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EMC Insurance Group 10-K 2010 UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
For the Fiscal Year Ended December 31, 2009
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
The aggregate market value of the voting stock held by non-affiliates of the registrant as of June 30, 2009 was $112,174,890.
The number of shares outstanding of the registrant’s common stock, $1.00 par value, on February 26, 2010, was 13,128,557.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the registrant’s definitive proxy statement for the Annual Meeting of Stockholders to be held on May 25, 2010, and to be filed pursuant to Regulation 14A within 120 days after the registrant’s fiscal year ended December 31, 2009, are incorporated by reference under Part III.
TABLE OF CONTENTS
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 60 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.
The Company conducts its insurance business through two business segments as follows:
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. 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 80 percent of consolidated premiums earned in 2009. 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 reinsurance pooling agreement, 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 reinsurance pooling agreement and its benefits, please see “Organizational Structure – Property and Casualty Insurance” below.
Reinsurance operations are conducted through EMC Reinsurance Company, and represented approximately 20 percent of consolidated premiums earned in 2009. The principal business activity of EMC Reinsurance Company is to assume, through a quota share reinsurance agreement, the voluntary reinsurance business written directly by Employers Mutual with unaffiliated insurance companies (subject to certain limited exceptions). Effective January 1, 2009, EMC Reinsurance Company began writing German assumed reinsurance business on a direct basis as a result of regulatory changes in Germany. For a discussion of the quota share reinsurance agreement and its benefits, please see “Organizational Structure – Reinsurance” below.
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 three 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. The aggregate participation of the Company’s property and casualty insurance subsidiaries is 30 percent.
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 computation 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 of the companies. The particular benefits that the Company’s property and casualty insurance subsidiaries realize from participating in the pooling agreement include the following:
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 $25,000,000 of surplus notes to Employers Mutual. 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 is a party to a quota share reinsurance retrocessional agreement with Employers Mutual (the “quota share agreement”). Under the terms of the quota share agreement, the 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. The cost of the $2,000,000 cap on losses assumed per event, which is treated as a reduction to premiums written, is 10.5 percent. 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 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. 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. 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.
As a result of regulatory changes in Germany, Employers Mutual ceased being an approved reinsurer in Germany effective January 1, 2009. To avoid the loss of this assumed reinsurance business, the Company’s reinsurance subsidiary began writing this business on a direct basis (outside the quota share agreement) effective January 1, 2009. Since this business is written outside the quota share agreement, it is not subject to the $2,000,000 cap on losses per event. Management has determined that this business has a low risk of generating losses above $2,000,000 per event and has therefore elected to not purchase stand-alone reinsurance coverage for these risks. Premium income from this business amounted to $3,695,000 in 2009.
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 even exceed, the amount of losses retained.
Effective January 1, 2010, the terms of the quota share agreement were revised to increase the retention, or cap, on losses assumed per event from $2,000,000 to $3,000,000. The cost for this protection (10.5 percent of premiums written) remains unchanged.
Property and Casualty Insurance and Reinsurance
The Company does not have any employees of its own. Employers Mutual performs all operations for all of its subsidiaries and affiliates. Such services include data processing, claims, financial, actuarial, legal, auditing, marketing and underwriting. Employers Mutual allocates a portion of the cost of these services to its subsidiaries that do not participate in the pooling agreement based upon a number of criteria, including usage of the services and the 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.
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 Part II, 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
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, 2009, by line of business.
(1) The amount for 2009 is somewhat distorted by a change from six month policies to annual policies.
Reinsurance
As previously noted, the reinsurance subsidiary primarily 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.
The following table sets forth the assumed premiums written of the reinsurance subsidiary for the three years ended December 31, 2009, by line of business.
Marketing and Distribution
Property and Casualty Insurance
The pool participants market a wide variety of commercial and personal lines insurance products through 16 full service branch offices, which actively write business in 41 states. The pool participants’ products are marketed exclusively through a network of over 2,140 local independent agents serviced by the branch offices. The pool participants primarily focus 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 pool participants also seek 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 approximately $1.1 billion in direct premiums in 2009, with 85 percent of this business coming from commercial lines products and 15 percent coming from personal lines products. Although a majority of the pool participants’ business is generated by sales in the Midwest, Employers Mutual’s branch 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 pool participants 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 pool participants to develop close relationships with the agents and customers with whom they do business.
Although each branch office offers a slightly different combination of products, the branches generally target three customer segments:
The pool participants write a number of target market and safety dividend group programs throughout the country, and have 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, 2009.
* Includes all other jurisdictions, none of which accounted for more than 3 percent.
During 2009 Employers Mutual began informing its independent agents that EMC Insurance Companies had submitted plans to regulatory authorities in the states of Georgia, Louisiana, Michigan, Mississippi, North Carolina, Pennsylvania and Virginia seeking to withdraw from personal lines programs in those states. This action was taken due to management’s conclusion, based on a number of factors, that these states offered only limited long-term growth and profit potential. Additionally, personal lines business did not represent a large part of the marketing plans of the local branch offices affected. The combination of these factors resulted in a disproportionately high cost of conducting personal lines business in these states.
The planned exit from personal lines business in these seven states should in no way be construed as a diminished emphasis on personal lines business. Rather, this action was taken so that the EMC Insurance Companies’ resources could be directed toward territories which offer the greatest potential for long-term growth and profitability.
Reinsurance
The reinsurance subsidiary currently obtains 95 percent of its business from Employers Mutual through the quota share agreement and writes 5 percent directly. 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.
Employers Mutual’s reinsurance business is derived from two sources. Approximately 81 percent of Employers Mutual’s assumed reinsurance premiums earned in 2009 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 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 19 percent of Employers Mutual’s assumed reinsurance premiums earned in 2009 were generated through participation in the MRB pool, an unincorporated association through which Employers Mutual and four 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 the MRB pool since 1957. 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.
Over the past 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 $14,111,000 in 2009. During 2009, Employers Mutual retained 10.5 percent of the net assumed premiums written subject to cession to the reinsurance subsidiary as compensation for the $2,000,000 cap on losses assumed per event, which amounted to $8,471,000. The reinsurance subsidiary also 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, as well as the German business written directly. The net foreign currency exchange gain assumed by the reinsurance subsidiary in 2009 was $29,000.
Competition
Property and Casualty Insurance
The property and casualty insurance business is very competitive. The 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 pool participants 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 pool participants’ insurance products are marketed exclusively through independent agencies, they face 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. Some ceding companies have tended to favor large, highly-capitalized 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 Ratings
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) financial strength 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 the “A-“ (Excellent) rating is 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.
Reinsurance
The most recent A.M. Best Property Casualty Key Rating Guide gives the Company’s reinsurance subsidiary an “A-” (Excellent) financial strength rating. However, because the majority 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 write 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, 2009. 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.
(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 increase in the property and casualty insurance segment’s aggregate pool participation from 23.5 percent to 30.0 percent. 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 2005 loss ratio, expense ratio, and combined trade ratio for “reinsurance” and “total insurance operations” reflect the previous terms of the quota share agreement, which 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. In addition, the 2006 expense ratio and combined trade ratio for “reinsurance” are distorted by $3,440,000 of negative premiums written and $1,343,000 of commission income that were recorded in connection with the change in Employers Mutual’s participation in the MRB pool. Excluding these adjustments, the expense ratio and combined trade ratio for “reinsurance” would have been 24.7 percent and 93.2 percent, respectively. These adjustments were not large enough to impact the expense ratio and the combined trade ratio for “total insurance operations.”
(3) As reported by A.M. Best Company. The ratio for 2009 is an estimate; the actual combined trade ratio is not currently available.
Claims Management
The pool participants believe that effective claims management is critical to their success. To this end, the pool participants have adopted a customer-focused claims management process that is believed to be cost efficient, and able to deliver an appropriate level of claims service that produces superior claims results. The 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 pool participants believe their process provides quality service and results in the appropriate handling of claims, allowing them to cost-effectively pay valid claims and contest fraudulent claims.
The claims management operation includes adjusters, appraisers, special investigators, attorneys and claims administrative personnel. The pool participants conduct their claims management operations out of 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 pool participants believe 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. A branch office must request input from home office claims once a case exceeds its authority level. 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 level.
The pool participants will allow claims to go to litigation in matters such as value disputes and questionable liability, and will defend appropriate denials of coverage. The pool participants generally retain outside defense counsel to litigate such matters; however, internal claims professionals manage the litigation process, rather than ceding control to an attorney. The pool participants have implemented a litigation management system that allows the claims staff to evaluate the quality and cost effectiveness of outside 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, historic loss emergence and other factors. Because of the inherent uncertainties involved in the establishment of reserves for less mature accident years, management’s reserving methodology for the current and more recent accident years utilizes prudently conservative assumptions. During the loss adjustment period, which may cover many years in some cases, the inherent uncertainty associated with these accident years declines as the Company learns additional facts regarding individual claims and potential future claims, and consequently it often becomes necessary to refine and adjust its estimates of 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, known as “case reserves”, 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. Case reserves on assumed reinsurance business are the amounts reported by the ceding companies.
The amount of reserves for unreported claims, known as “Incurred But Not Reported (IBNR) reserves”, is determined on the basis of statistical information for each line of insurance with respect to expected loss emergence arising from occurrences that have not yet been reported. Established reserves (for both reported and unreported claims) are closely monitored and are frequently examined using a variety of formulas and statistical techniques for analyzing loss development, as well as 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 quarter based on previous periods’ 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 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. Estimates of individual case loss reserves are monitored and reviewed on a regular basis by claim staff members. Special attention is given to large ($100,000 and over) claims and long-term and lifetime medical claims. Based on currently available information, individual case loss reserves are revised to reflect changes in estimated ultimate settlement values.
Despite the inherent uncertainties of estimating loss and settlement expense reserves, management believes that the Company’s reserves are being calculated in accordance with sound actuarial practices and, based upon current information, that the reserve for losses and settlement expenses at December 31, 2009 represents management’s best estimate of the Company’s overall liability.
Reserving Methodology
Management does not use accident year loss picks to establish the Company’s carried reserves. Case loss and IBNR reserves, as well as settlement expense reserves, are established independently of each other and added together to get the Company’s total loss and settlement expense reserve. The Company’s reserving methodology was expanded during 2007 to include bulk case loss reserves, which supplement the aggregate case loss reserves and are used by management to establish its best estimate of the Company’s liability for reported claims. By establishing bulk reserves independently of the case loss reserves, management believes that it is able to appropriately estimate the Company’s total loss and settlement expense exposures.
Case loss reserves are the individual reserves established for each reported claim based on the specific facts of each claim. Individual case loss reserves are based on the probable, or most likely, outcome for each claim, with probable outcome defined as what is most likely to be awarded if the case were to be decided by a civil court in the applicable venue or, in the case of a workers’ compensation case, by that state’s Workers’ Compensation Commission. Bulk case loss reserves are actuarially derived and are allocated to the various accident years on the basis of the underlying aggregated case loss reserves of the applicable lines of business.
IBNR loss reserves are established by applying actuarially derived “IBNR factors” to the previous twelve months earned premiums. The IBNR factors are determined for each line of business on an annual basis through an actuarial study of historic IBNR emergence relative to on-level premium. The IBNR factors are adjusted on a quarterly basis for rate level changes, and may be further adjusted if the actuarial department recommends that a change in the overall reserve level is warranted. The formula IBNR loss reserve established through this process is for all accident years combined, and is allocated to each preceding accident quarter by applying an allocation factor to the total formula IBNR amount. The accident quarter allocation factors are determined by line of business and are based on a study of the lag in historic claims reporting patterns from occurrence quarter to reported quarter. Other categories of the IBNR loss reserve, which are used to cover exposures associated with asbestos and environmental claims, storms and catastrophic events, are established independently. IBNR loss reserves associated with catastrophe and storm losses are event-specific, and are initially established based on known exposures and estimates of loss frequency and severity. The initial projections are adjusted as actual loss information is reported.
Settlement expense reserves are established by applying actuarially derived “settlement expense factors” to the loss reserves. The settlement expense factors are determined for each line of business on a quarterly basis through an actuarial study of historical ratios of paid expenses to paid losses. The settlement expense reserve established through this process is for all accident years combined, and is allocated to the various accident years proportional to the loss reserves.
Reserve Evaluation and Determination of Management’s Best Estimate of Overall Liability
Prior to the end of each quarter, management utilizes standard loss development methodologies to evaluate the adequacy of the previous quarter’s carried reserves. Management employs the use of paid and incurred accident year triangles, in what is normally referred to as the “chain ladder” method, to perform this evaluation. Management organizes the paid and incurred losses on a “rolling” accident year basis, meaning that at any particular quarter-end, an accident year is defined by the most recent four quarters and will, therefore, cross calendar years except at year-end. Using five different averaging periods to compute loss development factors, five separate point estimates of indicated reserves are developed for each paid and incurred triangle. The high and low point estimates derived from this process establish the actuarial range of reasonable reserves. An additional benchmark, referred to as the actuarial central estimate, is determined by calculating a separate point estimate using “selected paid” and “selected incurred” estimates. This actuarial central estimate is deemed to be an action point in the evaluation of the Company’s carried reserves. If the prior quarter’s total carried reserve falls below this threshold, the actuarial department will recommend that an adjustment be made to the current quarter’s carried reserves.
A separate evaluation of the prior quarter’s case and bulk case loss reserves is also performed each quarter. The evaluation methodology utilized is similar to the total carried reserve review, except that only a paid chain ladder is used, and the triangles include development on reported claims only.
The determination of management’s best estimate of the Company’s overall liability at each quarterly reporting date begins with the actuarial department performing a comparison of the prior quarter’s total carried reserve to the actuarial range of reasonable reserves and actuarial central estimate (as described in the preceding paragraph) for such prior quarter. Generally, if the prior quarter’s carried reserve is within a few percentage points of, but not below, the actuarial central estimate, and if the separate review of the case and bulk case loss reserves indicates that those reserves are within a few percentage points of the case reserve actuarial central estimate, the actuarial department will report that it is comfortable with the current quarter’s carried reserves, and the current quarter’s total carried reserve is deemed to be management’s best estimate of the Company’s overall liability. If the prior quarter’s total carried reserve falls outside of that quarter’s actuarial range of reasonable reserves, or if the review of the previous quarter’s total carried reserve and/or case and bulk case loss reserves indicates that those reserves are not within a few percentage points of their respective actuarial central estimate, the actuarial department will recommend that an adjustment be made to the current quarter’s total carried reserve. Management reviews all recommendations submitted by the actuarial department and considers such recommendations in the determination of its best estimate of overall liability.
Reserve Development
There is an inherent amount of uncertainty involved in the establishment of insurance liabilities. This uncertainty is greatest in the current and more recent accident years because a smaller percentage of the expected ultimate claims have been reported, adjusted and settled compared to more mature accident years. For this reason, carried reserves for these accident years reflect prudently conservative assumptions. As the carried reserves for these accident years run off, the overall expectation is that, more often than not, favorable development will occur. However, there is also the possibility that the ultimate settlement of liabilities associated with these accident years will show adverse development, and such adverse development could be substantial.
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.
Following is a detailed analysis of the development the Company has experienced on its prior accident years’ reserves during the past three years. Care should be exercised when attempting to analyze the financial impact of the reported development amounts because, as noted above, the overall expectation is that, more often than not, favorable development will occur as the prior accident year reserves run off.
Year ended December 31, 2009
Property and casualty insurance segment
For the property and casualty insurance segment, the December 31, 2009 estimate of loss and settlement expense reserves for accident years 2008 and prior decreased $34,641,000 from the estimate at December 31, 2008. This decrease represents approximately 8.1 percent of the December 31, 2008 carried reserves. No changes were made in the key actuarial assumptions utilized to estimate loss and settlement expense reserves during 2009.
Reserves on previously reported claims developed favorably in 2009 by approximately $12,509,000. Favorable development on case and bulk case loss reserves occurred in most major lines of business: commercial property ($5,438,000), other liability ($3,180,000), homeowners ($1,388,000), auto physical damage ($1,286,000), personal auto liability ($1,072,000), bonds ($601,000) and workers’ compensation ($83,000). Partially offsetting this favorable development was adverse development on the commercial auto line of business ($539,000). For all lines combined, the latest five prior accident years were responsible for over 95 percent of the total favorable development. In aggregate, the favorable development on previously reported claims is attributable to decreased severity on claims that closed during 2009.
IBNR loss reserves for prior accident years developed favorably by $12,130,000 as a result of better than expected emergence ($11,066,000), a reduction in the formula IBNR loss reserves based on an experience review ($801,000), and a change in the line of business distribution ($263,000). The emergence of IBNR claims was less than the decrease in prior accident years’ IBNR loss reserves and arose from nearly all major lines of business: other liability ($4,085,000), commercial auto liability ($2,176,000), workers’ compensation ($1,978,000), homeowners ($1,113,000), commercial property ($861,000), auto physical damage ($704,000), and personal auto liability ($467,000). Partially offsetting this favorable development was adverse development on bonds ($318,000). For all lines combined, approximately 99 percent of the favorable development is attributable to accident years 2007 and 2008.
During 2009, an underlying exposure decrease resulted in a premium decrease in the other liability line. Since formula IBNR loss reserves are calculated through the application of IBNR factors to premiums earned, this exposure decrease resulted in a decrease of $286,000 in prior accident year IBNR loss reserves. In addition, reserves for prior accident years’ asbestos claims were increased $810,000 to maintain adequacy targets. The net increase in IBNR loss reserves resulting from these two adjustments generated $524,000 of adverse development.
Total settlement expense reserves developed favorably in 2009 by $9,291,000. Approximately 75 percent of the favorable development is attributed to defense and cost containment expenses. The reserves associated with these expenses were established in bulk and were allocated to the various accident years in proportion to the accident year distribution of the underlying loss reserves. During 2009, the underlying loss reserves experienced favorable development, which generated favorable development in the settlement expense reserves. The remaining 25 percent of favorable development is attributed to adjusting and other expenses (i.e., internal claims department, independent adjuster and miscellaneous settlement expenses). Differences in the allocation factors used to distribute the reserves for these expenses at year-end 2009 compared to year-end 2008 generated $210,000 of favorable development. The majority of the remaining favorable development resulted from settlement expense payments that were lower than anticipated in the payment patterns used in the December 31, 2008 accident year allocations. This favorable development occurred primarily in the other liability, workers’ compensation and commercial auto liability lines of business.
Prior accident years’ reserves for non-voluntary assumed business developed favorably by $70,000, attributable primarily to assigned risk pools.
The above results reflect prior accident year reserve development on a direct and assumed basis. During 2009, ceded losses and settlement expenses for prior accident years increased $820,000. This increase in reinsurance recoveries is recognized as favorable development.
Reinsurance segment
For the reinsurance segment, the December 31, 2009 estimate of loss and settlement expense reserves for accident years 2008 and prior decreased $13,981,000 from the estimate at December 31, 2008. This represents 9.7 percent of the December 31, 2008 carried reserves and is primarily attributable to the HORAD book of business for accident year 2008. Included in this amount is $4,160,000 of favorable development that occurred in the fourth quarter as a result of a reduction in bulk IBNR loss reserves and the winding down of the MAERP Reinsurance Association. Much of the development can be attributed to reported losses that were below December 2008 implicit projections for policy years 2007 through 2008 in the property and casualty classes, and policy year 2008 in the catastrophe and multiline classes.
No changes were made in the key actuarial assumptions utilized to estimate loss and settlement expenses reserves during 2009.
Year ended December 31, 2008
Property and casualty insurance segment
For the property and casualty insurance segment, the December 31, 2008 estimate of loss and settlement expense reserves for accident years 2007 and prior decreased $21,564,000 from the estimate at December 31, 2007. This decrease represented approximately 5.3 percent of the December 31, 2007 carried reserves. No changes were made in the key actuarial assumptions utilized to estimate loss and settlement expense reserves during 2008.
Reserves on previously reported claims developed favorably in 2008 by approximately $2,755,000. Favorable development on case and bulk case loss reserves occurred in most major lines of business: other liability ($3,959,000), commercial property ($2,289,000), auto physical damage ($1,356,000), personal auto liability ($1,220,000), bonds ($1,073,000) and homeowners ($792,000). Partially offsetting this favorable development was adverse development in the workers’ compensation ($1,305,000) and commercial auto ($6,629,000) lines of business. For all lines combined, the latest five prior accident years were responsible for over 68 percent of the total favorable development. In aggregate, the favorable development on previously reported claims was attributable to decreased severity on claims that closed during 2008.
IBNR loss reserves for prior accident years developed favorably by $12,411,000 as a result of better than expected emergence ($11,135,000), a reduction in the formula IBNR reserves based on an experience review ($1,087,000), and a change in the line of business distribution ($189,000). The emergence of IBNR claims was less than the decrease in prior accident years’ IBNR loss reserves and arose from all major lines of business: other liability ($5,782,000), commercial property ($1,491,000), commercial auto liability ($1,238,000), homeowners ($1,045,000), auto physical damage ($848,000), workers’ compensation ($495,000), bonds ($148,000), and personal auto liability ($88,000). For all lines combined, approximately 84 percent of the favorable development was attributable to accident years 2006 and 2007.
During 2008, underlying exposure increases resulted in premium increases in certain lines of business, most notably in the other liability and workers’ compensation lines. Since formula IBNR loss reserves are calculated through the application of IBNR factors to premiums earned, these exposure increases resulted in an increase of $932,000 in prior accident year IBNR loss reserves. In addition, reserves for prior accident years’ asbestos claims were increased $942,000 to maintain adequacy targets. These increases partially offset the favorable case and IBNR loss reserve development described above.
Total settlement expense reserves developed favorably in 2008 by $8,347,000. Approximately 50 percent of the favorable development was related to internal claims department, independent adjuster, and miscellaneous settlement expenses. Current accident year allocation factors compared to those at December 31, 2007 generated $380,000 of favorable development. As further discussed below, the majority of the remaining favorable development resulted from settlement expense payments that were lower than anticipated in the payment patterns used in the December 31, 2007 accident year allocations. This favorable development occurred primarily in the other liability, workers’ compensation and commercial auto liability lines of business.
The defense and cost containment portion of prior accident years’ settlement reserves developed favorably in 2008 by $4,187,000. This favorable development resulted from 2008 expense payments that were $6,402,000 lower than anticipated in the 2007 year-end reserve levels. The other liability line of business accounted for approximately 80 percent of this favorable development. Partially offsetting this favorable development, settlement expense reserves were strengthened $1,800,000, of which $1,147,000 was allocated to prior accident years. This prior accident year strengthening occurred primarily in the other liability, commercial auto and workers’ compensation lines of business, and resulted from standard actuarial reserve reviews. In addition, asbestos defense and cost containment reserves were increased $558,000. Finally, settlement expense reserves for prior accident years increased approximately $331,000 due to the exposure increases mentioned above in the discussion of IBNR loss reserves.
Prior accident year reserves for non-voluntary assumed business developed adversely by $305,000, attributable primarily to assigned risk pools.
The above results reflect prior accident year reserve development on a direct and assumed basis. During 2008, ceded losses and settlement expenses for prior accident years increased $503,000. This increase in reinsurance recoveries is recognized as favorable development.
Reinsurance segment
For the reinsurance segment, the December 31, 2008 estimate of loss and settlement expense reserves for accident years 2007 and prior decreased $13,744,000 from the estimate at December 31, 2007. This represented 9.7 percent of the December 31, 2007 carried reserves and was primarily attributable to the 2007 accident year in the HORAD book of business. Much of this development can be attributed to reported losses that were below December 2007 implicit projections for policy years 2005 through 2007 in the property, casualty and multi-line classes.
For the HORAD and MRB books of business combined, the favorable development can be attributed to the property pro rata, property excess, and casualty excess lines of business.
No changes were made in the key actuarial assumptions utilized to estimate loss and settlement expenses reserves during 2008.
Year ended December 31, 2007
Property and casualty insurance segment
For the property and casualty insurance segment, the December 31, 2007 estimate of loss and settlement expense reserves for accident years 2006 and prior decreased $27,977,000 from the estimate at December 31, 2006. This decrease, a majority of which was attributable to favorable development on case loss reserves, represented approximately 6.8 percent of the December 31, 2006 gross carried reserves. No changes were made in the key actuarial assumptions utilized to estimate loss and settlement expense reserves during 2007.
Reserves on previously reported claims developed favorably in 2007 by approximately $17,154,000. Favorable development on case and bulk case loss reserves occurred in most major lines of business: other liability ($7,126,000), workers’ compensation ($6,005,000), commercial property ($3,083,000), auto physical damage ($1,327,000), bonds ($1,020,000), homeowners ($947,000) and personal auto liability ($764,000). For all lines combined, the latest three prior accident years were responsible for over 77 percent of the total favorable development, and the latest five prior accident years contributed over 99 percent. In aggregate, all of the favorable development on previously reported claims was attributable to decreased severity on claims that closed during 2007.
The emergence of IBNR claims was less than the decrease in prior accident years’ IBNR loss reserves, resulting in approximately $11,750,000 of favorable development in 2007. This development arose from all major lines of business: other liability ($4,607,000), commercial property ($1,814,000), commercial auto liability ($1,599,000), homeowners ($1,214,000), auto physical damage ($1,060,000), workers’ compensation ($847,000), bonds ($490,000) and personal auto liability ($119,000). For all lines combined, the favorable development on prior accident year IBNR loss reserves was attributable to accident year 2006.
During 2007, underlying exposure increases resulted in premium increases in certain lines of business, most notably in the other liability and workers’ compensation lines. Since formula IBNR loss reserves are calculated through the application of IBNR factors to premiums earned, these exposure increases resulted in an increase of $2,226,000 in prior accident year IBNR loss reserves, which partially offset the favorable case and IBNR loss reserve development described above.
Total settlement expense reserves developed favorably in 2007 by $6,760,000. Approximately 51 percent of the favorable development was related to internal claims department, independent adjuster, and miscellaneous settlement expenses. Settlement expense payments in these categories during 2007 were lower than anticipated in the payment patterns used in the accident year allocation of the December 31, 2006 settlement expense reserves. This favorable development occurred primarily in the workers’ compensation, other liability and commercial auto liability lines of business.
The defense and cost containment portion of prior accident year settlement expense reserves developed favorably in 2007 by $3,320,000. The favorable development resulted from expense payments in 2007 that were $5,763,000 lower than anticipated in the 2006 year-end reserve levels. The other liability line of business accounted for approximately three fourths of this favorable development. Partially offsetting this favorable development, settlement expense reserves were strengthened $2,700,000, of which approximately $1,752,000 was allocated to prior accident years. This prior accident year strengthening occurred primarily in the other liability, commercial auto and workers’ compensation lines of business, and resulted from standard actuarial reserve reviews. In addition, $824,000 of settlement expense reserves were reallocated to defense and cost containment, of which $590,000 was allocated to prior accident years. Finally, settlement expense reserves for prior accident years increased approximately $244,000 due to the exposure increases mentioned above in the discussion of IBNR loss reserves.
Prior accident year reserves for non-voluntary assumed business developed adversely by $127,000, attributable primarily to auto assigned risk pools.
The above results reflected reserve development on a direct and assumed basis. During 2007, ceded losses for prior accident years decreased $5,587,000, and was largely attributable to the workers’ compensation, umbrella, bonds and commercial property lines of business. This decrease in reinsurance recoveries is recognized as adverse development.
Reinsurance segment
For the reinsurance segment, the December 31, 2007 estimate of loss and settlement expense reserves for accident years 2006 and prior decreased $10,761,000 from the estimate at December 31, 2006. This represented 7.8 percent of the December 31, 2006 carried gross reserves and was attributable to the 2004 – 2006 accident years for the HORAD book of business. Much of this development was attributed to reported losses for policy years 2004 - 2006 for property, casualty and multi-line classes that were below December 31, 2006 implicit projections.
For the HORAD and MRB books of business combined, the favorable development was attributed to the property pro rata and property excess lines of business.
No changes were made in the key actuarial assumptions utilized to estimate loss and settlement expense reserves during 2007.
Calendar Year Development Table
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.
The table has been restated to reflect 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.
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