualty insurance to small and medium-sized businesses. These products are sold through independent insurance agents who are supported by a decentralized network of branch offices. Although the Company actively markets its insurance products in 41 states, the majority of its business is marketed and generated in the Midwest.
Illinois EMCASCO was formed in Illinois in 1976 (and was re-domesticated to Iowa in 2001), Dakota Fire was formed in North Dakota in 1957 and EMCASCO was formed in Iowa in 1958 for the purpose of writing property and casualty insurance. Farm and City was formed in Iowa in 1962 to write nonstandard risk automobile insurance and was purchased by the Company in 1984. Farm and City no longer writes direct business, but continues to participate in the reinsurance pooling agreement with Employers Mutual (see discussion under “Organizational Structure – Property and Casualty Insurance”). EMC Reinsurance Company was formed in 1981 to assume reinsurance business from Employers Mutual. The Company’s excess and surplus lines insurance agency, EMC Underwriters, LLC, was formed in Iowa in 1975 and was acquired by the Company in 1985. Effective December 31, 1998, the excess and surplus lines insurance agency was converted to a limited liability company and the ownership was contributed to EMCASCO.
Property and casualty insurance is the most significant segment of the Company’s business, representing approximately 81 percent of premiums earned in 2006. The property and casualty insurance operations are integrated with the property and casualty insurance operations of Employers Mutual through participation in a reinsurance pooling agreement. Because the Company conducts its property and casualty insurance operations together with Employers Mutual through the pooling arrangement, the Company shares the same business philosophy, management, employees and facilities as Employers Mutual and offers the same types of insurance products. For a discussion of the pooling agreement and its benefits, please see “Organizational Structure – Property and Casualty Insurance” below.
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Reinsurance operations are conducted through EMC Reinsurance Company, representing approximately 19 percent of premiums earned in 2006. The principal business activity of EMC Reinsurance Company is to assume the voluntary reinsurance business written directly by Employers Mutual with unaffiliated insurance companies (subject to certain limited exceptions).
The Company’s insurance agency, EMC Underwriters, LLC, specializes in marketing excess and surplus lines of insurance. The excess and surplus lines markets provide insurance coverage at negotiated rates for risks that are not acceptable to licensed insurance companies. EMC Underwriters accesses this market by working through independent agents and functions as managing underwriter for excess and surplus lines insurance for several of the pool participants. The Company derives income from this business based on the fees and commissions earned through placement of the business, as opposed to the underwriting of the risks associated with that business.
Organizational Structure
Property and Casualty Insurance
The four property and casualty insurance subsidiaries of the Company and two subsidiaries and an affiliate of Employers Mutual (Union Insurance Company of Providence, EMC Property & Casualty Company and Hamilton Mutual Insurance Company) 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 also 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 participants among all of the participants. The particular benefits that the Company’s property and casualty insurance companies realize from participating in the pooling agreement include the following:
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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 $34,890,000. 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 $115,042,000 and assets increased $108,523,000. The Company reimbursed Employers Mutual $6,519,000 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 $275,000 in interest income from Employers Mutual as the actual transfer of assets did not occur until February 15, 2005.
Effective January 1, 2005, the pooling agreement was amended to 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 (such as the sale or dissolution of a participant, or the acquisition by, or affiliation with, the Company or Employers Mutual of a subsidiary or affiliated company that desires to become a participant in the pooling agreement). Commencing January 1, 2008, the pooling agreement will be automatically renewed for an additional three-year term (and automatically renewed for three-year terms after the end of each renewal term), however, during any renewal term a participant may terminate its participation in the pool as of the beginning of the next calendar year by providing 12 months prior notice to Employers Mutual.
Effective January 1, 2005, the pooling agreement was further amended to comply with certain conditions established by A.M. Best Company that will enable the pool participants to have their financial strength ratings determined on a “group” basis. These amendments: (i) 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 (based on their participation interests in the pool), 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; (ii) 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 (iii) 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.
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The amount of insurance a property and casualty insurance company writes under industry standards is commonly expressed as a multiple of its surplus calculated in accordance with statutory accounting practices. Generally, a ratio of 3 or less is considered satisfactory by state insurance departments. The ratios of the pool participants for the past three years are as follows:
(1) The ratios for these companies reflects the issuance of an aggregate of $25,000,000 of surplus notes to Employers Mutual on December 28, 2001. Surplus notes are considered to be a component of surplus for statutory reporting purposes; however, under U.S. generally accepted accounting principles, surplus notes are considered to be debt and are reported as a liability in the Company’s financial statements.
Reinsurance
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, settlement expenses, and other underwriting and administrative 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 or the other pool participants; 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 participants of the pooling agreement. As a result, the reinsurance subsidiary’s assumed exposures include a small portion of the direct business produced by the participants in the pooling agreement, 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.
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 were as follows: (1) the reinsurance subsidiary’s maximum 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 gains/losses 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 10.5 percent of premiums written. The corresponding rate for 2005 was approximately 8.5 percent (4.5 percent override commission rate plus approximately 4.0 percent for the cost of the outside reinsurance protection).
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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 to the reinsurance subsidiary. 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.
Property and Casualty Insurance and Reinsurance
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. 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.
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 total of invested assets and number of investment transactions.
FINANCIAL INFORMATION ABOUT INDUSTRY SEGMENTS
For information concerning the Company’s revenues, operating income and identifiable assets attributable to each of its industry segments over the past three years, see note 7 of Notes to Consolidated Financial Statements under Item 8 of this Form 10-K.
NARRATIVE DESCRIPTION OF BUSINESS
Principal Products
Property and Casualty Insurance
The Company’s property and casualty insurance subsidiaries and the other parties to the pooling agreement underwrite both commercial and personal lines of property and casualty insurance. Those coverages consist of the following types of insurance:
Commercial Lines
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Personal Lines
The following table sets forth the aggregate direct premiums written of all parties to the pooling agreement for the three years ended December 31, 2006, by line of business.
Reinsurance
As previously noted, the reinsurance subsidiary assumes the voluntary reinsurance business written directly by Employers Mutual with unaffiliated insurance companies (subject to certain limited exceptions). Employers Mutual writes both pro rata and excess-of-loss reinsurance for unaffiliated insurance companies. Pro rata reinsurance is a form of reinsurance in which the reinsurer assumes a stated percentage of all premiums, losses and related expenses in a given class of business. In contrast, excess-of-loss reinsurance provides coverage for a portion of losses incurred by an insurer which exceed predetermined retention limits.
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The following table sets forth the assumed premiums written of the reinsurance subsidiary for the three years ended December 31, 2006, by line of business. For 2006, assumed premiums written 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 assumed premium written amount for 2006 also includes a negative $3,440,000 portfolio adjustment which serves as an offset to the decrease in unearned premiums recognized in connection with this change in participation.
Marketing and Distribution
Property and Casualty Insurance
The Company markets a wide variety of commercial and personal lines insurance products through 16 full service branch offices, which actively write business in 41 states. The Company’s products are marketed exclusively through a network of over 2,400 local independent agencies contracted and serviced by those branch offices. The Company primarily focuses on the sale of commercial lines of property and casualty insurance to small and medium-sized businesses, which are considered to be policyholders that pay less than $100,000 in annual premiums. The Company also seeks to provide more than one policy to a given customer, because this “account selling” strategy diversifies risks and generally improves underwriting results.
The pool participants wrote over $1.1 billion in direct premiums in 2006, with 86 percent of this business coming from commercial lines products and 14 percent coming from personal lines products. Although a majority of the Company’s business is generated by sales in the Midwest, its offices are located across the country to take advantage of local market conditions and opportunities, as well as to spread risk geographically. Each branch office performs its own underwriting, claims, marketing and risk management functions according to policies and procedures established and monitored by the home office. This decentralized network of branch offices allows the Company to develop marketing strategies, products and pricing that target the needs of individual marketing territories and take advantage of different opportunities for profit in each market. This operating structure also enables the Company to develop close relationships with the agents and customers with whom it does business.
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Although each branch office offers a slightly different combination of products, the branches generally target three customer segments:
The Company writes a number of target market and safety dividend group programs throughout the country, and has developed a strong reputation for these programs within the marketplace. These programs provide enhanced insurance protection to businesses or institutions that have similar hazards and exposures and are willing to implement loss prevention programs. Underwriting results for these programs are based on the experience of the group, rather than the individual participants. These groups include public schools, small municipalities, petroleum marketers, contractors and mobile home parks. As an example, the pool participants write coverage for approximately 1,500 school districts throughout the Midwest. These programs have been successful because they offer risk management products and services that are targeted to the needs of the group members through a local independent agent.
The following table sets forth the geographic distribution of the aggregate direct premiums written of all parties to the pooling agreement for the three years ended December 31, 2006.
* Includes all other jurisdictions, none of which accounted for more than 3 percent.
Reinsurance
The reinsurance subsidiary obtains 100 percent of its business from Employers Mutual through the quota share agreement. The reinsurance subsidiary relies on the financial strength of Employers Mutual to write the reinsurance business, as well as the competitive advantage that Employers Mutual has by virtue of being licensed in all 50 states. Reinsurance marketing is undertaken by Employers Mutual in its role as the direct writer of the reinsurance business; however, the reinsurance subsidiary is utilized in the marketing efforts to help differentiate the reinsurance business from the direct insurance business that is written by Employers Mutual and the other pool participants.
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Employers Mutual’s reinsurance business is derived from two sources. Approximately 70 percent of Employers Mutual’s assumed reinsurance premiums earned in 2006 were generated through the activities of its Home Office Reinsurance Assumed Department (also known as “HORAD”). The reinsurance business written by HORAD is brokered through independent intermediaries. As a result, the risks assumed by HORAD do not materially overlap with the risks assumed by MRB (discussed below). The risks which are assumed by Employers Mutual through HORAD are directly underwritten and priced by Employers Mutual. As such, Employers Mutual has discretion with respect to the type and size of risks which it assumes and services through these activities.
The remaining 30 percent of Employers Mutual’s assumed reinsurance premiums earned in 2006 were generated through participation in the MRB pool, an unincorporated association through which Employers Mutual and other unaffiliated insurance companies participate in a voluntary reinsurance pool to meet the reinsurance needs of small and medium-sized, unaffiliated mutual insurance companies. Employers Mutual has participated in MRB since 1957. Effective January 1, 2006, the board of directors of the MRB pool approved the admission of two new assuming companies to the pool. 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). Both of the new assuming companies carry an A+ (Superior) rating from A.M. Best Company and their addition enhances the financial strength of the pool. MRB is controlled by a board of directors composed of the five members, including one representative designated by Employers Mutual. As a member of this organization, Employers Mutual assumes its proportionate share of the risks ceded to MRB by unaffiliated insurers. Since MRB is structured on a joint liability basis, Employers Mutual, and therefore the Company’s reinsurance subsidiary, would be obligated with respect to the proportionate share of risks assumed by the other participants in the event they were unable to perform. MRB, which is operated by an independent management team, manages assumed risks through typical underwriting practices, including loss exposure controls provided through reinsurance coverage obtained for the benefit of MRB. The reinsurance risks for MRB arise primarily from the Northeast and Midwest markets. Underwriting of risks and pricing of coverage is performed by MRB management under general guidelines established by Employers Mutual and the other participating insurers. Apart from these procedures, Employers Mutual has only limited control over the risks assumed by, and the operating results of, MRB. Because of the joint liability structure, MRB participating companies must maintain a rating of “A-” (Excellent) or above from A.M. Best Company and meet certain other standards.
On March 8, 2007 the management of the MRB pool announced that Auto-Owners Insurance Company will terminate its participation in the MRB pool effective January 1, 2008. The management of the MRB pool anticipates that a new participant will be found to replace Auto-Owners and that the MRB pool will continue operating at the current five participant level in 2008; however, they are prepared to operate the pool with the remaining four participants if necessary. In the event that Employers Mutual becomes a one-fourth participant in the MRB pool in 2008, the premium volume of the Company’s reinsurance subsidiary would be expected to increase by approximately $4.5 million, based on current projections of the MRB pool’s management.
Over the last several years Employers Mutual has emphasized writing excess-of-loss reinsurance business in its HORAD operation and has worked to increase its participation on existing contracts that had favorable terms. Employers Mutual strives to be flexible in the types of reinsurance products it offers, but generally limits its writings to direct reinsurance business, rather than providing retrocessional covers. In recent years there has been a trend in the reinsurance marketplace for “across the board” participation on excess-of-loss reinsurance contracts. As a result, reinsurance companies must be willing to participate on all layers offered under a specific contract in order to be considered a viable reinsurer.
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 for this purpose amounted to $15,650,000 in 2006. During 2006, Employers Mutual retained 10.5 percent of the gross assumed premiums written subject to cession to the reinsurance subsidiary as compensation for the $2.0 million cap on losses assumed per event, which amounted to $7,774,000. The reinsurance subsidiary also assumed all foreign currency exchange gain/loss associated with contracts incepting on January 1, 2006 and thereafter that were subject to the quota share agreement. The net foreign currency exchange loss assumed by the reinsurance subsidiary in 2006 was $61,000.
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Competition
Property and Casualty Insurance
The property and casualty insurance business is very competitive. The Company’s property and casualty insurance subsidiaries and the other pool participants compete in the United States insurance market with numerous insurers, many of which have greater financial resources. Competition in the types of insurance in which the property and casualty insurance subsidiaries are engaged is based on many factors, including the perceived overall financial strength of the insurer, premiums charged, contract terms and conditions, services offered, speed of claim payments, reputation and experience. Because the insurance products of the pool participants are marketed exclusively through independent agencies, the Company faces competition to retain qualified agencies, as well as competition within the agencies. The pool participants also compete with direct writers, who utilize salaried employees and generally offer their products at a lower cost, exclusive agencies who write insurance business for only one company, and to a lesser extent, internet-based enterprises. The pool participants utilize a profit-sharing plan as an incentive for the independent agencies to place high-quality insurance business with them.
Reinsurance
Employers Mutual, in writing reinsurance business through its HORAD operation, competes in the global reinsurance market with numerous reinsurance companies, many of which have substantially greater financial resources. Competition for reinsurance business is based on many factors, including financial strength, industry ratings, stability in products offered and licensing status. During the last several years, some ceding companies have tended to favor large, financially strong reinsurance companies who are able to provide “mega” line capacity for multiple lines of business. Employers Mutual faces the risk of ceding companies becoming less interested in diversity and spread of reinsurance risk in favor of having fewer, highly-capitalized reinsurance companies on their program.
While reinsurer competition for national and regional company business is growing, the Company believes that MRB has a competitive advantage in the smaller mutual company market that it serves. This segment of the market is not targeted by the London and Bermuda markets, which tend to deal with larger insurers at higher margins. MRB understands the needs of the smaller company market and operates at a very low expense ratio, enabling it to offer reinsurance coverage (on business that generally presents less risk) to an under-served market at lower margins.
A.M. Best Company Rating
Property and Casualty Insurance
A.M. Best Company (A.M. Best) rates insurance companies based on their relative financial strength and ability to meet their contractual obligations. The most recent A.M. Best Property Casualty Key Rating Guide gives the Company’s property and casualty insurance subsidiaries an “A-” (Excellent) policyholders rating in their capacity as participants in the pooling agreement. A.M. Best re-evaluates its ratings from time to time (normally on an annual basis) and there can be no assurance that the Company’s property and casualty insurance subsidiaries and the other pool participants will maintain their current rating in the future. Management believes that an A.M. Best rating of “A-” (Excellent) or better is important to the Company’s business since many insureds require that companies with which they insure be so rated. A.M. Best’s publications indicate that these ratings are assigned to companies that have achieved excellent overall performance and have a strong ability to meet their obligations over a long period of time. A.M. Best’s ratings are based upon factors of concern to policyholders and insurance agents, and are not directed toward the protection of investors.
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Reinsurance
The most recent A.M. Best Property Casualty Key Rating Guide gives the Company’s reinsurance subsidiary an “A-” (Excellent) policyholders’ rating. However, because all of the reinsurance business assumed by the reinsurance subsidiary is produced by Employers Mutual, the rating of the reinsurance subsidiary is not critical to the Company’s reinsurance operations. The rating of Employers Mutual is, however, critical to the Company’s reinsurance operations, as the unaffiliated insurance companies that cede business to Employers Mutual view the rating as an indication of Employers Mutual’s ability to meet its obligations to those insurance companies. Employers Mutual’s rating of “A-” (Excellent) has resulted in the loss of some reinsurance business because some insurance companies require a rating of “A” (Excellent) or higher. A downgrade of Employers Mutual’s rating would have a material adverse impact on the Company’s reinsurance subsidiary, as a downgrade would negatively impact Employers Mutual’s ability to assume reinsurance business and, consequently, to cede that business to the Company’s reinsurance subsidiary.
Statutory Combined Trade Ratios
The following table sets forth the statutory combined trade ratios of the Company’s insurance subsidiaries and the property and casualty insurance industry averages for the five years ended December 31, 2006. The combined trade ratios below are the sum of the following: the loss ratio, calculated by dividing losses and settlement expenses incurred by net premiums earned, and the expense ratio, calculated by dividing underwriting expenses incurred by net premiums written and policyholder dividends by net premiums earned. Generally, if the combined trade ratio is below 100 percent, a company has an underwriting profit; if it is above 100 percent, a company has an underwriting loss.
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(1) The 2005 expense ratio and combined trade ratio for “property and casualty insurance” and “total insurance operations” are distorted by $29,631,000 of additional premiums written and $6,519,000 of commission expense that were recorded in connection with the change in the property and casualty insurance segment’s aggregate pool participation. Excluding these adjustments, the expense ratios would have been 34.4 percent and 32.9 percent, respectively, and the combined trade ratios would have been 96.5 percent and 95.3 percent, respectively.
(2) The 2006 loss ratio, expense ratio, and combined trade ratio for “reinsurance” and “total insurance operations” reflect the revised terms of the quota share agreement. The previous terms of the quota share agreement provided for a 4.5 percent override commission expense payment to Employers Mutual as compensation for the cap on losses assumed per event. Effective January 1, 2006, the reinsurance subsidiary no longer pays this override commission, and instead pays a 10.5 percent premium charge. For comparison purposes, had the revised terms of the quota share agreement been in place in 2005, the loss ratio, expense ratio, and combined trade ratio would have been 68.6 percent, 24.7 percent, and 93.3 percent, respectively for “reinsurance”, and 63.5 percent, 31.7 percent, and 95.2 percent, respectively for “total insurance operations”.
(3) As reported by A.M. Best Company. The ratio for 2006 is an estimate; the actual combined ratio is not currently available.
Claims Management
The Company believes that effective claims management is critical to its success. To this end, the Company has adopted a customer-focused claims management process that it believes is cost efficient, delivers the appropriate claims service and produces superior claims results. The Company’s claims management process is focused on controlling claims from their inception, accelerating communication to insureds and claimants and compressing the cycle time of claims to control both loss costs and claims-handling costs. The Company believes its process provides quality service and results in the appropriate handling of claims, allowing it to cost-effectively pay valid claims and contest fraudulent claims.
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The Company’s claims management operation includes adjusters, appraisers, special investigators, attorneys and claims administrative personnel. The Company conducts its claims management operations out of its 16 branch offices and five service offices located throughout the United States. The home office claims group provides advice and counsel for branch claims staff in investigating, reserving and settling claims. The home office claims staff also evaluates branch claims operations and makes recommendations for improvements in performance. Additional home office services provided include: complex claim handling, physical damage and property review, medical case management, medical bill review, legal coverage analysis, litigation management and subrogation. The Company believes these home office services assist the branch claims personnel in producing greater efficiencies than can be achieved at the local level.
Each branch office is responsible for evaluating and settling claims within the authority provided by home office claims. Authority levels within the branch offices are granted based upon an adjuster’s experience and expertise. The branch office must request input from home office claims once a case exceeds its authority. A claims committee exists within home office and is chaired by the Senior Vice President of Claims. This committee meets on a weekly basis to assist the branches in evaluating and settling claims beyond their authority.
The Company will allow claims to go to litigation in matters such as value disputes and questionable liability, and will defend appropriate denials of coverage. The Company generally retains outside defense counsel to litigate such matters. The Company’s claims professionals manage the litigation process, rather than ceding control to an attorney. The Company has implemented a litigation management system that provides data that allows the claims staff to evaluate the quality and cost effectiveness of legal services provided. Cases are constantly reviewed to adjust the litigation plan if necessary, and all cases going to trial are carefully reviewed to assess the value of trial or settlement.
Loss and Settlement Expense Reserves
Liabilities for losses and settlement expenses are estimates at a given point in time of what an insurer expects to pay to claimants and the cost of settling claims, based on facts and circumstances then known. It can be expected that the insurer’s ultimate liability for losses and settlement expenses may either exceed or be less than such estimates. The Company’s estimates of the liabilities for losses and settlement expenses are based on estimates of future trends and claims severity, judicial theories of liability and other factors. However, during the loss adjustment period, which may cover many years in some cases, the Company may learn additional facts regarding individual claims, and consequently it often becomes necessary to refine and adjust its estimates of the liability. The Company reflects any adjustments to its liabilities for losses and settlement expenses in its operating results in the period in which the changes in estimates are made.
The Company maintains reserves for losses and settlement expenses with respect to both reported and unreported claims. The amount of reserves for reported claims is primarily based upon a case-by-case evaluation of the specific type of claim, knowledge of the circumstances surrounding each claim and the policy provisions relating to the type of loss. Reserves on assumed reinsurance business are the amounts reported by the ceding companies.
The amount of reserves for unreported claims is determined on the basis of statistical information for each line of insurance with respect to the probable number and nature of claims arising from occurrences that have not yet been reported. Established reserves are closely monitored and are frequently recomputed using a variety of formulas and statistical techniques for analyzing actual claim costs, frequency data and other economic and social factors.
Settlement expense reserves are intended to cover the ultimate cost of investigating claims and defending lawsuits arising from claims. These reserves are established each year based on previous years’ experience to project the ultimate cost of settlement expenses. To the extent that adjustments are required to be made in the amount of loss reserves each year, settlement expense reserves are correspondingly revised, if necessary.
The Company’s actuaries conduct quarterly reviews of the direct loss and settlement expense reserves. In addition, they specifically analyze direct case loss reserves on a quarterly basis and direct incurred but not reported (“IBNR”) loss reserves on an annual basis. Based on the results of these regularly-scheduled evaluations, the Company’s actuaries make recommendations regarding adjustments to direct reserve levels, if deemed appropriate.
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The Company does not discount reserves. Inflation is implicitly provided for in the reserving function through analysis of cost trends, reviews of historical reserving results and projections of future economic conditions. Large ($100,000 and over) incurred and reported gross reserves are reviewed regularly for adequacy. In addition, long-term and lifetime medical claims are periodically reviewed for cost trends and the applicable reserves are appropriately revised, if necessary.
Despite the inherent uncertainties of estimating loss and settlement expense reserves, the Company believes that its reserves are being calculated in accordance with sound actuarial practices and, based upon current information, that its reserves for losses and settlement expenses at December 31, 2006 are adequate.
The following table sets forth a reconciliation of beginning and ending reserves for losses and settlement expenses of the property and casualty insurance subsidiaries and the reinsurance subsidiary. 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.
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During the years ended December 31, 2006 and 2005, the Company experienced favorable development in the provision for insured events of prior years, compared to adverse development during the year ended December 31, 2004. The majority of the adverse development experienced in 2004 came from the property and casualty insurance segment and occurred in the workers’ compensation and other liability lines of business. Following are the significant issues and trends that were identified as contributors to this adverse development.
Workers’ compensation claim severity increased significantly, with the projected ultimate average claim amount increasing approximately 72 percent over the five year period ending in 2004. An increase of this magnitude made the establishment of adequate case loss reserves challenging. A review of claims data indicated that claims adjusters had underestimated medical costs and the length of time injured workers were away from work. In addition, partial disability benefits had been underestimated or unanticipated. Large increases in drug costs and the availability and utilization of new and costly medical procedures contributed to the rapidly escalating medical costs.
Construction defect claims arising from general liability policies issued to contractors contributed to the adverse reserve development. States with significant construction defect losses included Alabama, Arizona, California, Colorado, Nevada and Texas.
Large umbrella claims contributed to the adverse development experienced in the other liability line of business. Also contributing to overall umbrella reserve development was an increase in claims arising from underlying general liability policies.
Legal expenses for the other liability line of business increased rapidly over the three year period ending in 2004, with defense costs increasing at an average rate of approximately 14 percent per year. This increase in legal expenses occurred despite a reduction in the number of new lawsuits.
In response to an indicated deficiency in case reserves at December 31, 2003, the home office claims department in early 2004 instructed each of the 16 branch offices to review and carefully re-evaluate all claim reserves for adequacy. As a result of these reviews, case loss reserves were strengthened in both the second and third quarters of 2004. However, during the required fourth quarter inventory and review process, the branch offices further strengthened their case loss reserves, generating a significant amount of adverse development on prior years’ reserves.
Following is a detailed analysis of the reserve development the Company has experienced during the past three years.
Year ended December 31, 2006
Property and casualty insurance segment
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 $32,255,000 from the estimate at December 31, 2005. This decrease represents approximately 7.9 percent of the December 31, 2005 carried reserves and is attributed primarily to favorable development on case loss reserves of previously reported claims. No changes were made in the key actuarial assumptions utilized to estimate loss and settlement expense reserves during 2006.
Reserves on previously reported claims developed favorably in 2006 by approximately $28,187,000. Favorable case loss reserve development occurred in all major lines of business: workers’ compensation ($11,366,000), other liability ($8,503,000), commercial property ($2,369,000), personal auto liability ($1,436,000), homeowners ($1,412,000), auto physical damage ($1,304,000), bonds ($1,248,000), and commercial auto liability ($549,000). For all lines combined, the latest three prior accident years were responsible for over 80 percent of the total favorable development, and the latest five prior accident years contributed over 95 percent. In aggregate, all of the favorable development is attributable to claims that closed during 2006.
During 2006, direct IBNR loss reserves other than asbestos were strengthened $1,800,000, of which approximately $970,000 was allocated to prior accident years. This reserving action resulted from standard actuarial reserve reviews and reflects somewhat higher ratios of IBNR emergence to premiums earned for several lines of business. In addition, asbestos IBNR loss reserves were strengthened $170,000, reflecting the results of an outside consultant’s analysis of the Company’s asbestos liabilities.
16
The emergence of IBNR claims was lower than the change in prior year IBNR loss reserves, resulting in approximately $5,195,000 of favorable development in 2006. This favorable development arose from five lines of business: other liability ($2,755,000), commercial auto liability ($2,018,000), homeowners ($1,401,000), auto physical damage ($859,000), and commercial property ($102,000). Partially offsetting this favorable development was adverse development totaling ($1,940,000) on the remaining lines of business. For all lines combined, the favorable development of prior year IBNR loss reserves is attributable to accident year 2005.
During 2006, underlying exposure increases resulted in premium increases in certain lines of business, most notably in the other liability line. Since formula IBNR loss reserves are calculated through the application of IBNR factors to premiums earned, these exposure increases resulted in an increase of $1,554,000 in prior accident year IBNR loss reserves.
Total settlement expense reserves developed downward in 2006 by $3,915,000. Approximately 57 percent of the downward development is related to internal claims department, independent adjuster, and miscellaneous settlement expenses. Settlement expense payments in these categories during 2006 were lower than anticipated in the payment patterns used in the accident year allocation of settlement expense reserves at December 31, 2005. This downward development occurred primarily in the workers’ compensation, other liability, and commercial auto liability lines of business.
The defense and cost containment portion of prior year settlement expense reserves developed downward in 2006 by $1,690,000. The favorable development resulted from expense payments in 2006 that were $3,681,000 lower than anticipated in the 2005 year-end reserve levels. The other liability line of business accounts for approximately 80 percent of this downward development. During 2006, the settlement expense formula case loss reserve for involuntary auto business was eliminated, resulting in $206,000 of additional downward development. Partially offsetting this favorable development was $511,000 of strengthening in asbestos settlement expense reserves, which resulted from an outside consultant’s analysis of the Company’s asbestos liabilities. Settlement expense reserves other than asbestos were strengthened $1,800,000, of which approximately $1,183,000 was allocated to prior accident years. About 80 percent of this prior year strengthening occurred in the other liability and workers’ compensation lines of business. This reserving action resulted from standard actuarial reserve reviews, which indicated generally higher ultimate expense to loss ratios in these lines of business. In addition, settlement expense reserves for prior years increased approximately $421,000 due to the exposure increases mentioned above in the discussion of IBNR loss reserves.
The above results reflect reserve development on a direct and assumed basis. During 2006, ceded losses for prior accident years decreased $2,378,000, which is attributable to a reduction in prior year losses ceded to workers’ compensation assigned risk pools. The impact of the decrease in reinsurance recoverables was to reduce the favorable development on the direct and assumed business described above.
Reinsurance segment
For the reinsurance segment, the December 31, 2006 estimate of loss and settlement expense reserves for accident years 2005 and prior decreased $9,661,000 from the estimate at December 31, 2005. This represents 7.2 percent of the December 31, 2005 carried reserves and is attributable primarily to the HORAD book of business, which developed downward by $7,896,000. Approximately 95 percent of the HORAD favorable development arose from accident years 2004 and 2005. Much of this development can be attributed to reported policy year 2004 and 2005 losses for property, casualty, ocean marine, and multi-line classes that were below December 31, 2005 implicit projections.
MRB reserves developed favorably by $1,765,000, which is less than 20 percent of the total favorable development in the reinsurance segment. This development is attributable to accident years 2004 and 2005, which experienced $2,037,000 of favorable development. During 2006, system changes were implemented to split reported settlement expense reserves from reported loss reserves. Simultaneously, the Company eliminated the formula case loss reserve for settlement expenses that had been carried in previous years. This action accounts for approximately two-thirds of the total MRB favorable development.
For the HORAD and MRB books of business combined, the property excess and casualty excess classes account for about 90 percent of the total favorable development.
No changes were made in the key actuarial assumptions utilized to estimate loss and settlement expense reserves during 2006.
17
Year ended December 31, 2005
Property and casualty insurance segment
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 $14,808,000 from the estimate at December 31, 2004. This decrease represents approximately 5 percent of the December 31, 2004 carried reserves and is primarily attributed to downward development of individual case loss reserves of previously reported claims, downward development of settlement expense reserves and the elimination of a workers’ compensation bulk case reserve. No changes were made in the key actuarial assumptions utilized to estimate loss and settlement expense reserves during 2005.
Reserves on previously reported claims developed downward in 2005 by approximately $6,539,000. Favorable case reserve development occurred in most lines of business as follows: other liability ($6,180,000), commercial property ($3,165,000), personal auto liability ($1,621,000), homeowners ($1,316,000), auto physical damage ($1,162,000), and bonds ($428,000). Partially offsetting these reductions was adverse development in two lines of business: workers’ compensation ($5,049,000) and commercial auto liability ($2,284,000). About one-fourth of the workers' compensation adverse development was from assigned risk claims, which are ceded 100 percent to an involuntary pool. For all lines combined, the latest three accident years were responsible for about 90 percent of the total favorable development.
During 2005, direct IBNR loss reserves, excluding asbestos and environmental-related exposures, were strengthened $6,403,000, of which approximately $3,510,000 was allocated to prior accident years. Over 85 percent of the prior year strengthening was in the other liability line of business. In addition, asbestos IBNR loss reserves were strengthened $600,000. Both of these reserving actions resulted from standard actuarial reviews.
The emergence of IBNR claims in excess of the change in prior year IBNR loss reserves resulted in approximately $1,318,000 of adverse development in 2005. This adverse development arose from two lines of business: personal auto ($2,435,000), with nearly all of the development attributable to a large Michigan no-fault claim, which is ceded 100 percent to the Michigan Catastrophic Claims Association, and workers’ compensation ($2,336,000), about half of which is attributable to a re-allocation of IBNR loss reserves by accident year as a result of the 2005 actuarial analysis. IBNR loss reserves for the other liability line of business developed downward by $1,239,000 despite a $2,906,000 increase in prior accident year IBNR loss reserves that resulted from a re-allocation of IBNR loss reserves by accident year.
Settlement expense reserves developed downward in 2005 by $3,815,000. About 70 percent of this favorable development can be attributed to three lines of business: workers’ compensation ($1,571,000), other liability ($653,000), and commercial auto liability ($459,000). Approximately one-third of the total decline is due to a reduction in the reserve for internal settlement expenses, a decrease that was indicated by the standard methodology used to establish this reserve. The remainder can be attributed primarily to settlement expense payments during 2005 that were lower than those anticipated in the payment patterns used at December 31, 2004 to allocate settlement expense reserves by accident year. This decline more than offset an approximate $561,000 increase in prior year internal expenses for contingent salaries, bonuses and retirement plans.
There were relatively offsetting effects in the defense and cost containment portions of prior year settlement expense reserves. Settlement expense reserves were strengthened $600,000 for asbestos exposures and $900,000 for the other liability line of business, excluding asbestos, of which approximately $631,000 was allocated to prior accident years. These reserving actions resulted from standard actuarial reviews. Because the Company establishes settlement expense reserves as a percentage of loss reserves, IBNR strengthening associated with increases in premium rate levels produced a $470,000 increase in prior year settlement expense reserves. The takedown of a workers’ compensation bulk case reserve, the re-allocation of IBNR loss reserves by accident year, and a strengthening of IBNR loss reserves in the other liability line of business resulted in net adverse development of approximately $1,329,000 in prior year settlement expense reserves. This increase in the defense portion of the prior year settlement expense reserve was more than offset by a reduction in the legal and cost containment portion of the reserve that resulted from a reduction in prior accident year case and IBNR loss reserves. Overall, the defense and cost containment portion of the total prior year settlement expense reserve generated a modest $455,000 of favorable development.
18
During 2005, the involuntary workers’ compensation and auto assigned risk business experienced adverse development of $688,000. Losses and settlement expenses for these mandatory pools are booked as reported to the Company, with the exception of a current accident year IBNR loss reserve provision to cover a one-quarter reporting lag.
At January 1, 2005, the Company carried a bulk case reserve in the amount of $7,950,000 in the workers’ compensation line of business. Due to indications of a potential shortage in IBNR loss reserves in the other liability line of business, one-half of this bulk case reserve was re-allocated to other liability IBNR loss reserves at March 31, 2005, with no effect on underwriting results. Actuarial reviews performed during the remainder of 2005 indicated that the estimated adequacy of individual workers’ compensation case loss reserves and total case loss reserves remained fairly constant with the levels perceived at December 31, 2004. As a result, a portion of the remaining bulk case reserve was re-allocated to various components of the loss and settlement expense reserve for the other liability line of business (IBNR, asbestos and settlement expense) at December 31, 2005 and the remainder was eliminated. These actions resulted in the recognition of $2,145,000 of favorable development on prior years’ reserves during the fourth quarter of 2005. For the twelve months of 2005, the elimination of workers’ compensation bulk case reserve resulted in $7,950,000 of favorable development in the workers’ compensation line of business.
The above results reflect reserve development on a direct and assumed basis. During 2005, ceded losses for prior accident years increased $2,853,000. This includes increases of $2,855,000 and $1,719,000 in the workers’ compensation and personal auto lines of business due to an increase in losses ceded to mandatory pools and a decline of $2,159,000 in the other liability line of business. The impact of the increase in reinsurance recoverables was to enhance the favorable development experienced on the direct and assumed business described above.
Reinsurance segment
For the reinsurance segment, the December 31, 2005 estimate of loss and settlement expense reserves for accident years 2004 and prior decreased $600,000 from the estimate at December 31, 2004. This modest decrease represents less than 1 percent of the December 31, 2004 carried reserves and is attributable to the HORAD book of business, which developed downward by $2,291,000. Accident years 2002 and 2003 developed downward $3,766,000. Much of this favorable development can be attributed to reported policy year 2002 and 2003 losses for property, casualty, ocean marine, and multi-line classes that were below December 31, 2004 implicit projections. Accident year 2004 developed upward $2,057,000, while most accident years prior to 2002 developed modestly downward, offsetting about 30 percent of the accident year 2004 adverse development. The accident year 2004 development arose primarily from ocean marine and casualty excess classes.
MRB reserves developed adversely in 2005 by $1,691,000. Approximately 85 percent of this development arose from accident years 2001 – 2004. The classes showing the most significant adverse development were casualty excess and property excess. The management of MRB only reduced prior accident year casualty excess IBNR loss reserves by two-thirds of the prior accident year losses reported during the year, generating adverse development in that class of business. Most of the property excess development can be attributed to 2004 hurricane claims.
No changes were made in the key actuarial assumptions utilized to estimate loss and settlement expense reserves during 2005.
Year ended December 31, 2004
Property and casualty insurance segment
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 $23,750,000 from the estimate at December 31, 2003. This increase represents 10 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, development on case loss reserves of previously reported claims, bulk reserve strengthening and settlement expense reserve increases resulting from increases in case loss reserves. No changes were made in the key actuarial assumptions utilized to estimate loss and settlement expense reserves during 2004.
19
During 2004, case loss reserves increased $39,644,000. Actuarial analysis indicates that this increase represents substantial case loss reserve strengthening. Although figures for the first quarter are not available, the Company estimates that from the end of the first quarter through year-end 2004, case loss reserves were strengthened $20,904,000. This reserving action is an important underlying reason for the adverse reserve development that occurred during 2004, which is discussed in detail below.
Because the Company establishes settlement expense reserves as a percentage of case loss reserves, the increase in case loss reserves resulted in a $8,731,000 increase in settlement expense reserves, approximately $3,122,000 of which can be attributed to case loss reserve strengthening. The case loss reserve increase resulted in an estimated $6,209,000 of settlement expense adverse development.
The emergence of IBNR claims in excess of carried IBNR loss reserves resulted in approximately $14,758,000 of adverse development in 2004. The most significant development occurred in the other liability ($7,812,000), personal auto liability ($5,991,000), commercial auto liability ($1,871,000), and workers’ compensation ($1,634,000) lines of business. The other liability development can be attributed to an unusual number of umbrella claims and to construction defect claims. More than 80 percent of the other liability development came from accident years 1999 - 2003, which are the years with the vast majority of umbrella IBNR claims. For personal auto, nearly all of the development resulted from a change in the recording of large Michigan no-fault claims; however, the additional reserves are ceded 100 percent to the Michigan Catastrophic Claims Association. For commercial auto, the upward development arose mainly from accident years 2000 - 2003. Approximately 70 percent of the workers’ compensation development is from accident years 1999 - 2003. For all other lines combined, IBNR loss reserves developed downward ($2,550,000), with variations by line of business ranging from downward development of $1,139,000 for commercial property to upward development of $85,000 for bonds.
Reserves on previously reported claims also developed upward in 2004 by approximately $11,037,000. Adverse case loss reserve development occurred primarily in the workers’ compensation line of business ($12,265,000), with a smaller amount of adverse development occurring in the commercial auto liability ($1,987,000) and other liability ($1,212,000) lines. Partially offsetting these three lines was favorable development in the remaining lines, most notably property ($1,853,000), auto physical damage ($1,041,000) and homeowners ($905,000). About two-thirds of the workers’ compensation adverse development came from the latest three accident years. For all lines combined, the latest three accident years were responsible for about 80 percent of the total adverse development.
For workers’ compensation, the adverse development on previously reported claims is tempered by a reduction of $2,609,000 in the bulk case reserve allocated to accident years 2003 and prior. With this adjustment, the workers’ compensation adverse case loss reserve development was $9,656,000.
The Company also strengthened IBNR loss reserves in 2004 in response to the results of a regularly-scheduled actuarial analysis, which indicated a higher ratio of IBNR emergence in relation to premiums earned than the 2003 review. The portion of IBNR loss reserve strengthening allocated to prior accident years totaled $1,521,000. The largest indicated increase in IBNR loss reserves was in the other liability line of business, where strengthening totaled $1,391,000.
As previously noted, case loss reserves for the property and casualty insurance segment developed upward during 2004, which represented a significant change from the historical development pattern prior to 2003. To supplement the individual case loss reserves, the Company increased the bulk case reserve for the workers’ compensation line of business, which was primarily responsible for the adverse development. The portion of the bulk reserve increase allocated to prior accident years was $703,000. The increase in the bulk reserve was in response to quarterly actuarial reviews of case loss reserves. These reviews were initiated in 2003 and the methodology was refined in 2004. The methodology projects paid losses to an ultimate level, with the data limited to claims reported as of the evaluation date.
Settlement expense reserves were strengthened during 2004 in response to actuarial analyses completed in 2004. These reviews indicated generally higher ultimate expense to loss ratios for the other liability line of business, along with higher estimates of ultimate losses than projected during 2003. Accordingly, settlement expense reserves were strengthened, with $2,735,000 of the increase allocated to prior accident years.
20
The above results reflect reserve development on a direct basis. During 2004, ceded losses for prior accident years increased $10,437,000. Approximately three-fourths of the increase was in the workers’ compensation and personal auto lines of business, primarily as a result of increases in prior year losses ceded to workers’ compensation assigned risk pools and the Michigan Catastrophic Claims Association. The impact of the increase in reinsurance recoverables was to offset a portion of the adverse development on direct business described above.
Reinsurance segment
For the reinsurance segment, the December 31, 2004 estimate of loss and settlement expense reserves for accident years 2003 and prior decreased $3,602,000 from the estimate at December 31, 2003. This decrease represents 3.1 percent of the December 31, 2003 carried reserves and is attributable to the 2003 accident year in the HORAD book of business, which developed downward by $3,674,000. This favorable development can be attributed to reported policy year 2003 losses for property, casualty and multi-line classes that were approximately $5,264,000 below 2003 implicit projections. HORAD accident years 2002 and prior developed upward approximately $1,619,000. This development arose from accident years 1998 - 2002, primarily in multi-line excess, property pro rata and marine lines of business. Most accident years prior to 1998 developed modestly downward.
No changes were made in the key actuarial assumptions utilized to estimate loss and settlement expense reserves during 2004.
The following table shows the calendar year development of the loss and settlement expense reserves of the property and casualty insurance subsidiaries and the reinsurance subsidiary. Amounts presented are on a net basis with (i) a reconciliation of the net loss and settlement expense reserves to the gross amounts presented in the consolidated financial statements and (ii) disclosure of the gross re-estimated loss and settlement expense reserves and the related re-estimated reinsurance receivables.
Reflected in this table is the increase in the reinsurance subsidiary’s quota share assumption of Employers Mutual’s assumed reinsurance business from 95 percent to 100 percent in 1997. The table has been restated to reflect the addition of Hamilton Mutual Insurance Company to the pooling agreement effective January 1, 1997, the addition of Farm and City Insurance Company to the pooling agreement effective January 1, 1998, and the increase in the property and casualty insurance subsidiaries’ aggregate participation in the pooling agreement to 30.0 percent effective January 1, 2005.
In evaluating the table, it should be noted that each cumulative redundancy (deficiency) amount includes the effects of all changes in reserves for prior periods. Conditions and trends that have affected development of the liability in the past, such as a time lag in the reporting of assumed reinsurance business, the high rate of inflation associated with medical services and supplies and the reform measures implemented by several states to control administrative costs for workers’ compensation insurance, may not necessarily occur in the future. Accordingly, it may not be appropriate to project future development of reserves based on this table.
21
22
Asbestos and Environmental 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. With regard to the assumed reinsurance business, however, all asbestos and environmental exposures related to 1980 and prior accident years are retained by Employers Mutual.
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 the claim history and trends within the Company and the industry.
During 2006, the Company elected to strengthen direct asbestos IBNR loss and settlement expense reserves to the middle scenario of an independent actuarial review conducted during the year. As a result, asbestos IBNR loss and settlement expense reserves were increased by $170,000 and $511,000, respectively. During 2005, the Company elected to strengthen direct asbestos reserves in consideration of the implied three-year survival ratio (ratio of loss reserves to the three-year average of loss payments). As a result, asbestos IBNR loss and settlement expense reserves were each increased by $600,000.
The following table presents asbestos and environmental-related losses and settlement expenses incurred and reserves outstanding for the Company:
23
Based upon current facts, management believes the reserves established for asbestos and environmental-related claims at December 31, 2006 are adequate. Although future changes in the legal and political environment may result in adjustment to these reserves, management believes any adjustment will not have a material impact on the financial condition or results of operations of the Company.
Reinsurance Ceded
The following table presents amounts due to the Company from reinsurers for losses and settlement expenses and prepaid reinsurance premiums as of December 31, 2006:
24
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.
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