EMC Insurance Group 10-Q 2008
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended JUNE 30, 2008
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
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Sections 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of large accelerated filer, accelerated filer and smaller reporting company in Rule 12b-2 of the Exchange Act.
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Indicate the number of shares outstanding of each of the issuers classes of common stock, as of the latest practicable date.
TABLE OF CONTENTS
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
See accompanying Notes to Consolidated Financial Statements.
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
See accompanying Notes to Consolidated Financial Statements.
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
All balances presented below, with the exception of net investment income, realized investment gains (losses) and income tax expense (benefit), are the result of related party transactions with Employers Mutual.
See accompanying Notes to Consolidated Financial Statements.
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
See accompanying Notes to Consolidated Financial Statements.
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS, CONTINUED
See accompanying Notes to Consolidated Financial Statements.
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The accompanying unaudited consolidated financial statements have been prepared on the basis of U.S. generally accepted accounting principles (GAAP) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and notes required by GAAP for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation of the interim financial statements have been included. The results of operations for the interim periods reported are not necessarily indicative of results to be expected for the year.
The consolidated balance sheet at December 31, 2007 has been derived from the audited financial statements at that date, but does not include all of the information and notes required by GAAP for complete financial statements.
Certain amounts previously reported in prior years consolidated financial statements have been reclassified to conform to current year presentation.
In reading these financial statements, reference should be made to the Companys 2007 Form 10-K or the 2007 Annual Report to Stockholders for more detailed footnote information.
In September 2006, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 157, Fair Value Measurements, which defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. The provisions of SFAS 157 are effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The Company adopted the requirements of SFAS 157 effective January 1, 2008, which resulted in additional disclosures, but no impact on operating results.
In September 2006, the FASB issued SFAS No. 158, Employers Accounting for Defined Benefit Pension and Other Postretirement Plans. SFAS 158 includes a requirement to measure the defined benefit plan assets and obligations as of the end of the employers fiscal year. This requirement is effective for fiscal years ending after December 15, 2008. SFAS 158 provides two approaches to measure the adjustment from a previously reported non-fiscal year-end measurement date to a fiscal year-end measurement date, both of which require the adjustment be recorded to beginning retained earnings and accumulated other comprehensive income, as applicable. SFAS 158 does not change the method of calculating the net periodic cost that existed under previous guidance. Effective January 1, 2008, the Company elected to apply the approach under which the Companys previous November 1, 2007 measurement date was used to obtain the adjustment for the two month transition period. As a result, on January 1, 2008, the Company recorded a $205,751 decrease to retained earnings and a $46,057 decrease to accumulated other comprehensive income to record the net periodic cost associated with the two month transition period.
In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities. SFAS 159 permits reporting entities to choose, at specified election dates, to measure eligible items at fair value (the fair value option). The unrealized gains and losses on items for which the fair value option has been elected will be reported in earnings. As it relates to the Companys financial reporting, the Company would be permitted to elect fair value recognition of fixed maturity and equity securities currently classified as either available-for-sale or held-to-maturity, and report future unrealized gains and losses from these securities in earnings. Electing the fair value option for an existing held-to-maturity security will not call into question the intent of an entity to hold other fixed maturity securities to maturity in the future. The provisions of this statement are effective beginning with the first fiscal year that begins after November 15, 2007. The Company adopted the requirements of SFAS 159 effective January 1, 2008, but did not elect the fair value option. Therefore, adoption of this statement had no effect on the operating results of the Company.
In December 2007, the FASB issued SFAS No. 141 (revised 2007), Business Combinations. This statement replaces SFAS No. 141, Business Combinations; however, it retains the fundamental requirements of SFAS No. 141 in that the acquisition method of accounting (referred to as purchase method in SFAS 141) be used for all business combinations. SFAS 141 (revised) is to be applied prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. Adoption of this statement is not expected to have any effect on the operating results of the Company.
The effect of reinsurance on premiums written and earned, and losses and settlement expenses incurred, for the three months and six months ended June 30, 2008 and 2007 is presented below.
The Companys operations consist of a property and casualty insurance segment and a reinsurance segment. The property and casualty insurance segment writes both commercial and personal lines of insurance, with a focus on medium-sized commercial accounts. The reinsurance segment provides reinsurance for other insurers and reinsurers. The segments are managed separately due to differences in the insurance products sold and the business environments in which they operate.
The following table displays the net premiums earned of the property and casualty insurance segment and the reinsurance segment for the three months and six months ended June 30, 2008 and 2007, by line of business.
The actual income tax expense (benefit) for the three months and six months ended June 30, 2008 and 2007 differed from the expected income tax expense (benefit) for those periods (computed by applying the United States federal corporate tax rate of 35 percent to income before income tax expense) primarily due to tax-exempt interest income.
The Company had no provision for uncertain tax positions at June 30, 2008 or December 31, 2007. The Company did not recognize any interest or other penalties related to U.S. federal or state income taxes during the three months and six months ended June 30, 2008 or 2007. It is the Companys accounting policy to reflect income tax penalties as other expense, and interest as interest expense.
The Company files U.S. federal tax returns, along with various state income tax returns. The Company is no longer subject to U.S. federal and state income tax examinations by tax authorities for years before 2004.
The components of net periodic benefit cost for Employers Mutuals pension and postretirement benefit plans is as follows:
The large decrease in net periodic postretirement benefit cost for the three months and six months ended June 30, 2008 is due to a plan amendment that became effective on January 1, 2008. This plan amendment increased the minimum retirement age and length of service requirement to receive the full employer contribution amount in the postretirement health care benefit plan.
Net periodic pension benefit cost allocated to the Company amounted to $353,340 and $378,534 for the three months and $706,677 and $757,070 for the six months ended June 30, 2008 and 2007, respectively. Net periodic postretirement benefit cost allocated to the Company amounted to $188,079 and $566,839 for the three months and $376,156 and $1,133,676 for the six months ended June 30, 2008 and 2007, respectively.
Employers Mutual plans to contribute approximately $10,000,000 to the pension plan and $2,700,000 to the VEBA trust in 2008. As of June 30, 2008, Employers Mutual has not made a contribution to the pension plan and has contributed $1,200,000 to the postretirement benefit plans VEBA trust.
The Company has no stock-based compensation plans of its own; however, Employers Mutual has several stock plans which utilize the common stock of the Company. Employers Mutual can provide the common stock required under its plans by: 1) using shares of common stock that it currently owns; 2) purchasing common stock on the open market; or 3) directly purchasing common stock from the Company at the current fair value. Employers Mutual has historically purchased common stock from the Company for use in its incentive stock option plans and its non-employee director stock option plan.
Employers Mutual maintains two separate incentive stock option plans for the benefit of officers and key employees of Employers Mutual and its subsidiaries. A total of 1,000,000 shares of the Companys common stock have been reserved for issuance under the 1993 Employers Mutual Casualty Company Incentive Stock Option Plan (1993 Plan), and a total of 1,500,000 shares have been reserved for issuance under the 2003 Employers Mutual Casualty Company Incentive Stock Option Plan (2003 Plan).
Both plans have a ten year time limit for granting options. Options can no longer be granted under the 1993 Plan and no additional options will be granted under the 2003 Plan as Employers Mutual recently implemented a new stock incentive plan. Options granted under the 1993 Plan and 2003 Plan have a vesting period of two, three, four or five years with options becoming exercisable in equal annual cumulative increments. Option prices cannot be less than the fair value of the common stock on the date of grant.
On June 1, 2007, the Company registered 2,000,000 shares of the Companys common stock for use in the 2007 Employers Mutual Casualty Company Stock Incentive Plan (2007 Plan). The 2007 Plan provides for the awarding of performance shares, performance units, and other stock-based awards, in addition to qualified (incentive) and non-qualified stock options, stock appreciation rights, restricted stock and restricted stock units. The 2007 Plan provides for a ten-year time limit for granting awards. Officers, key employees and non-employee directors of Employers Mutual and its subsidiaries and affiliates, as well as certain agents, may participate in the plan.
The Senior Executive Compensation and Stock Option Committee (the Committee) of Employers Mutuals Board of Directors (the Board) grants the awards and is the administrator of the plans. The Companys Compensation Committee must consider and approve all awards granted to the Companys senior executive officers.
The Company recognized compensation expense of $50,027 ($48,957 net of tax) and $46,243 (gross and net of tax) for the three months and $132,265 ($128,712 net of tax) and $108,455 (gross and net of tax) for the six months ended June 30, 2008 and 2007, respectively, related to the 2003 and 2007 Plans. During the first six months of 2008, 221,875 options were granted under the 2007 Plan to eligible participants at a price of $23.467, and 65,805 options were exercised under the plans at prices ranging from $9.25 to $25.455. The Company recognized negative compensation expense of $9,360 ($6,084 net of tax) and $10,057 ($6,537 net of tax) during the three months ended June 30, 2008 and 2007, respectively, related to a stock appreciation rights agreement that is being accounted for as a liability-classified award. No compensation expense was recognized for this agreement during the six months ended June 30, 2008 due to the terms of the agreement, and negative compensation expense of $96,547 ($62,756 net of tax) was recognized during the six months ended June 30, 2007.
The weighted average fair value of options granted during the six months ended June 30, 2008 and 2007 amounted to $2.77 and $3.78, respectively. The fair value of each option grant was estimated on the date of grant using the Black-Scholes-Merton option-pricing model and the following assumptions:
The expected term of the options granted in 2008 was estimated using historical data that was adjusted to remove the effect of option exercises prior to the normal vesting period due to the retirement of the option holder. The expected term of options granted to individuals who are, or will be, eligible to retire prior to the completion of the normal vesting period has been adjusted to reflect the potential accelerated vesting period. This produced a weighted-average expected term of 2.79 years.
The expected volatility in the price of the underlying shares for the 2008 option grant was computed by using the historical average high and low monthly prices of the Companys common stock for a period covering 6.25 years, which approximates the average term of the options and produced an expected volatility of 23.2 percent. The expected volatility of options granted to individuals who are, or will be, eligible to retire prior to the completion of the normal vesting period was computed by using the historical average high and low daily, weekly, or monthly prices for the period approximating the expected term of those options. This produced expected volatility ranging from 21.0 percent to 30.1 percent.
As previously discussed, the Company adopted SFAS 157 on January 1, 2008. SFAS 157 applies to all assets and liabilities that are measured and reported on a fair value basis. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. SFAS 157 also establishes the following fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value:
Level 1 - Unadjusted quoted prices for identical assets or liabilities in active markets that the Company has the ability to access.
Level 2 - Quoted prices for similar assets or liabilities in active markets; quoted prices for identical or similar assets or liabilities in inactive markets; or valuations based on models where the significant inputs are observable (e.g., interest rates, yield curves, prepayment speeds, default rates, loss severities, etc.) or can be corroborated by observable market data.
Level 3 - Prices or valuation techniques that require significant unobservable inputs. The unobservable inputs may reflect the Companys own assumptions about the assumptions that market participants would use.
The Company uses an independent pricing source to obtain the estimated fair value of a majority of its securities. The fair value is based on quoted market prices, where available. This is typically the case for equity securities and short-term investments, which are accordingly classified as Level 1 fair value measurements. In cases where quoted market prices are not available, fair value is based on a variety of valuation techniques depending on the type of security. Many of the fixed maturity securities in the Companys portfolio do not trade on a daily basis; however, observable inputs are utilized in their valuations, and these securities are therefore classified as Level 2 fair value measurements. Following is a brief description of the various pricing techniques used by the independent pricing service for different asset classes.
On a quarterly basis, the Company receives from its independent pricing service a list of fixed maturity securities that were priced solely from broker quotes. Since this is not an observable input, any fixed maturity security in the Companys portfolio that is on this list is classified as a Level 3 fair value measurement. At January 1, 2008, one of the Companys fixed maturity securities (Continental Airlines) was on this list and was reported at the fair value provided by the independent pricing service ($696,561). This security was subsequently priced by the independent pricing service using observable inputs (as described above), and was transferred from the Level 3 fair value measurement category to the Level 2 fair value measurement category on March 31, 2008.
A small number of the Companys securities are not priced by the independent pricing service. Two of the Companys equity securities are reported at the fair value obtained from the Securities Valuation Office (SVO) of the National Association of Insurance Commissioners (NAIC). These securities are reported as Level 3 fair value measurements since the SVO is not able to use reliable observable inputs in its valuations. The SVO establishes a per share price for Insurance Services Office Inc. (ISO) Class B shares by averaging Class B trades during the past year and reviewing the quarterly valuations produced by a nationally recognized independent firm for the Class A shares (Class B shares typically trade at approximately 60 percent of the fair value of the Class A shares). This valuation is typically performed twice a year, and resulted in a fair value for the Class B shares held by the Company of $10,847,435 at June 30, 2008 and $10,180,245 at December 31, 2007. The SVO establishes a per share price for the other equity security based on an annual review of that companys financial statements. This review is typically performed during the second quarter, and resulted in a fair value for the shares held by the Company of $3,641 at June 30, 2008 and $6,719 at December 31, 2007. The remaining four securities not priced by the Companys independent pricing service are fixed maturity securities. One of the securities is classified as a Level 3 fair value measurement and is carried at its amortized cost of $24,052 ($46,795 at December 31, 2007). The other three fixed maturity securities are classified as Level 2 fair value measurements and are carried at aggregate fair values of $8,823,161 at June 30, 2008 and $9,698,884 at December 31, 2007. The fair values for these three fixed maturity securities were obtained from the Companys investment custodian using an independent pricing service which utilizes similar pricing techniques as the Companys independent pricing service.
The fair values obtained from the independent pricing sources are reviewed by the Company for reasonableness and any discrepancies are investigated for final valuation.
The Companys fixed maturity securities and equity securities available-for-sale and short-term investments are measured at fair value on a recurring basis. No assets or liabilities are currently measured at fair value on a non-recurring basis. Presented in the table below are the Companys assets that are measured at fair value on a recurring basis, as of June 30, 2008.
Presented in the table below is a reconciliation of the assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the three and six months ended June 30, 2008. Any unrealized gains or losses on these securities would be recognized in other comprehensive income. Any gains or losses from disposals or impairments of these securities would be reported as realized investment gains or losses in the income statement.
The Company and Employers Mutual and its other subsidiaries are parties to numerous lawsuits arising in the normal course of the insurance business. The Company believes that the resolution of these lawsuits will not have a material adverse effect on its financial condition or its results of operations. The companies involved have established reserves which are believed adequate to cover any potential liabilities arising out of all such pending or threatened proceedings.
The participants in the pooling agreement have purchased annuities from life insurance companies, under which the claimant is payee, to fund future payments that are fixed pursuant to specific claim settlement provisions. The Companys share of loss reserves eliminated by the purchase of these annuities was $2,024,184 at December 31, 2007. The Company has a contingent liability of $2,024,184 should the issuers of these annuities fail to perform under the terms of the annuity. The probability of a material loss due to failure of performance by the issuers of these annuities is considered remote. The Companys share of the amount due from any one life insurance company does not equal or exceed one percent of its subsidiaries aggregate policyholders surplus.
On March 10, 2008, the Companys Board of Directors authorized a $15 million stock repurchase program. This program became effective immediately and does not have an expiration date. The timing and terms of the purchases are determined by management based on market conditions and are conducted in accordance with the applicable rules of the Securities and Exchange Commission. Common stock purchased under this program is being retired by the Company. As of June 30, 2008, 254,366 shares of common stock had been repurchased at a cost of $7,016,961.
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
The following discussion and analysis of EMC Insurance Group Inc. and Subsidiaries financial condition and results of operations should be read in conjunction with the Consolidated Financial Statements and Notes to Consolidated Financial Statements included under Item 1 of this Form 10-Q, and the Managements Discussion and Analysis of Financial Condition and Results of Operations section of the Companys 2007 Form 10-K.
EMC Insurance Group Inc., a 57.9 percent owned subsidiary of Employers Mutual Casualty Company (Employers Mutual), is an insurance holding company with operations in property and casualty insurance and reinsurance. Property and casualty insurance is the most significant segment, representing 82.2 percent of consolidated premiums earned during the first six months of 2008. For purposes of this discussion, 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.
In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation of the interim financial statements have been included. The results of operations for the interim periods reported are not necessarily indicative of results to be expected for the year.
MANAGEMENT ISSUES AND PERSPECTIVES
During the first six months of 2008 management continued to focus its efforts on writing profitable business in the increasingly competitive insurance marketplace, and maintaining adequate and consistent loss and settlement expense reserves. Management was also confronted with a record amount of catastrophe and storm losses during the second quarter, and spent a considerable amount of time and effort ensuring that all claims were inspected and adjusted in a timely manner. In addition, management evaluated and implemented a new investment strategy designed to take advantage of the liquidity-induced market dislocation that currently exists in the securitized residential mortgage marketplace. Following is a more detailed discussion of these issues.
Competitive insurance marketplace
Net premiums written for the EMC Insurance Companies pool have remained nearly unchanged in recent years due to the increasingly competitive insurance marketplace and increased reinsurance costs. All lines of business have experienced a decline in premium rate levels of varying magnitude over the past three years. During this period, policy retention has remained at a high level, but policy count has declined as a result of the increased competition for desirable business and management initiatives to exit unprofitable business. The increase in premium rate competition is being driven by the profitable underwriting results, and resulting high capitalization level, of the property and casualty insurance industry during the past three years. On an overall basis, premium rate levels declined approximately 3.7 percent in 2006 and 4.9 percent in 2007, and are expected to decline an additional 5.5 percent in 2008. Given this competitive pricing environment, management is targeting a modest level of premium growth through new business writings that are carefully selected and adequately priced, and from continuing efforts to maintain, or improve, policy retention.
In response to this competitive environment, management has over the past three years formulated and implemented strategies to generate profitable business, and is now closely monitoring and adjusting those strategies as necessary. The areas of focus have included establishing business plans with the Companys independent insurance agents to increase new business production; improving the ease of conducting business through technological improvements; expanding on the pool participants three programs for writing homogenous risks: target markets, EMC Choice programs and safety dividend programs; implementing a more formalized process for commercial lines product development; and improving sales effectiveness skills through ongoing training.
Central to managements business plan to increase new business production is a focus on the Companys only distribution channel, the independent insurance agent. Management spent a considerable amount of time during the first half of 2008 working closely with local branch underwriting and marketing personnel and their independent insurance agents to identify new business desirable to the Company. Supporting this focus on new business opportunities are sophisticated underwriting tools (including tools with predictive modeling and monitoring capabilities) that help determine whether individually submitted applications, as well as renewal business, are acceptable, and the appropriate price for each individual risk. These underwriting tools produce information in real time to underwriters as they consider a new risk, or renew an existing risk. Management is also in the early stages of implementing data mining software that is capable of producing easily accessible, highly insightful summary information that can be quickly constructed from the vast amounts of data contained in Employers Mutuals claims system. Such information can be used to alert management of conditions that have affected the pool participants underwriting results. Once alerted, management can adjust underwriting practices and/or pricing to address and mitigate any developing adverse trends.
Maintaining adequate and consistent loss and settlement expense reserves
Over the past several years management has devoted a substantial amount of time and resources to improving the adequacy and consistency of the Companys case loss reserves by implementing procedures and guidelines that assist claims personnel in establishing and maintaining proper reserve amounts. Because of these improvements in the claims handling process, favorable development on prior years case loss reserves was not unexpected during calendar years 2006 and 2007; however, the magnitude of the favorable development experienced during these periods was not anticipated.
From managements perspective, investors and potential investors should not place undue emphasis on the composition of the Companys underwriting results (i.e. the breakdown between the amount of favorable development reported on prior years reserves versus the indicated current accident year results) because, as explained below, the Companys reserving methodology does not lend itself to that type of analysis very well. Management believes that it is important for investors and potential investors to have an appropriate understanding of the Companys reserving methodology so that they are able to properly interpret the Companys results of operations and make informed investment decisions. Following is a brief discussion of the Companys reserving methodology.
Management does not use accident year loss picks to establish the Companys 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 Companys total loss and settlement expense reserve estimate.
As part of the ongoing effort to enhance the effectiveness of the Companys reserving process, the methodology was expanded during 2007 to include bulk case loss reserves. These bulk reserves supplement the aggregate reserves of the individual claim files and are used to help maintain a consistent level of overall case loss reserve adequacy. Bulk case loss reserves (both positive and negative) are established when necessary to keep the estimated adequacy of the Companys carried case loss reserves at a level consistent with managements best estimate of the Companys overall liability. For financial reporting purposes, bulk case loss reserves are included in case loss reserves.
Case loss reserves are the individual reserves established for each reported claim based on the specific facts associated with 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 states Workers Compensation Commission. Bulk case loss reserves are actuarially derived and are allocated to the various accident years on the basis of the underlying aggregate case loss reserves of the applicable lines of business. IBNR and settlement expense reserves are established through an actuarial process for each line of business. The IBNR and certain settlement expense reserves are allocated to the various accident years using historical claim emergence and settlement payment patterns; other settlement expense reserves are allocated to the various accident years on the basis of case loss reserves.
The current and more recent accident years have a larger proportion of case, IBNR and settlement expense reserves than earlier accident years. Since the Companys reserve levels are established somewhat conservatively, the relatively high proportion of reserves in the more recent accident years generates relatively high loss and settlement expense ratios in the early stages of an accident years development; however, as those accident years mature, claims are gradually settled, the reserves for those years become smaller, and the loss and settlement expense ratios generally decline.
Without a proper understanding of the Companys reserving methodology, the current and more recent accident year combined ratios can be misinterpreted. For example, the Company reported a combined ratio of
106.6 percent for the first six months of 2008. If the large amount of favorable development experienced on prior years reserves during this period is added back to the losses and settlement expenses incurred, it would appear that the 2008 accident year generated a combined ratio of 120.1 percent. However, managements current actuarial projections indicate that the 2008 accident year combined ratio will continue to decline as claims are settled, and will ultimately reach approximately 106.7 percent.
It is managements intention to continue to apply this reserving methodology on a consistent basis. With reasonably consistent levels of reserve adequacy, management expects earnings from downward development of prior accident year reserves to continue in future years. For that reason, management believes that less emphasis should be placed on the composition of the Companys underwriting results between the current and prior accident years, and more emphasis should be placed on where the Companys carried reserves fall within the range of actuarial indications.
As of March 31, 2008, the Companys loss and settlement expense reserves were in the upper quarter of the range of actuarial indications. Although the actuarial analysis as of March 31, 2008 indicates that the Companys loss and settlement expense reserves are at a high level of adequacy, management is not able to predict whether, or to what extent, the Company will continue to experience favorable development on its reserves.
Record catastrophe and storm losses
During the second quarter of 2008, the Company experienced a record $23.5 million of catastrophe and storm losses. This record level of catastrophe and storm losses was primarily due to several severe storm systems that produced wind, tornado and hail losses over a wide geographic region of the Midwest, including a devastating EF5 tornado that struck Parkersburg, Iowa and destroyed the high school and many homes. The second quarter storm losses were in addition to the high level of storm losses experienced in the first quarter, bringing total catastrophe and storm losses to $29.2 million for the first six months of 2008. Catastrophe and storm losses added 24.3 and 15.3 percentage points to the combined ratios for the three and six months ended June 30, 2008, compared to 9.8 and 6.3 points for the same periods in 2007. Assuming normal storm activity for the remainder of the year, management is currently projecting that catastrophe and storm losses will approximate 11.5 percent of earned premiums in 2008, compared to an average of 5.4 percent of earned premiums during the period 1998 through 2007.
Absent the excessive level of storm losses management believes that the Companys underlying book of business continued to perform reasonably well and within expectations during the first six months of 2008, given the competitive market conditions. The record level of storm losses that occurred during the second quarter of 2008 was not caused by a concentration of exposures, but rather the number of severe storms and wide geographical region affected by those storms.
Management recognizes that policyholders are counting on the Company to help them get their lives back in order after a storm loss occurs, and takes that responsibility very seriously. As of June 30, all second quarter storm claims had been adjusted and over ninety percent of the claims had been paid, many within days of the loss event.
Residential Mortgage-Backed Securities Investment Strategy
During the second quarter, management evaluated and implemented a new investment strategy targeting high-quality residential mortgage-backed securities. This investment strategy is being administered by Harris Investment Management, Inc. and is designed to take advantage of the liquidity-induced market dislocation that currently exists in the securitized residential mortgage marketplace. This is a self-liquidating investment strategy that will target AAA rated residential bonds that are current on payments, as well as other traditional high-quality securitized assets (no securities backed by subprime mortgages will be purchased). The investments will be prudently diversified with respect to key risk factors (such as vintage, originator and geography), will have an average duration of 5 to 7 years, and will have projected yields of approximately 7 to 8 percent. The Company has committed a total of $40.0 million to this investment strategy, of which $13.8 million had been invested as of June 30, 2008.
CRITICAL ACCOUNTING POLICIES
The accounting policies considered by management to be critically important in the preparation and understanding of the Companys financial statements and related disclosures are presented in the Managements Discussion and Analysis of Financial Condition and Results of Operations section of the Companys 2007
RESULTS OF OPERATIONS
Segment information and consolidated net income for the three months and six months ended June 30, 2008 and 2007 are as follows:
The Company reported a net loss of $940,000 ($0.07 per share) for the three months ended June 30, 2008 compared to record second quarter net income of $13,991,000 ($1.02 per share) in 2007. For the six months ended June 30, 2008, net income was $7,279,000 ($0.53 per share) compared to $28,692,000 ($2.09 per share) for the same period in 2007. These declines are attributed to a record amount of catastrophe and storm losses experienced during the second quarter, an expected decline in the amount of favorable development experienced on prior years reserves, and a moderate, but steady, decline in overall premium rate levels. In addition, results for the three and six months ended June 30, 2008 were negatively impacted by $1,695,000 and $4,597,000, respectively, of other-than-temporary investment impairment losses that were recognized in the Companys equity portfolio.
Premiums earned decreased 2.9 percent and 1.2 percent to $96,617,000 and $191,595,000 for the three months and six months ended June 30, 2008 from $99,499,000 and $194,005,000 for the same periods in 2007. These decreases are primarily attributed to the moderate, but steady, decline in overall premium rate levels that have occurred over the past three years due to the competitive market conditions associated with the current soft market. While there is some encouragement in the stability of the premium rate declines experienced during this soft market (i.e., no free-fall in pricing as was prevalent in the previous soft market), it is expected that the current competitive pricing environment will continue at least through the remainder of the year due to the high capitalization level of the industry, as well as current economic conditions.
Premiums earned for the property and casualty insurance segment decreased 1.7 percent and 0.9 percent to $78,464,000 and $157,554,000 for the three months and six months ended June 30, 2008 from $79,803,000 and $159,007,000 for the same periods in 2007. Underlying these small decreases in premium income is a continued decline in overall premium rate levels, as total policy count increased slightly in both the commercial and personal lines of business. New business policy count was up in personal lines of business, and was relatively flat in commercial lines of business; however, personal lines new business premium increased 11.8 percent while commercial lines new business premium declined 10.3 percent. The decline in commercial lines new business premium is attributed to a combination of declining rates (rate declines are larger in commercial lines of business) and reduced exposures on new business (with a corresponding reduction in premium). The growth in personal lines new business premium is occurring in selected territories which management has identified as having greater profit potential. Retention rates remain above industry standards, with commercial lines and personal auto remaining relatively steady at 86.5 percent and 87.3 percent, respectively, while personal property retention rates climbed slightly to 86.5 percent. During the first six months of 2008, new business premium was not sufficient to offset the premium lost from declining premium rate levels and business not retained, resulting in a 2.9 percent decline in written premiums.
Premiums earned for the reinsurance segment decreased 7.8 percent and 2.7 percent to $18,153,000 and $34,041,000 for the three months and six months ended June 30, 2008 from $19,696,000 and $34,998,000 for the same periods in 2007. The decrease for the three months ended June 30, 2008 was driven by declines in both brokered business and business assumed from the Mutual Reinsurance Bureau (MRB) pool, and reflects the loss of a few accounts, increased retentions by some of the ceding companies and lower premium rates. These factors also negatively impacted premium income for the first six months of 2008; however, the decline was primarily confined to the MRB pool as the brokered business was essentially flat. Premium rate competition continues to increase in the reinsurance marketplace. This was evident during the January renewal season as the reinsurance segment experienced an overall decline in the average rate on-line for its accounts. There was some additional minor deterioration in rates during the July renewal period, but increased terms on those accounts with recent loss experience kept overall rate adequacy at a fairly consistent level. As a result of the loss of several accounts and increased retentions by some of the ceding companies, premium income for calendar year 2008 is expected to decline moderately from 2007.
Losses and settlement expenses
Losses and settlement expenses increased 42.4 percent and 27.7 percent to $80,337,000 and $140,344,000 for the three months and six months ended June 30, 2008 from $56,414,000 and $109,890,000 for the same periods in 2007. The loss and settlement expense ratio increased to 83.1 percent and 73.3 percent for the three months and six months ended June 30, 2008 from 56.7 percent and 56.6 percent for the same periods in 2007. The increase in these ratios is primarily attributed to the property and casualty insurance segment, which experienced record storm losses and an expected decline in the amount of favorable development experienced on prior years reserves. Catastrophe and storm losses totaled $23,518,000 and $29,248,000 for the three months and six months ended June 30, 2008 compared to $9,790,000 and $12,261,000 for the same periods in 2007, and added 24.3 and 15.3 percentage points to the loss and settlement expense ratio for the three and six months ended June 30, 2008, compared to 9.8 and 6.3 percentage points for the same periods in 2007.
The loss and settlement expense ratio for the property and casualty insurance segment increased to 84.8 percent and 72.5 percent for the three months and six months ended June 30, 2008 from 57.3 percent and 55.2 percent for the same periods in 2007. Midwest storm losses were the driving force behind these increases, as catastrophe and storm losses more than doubled to a record $21,968,000 and $27,616,000 for the three months and six months ended June 30, 2008 from $9,417,000 and $11,852,000 for the same periods in 2007. These storm losses contributed 28.0 and 17.5 percentage points, respectively, to the three and six month loss and settlement expense ratios, which were increases of 16.2 and 10.1 percentage points over the comparable ratios of 2007. The second quarter storm losses were largely from a widespread series of storms that produced wind, tornado, and hail losses throughout the Midwest, including the horrific tornado damage inflicted on the high school and other property in and around Parkersburg, Iowa. These second quarter storm losses added to the high level of storm losses experienced during the first quarter of 2008. An expected decline in the amount of favorable development experienced on prior years reserves also contributed to the increase in the loss and settlement expense ratio. Finally, the moderate, but steady, decline in premium rate levels over the past several years is estimated to have added approximately 4 percentage points to the loss and settlement expense ratio during the first six months of 2008.
The loss and settlement expense ratio for the reinsurance segment increased to 76.0 percent and 76.9 percent for the three months and six months ended June 30, 2008 from 54.2 percent and 63.3 percent for the same periods in 2007. These increases reflect increases in the IBNR reserve of $2,970,000 and $3,775,000 during the three months and six months ended June 30, 2008, compared to a $3,058,000 decrease and a $1,787,000 increase during the same periods of 2007.
Acquisition and other expenses
Acquisition and other expenses declined 7.4 percent and 4.7 percent to $31,756,000 and $63,811,000 for the three months and six months ended June 30, 2008 from $34,303,000 and $66,989,000 for the same periods in 2007. The acquisition expense ratio declined to 32.9 percent and 33.3 percent for the three months and six months ended June 30, 2008 from 34.5 percent and 34.6 percent for the same periods in 2007. These declines are attributed to the property and casualty insurance segment and reflect reductions in the amount of expense recorded for policyholder dividends, postretirement benefits, and executive bonuses and contingent salaries.
For the property and casualty insurance segment, the acquisition expense ratio declined to 35.6 percent and 35.2 percent for the three months and six months ended June 30, 2008 from 38.0 percent and 37.3 percent for the same periods in 2007. These decreases are attributed to declines in the amount of expense recorded for policyholder dividends, postretirement benefits, executive bonuses and contingent salaries, and contingent commissions (in the form of agents profit share expense). The decline in policyholder dividend expense is largely due to a decrease in the estimated dividend payable on some of the Companys safety dividend groups, which are based on the total loss experience of the respective safety groups. The decline in postretirement benefits expense reflects a decrease in the service cost component and the amortization of a prior service credit resulting from a plan amendment that became effective in the first quarter of 2008. The declines in executive bonuses and contingent salaries, and agents profit share expenses reflect the large decline in underwriting profitability that occurred during the second quarter of 2008.
For the reinsurance segment, the acquisition expense ratio increased to 21.2 percent and 24.2 percent for the three months and six months ended June 30, 2008 from 20.1 percent and 21.8 percent for the same periods in 2007. The increase for the three months ended June 30, 2008 is primarily attributed to higher contingent commission expenses. The increase for the six months ended June 30, 2008 is primarily due to an increase in the estimate of commission expense on earned but not reported premiums, and to a lesser extent the increase in contingent commission expense during the second quarter.
Net investment income increased 3.0 percent and 1.3 percent to $12,000,000 and $23,940,000 for the three months and six months ended June 30, 2008 from $11,655,000 and $23,643,000 for the same periods in 2007. These increases reflect a higher average invested balance in interest bearing investments (fixed maturity securities and short-term investments). The increase for the six months ended June 30, 2008 was somewhat limited by a significant amount of call activity on the Companys U.S. Government Agency securities during the first quarter due to the declining interest rate environment. The proceeds from these called securities were invested in short-term securities until attractive long-term opportunities could be identified. As of March 31, 2008, approximately 55 percent of the $211 million in proceeds received from called securities had been reinvested in long-term securities, and by June 30, 2008 approximately 87 percent of the $258 million in proceeds from this call activity had been reinvested. With the reinvestment of these proceeds, net investment income has increased.
The Company reported net realized investment gains of $371,000 and $217,000 for the three months ended June 30, 2008 and 2007, respectively, primarily from sales of equity investments. Reducing these gains were other-than-temporary investment impairment losses totaling $1,695,000 on seven equity securities during the second quarter of 2008, and $324,000 on four equity securities during the second quarter of 2007. For the six months ended June 30, 2008, the Company reported a net realized investment loss of $2,541,000 compared to a net gain of $1,513,000 for the same period in 2007, also primarily from equity investments. The Company recognized other-than-temporary investment impairment losses totaling $4,597,000 on 18 equity securities during the first six months of 2008, compared to $384,000 on seven equity securities during the first six months of 2007. These impairment losses were recognized because the Companys equity manager indicated that these securities, which were in an unrealized loss position, would likely be sold before they recovered to their cost basis. As a result, the intent to hold these securities to recovery did not exist.
The total rate of return on the Companys equity portfolio was negative 7.39 percent, compared to a negative 11.91 percent for the S&P 500. The current annualized yield on the bond portfolio and cash is 5.3 percent and the effective duration is 5.11 years, which is up from 4.76 years at March 31, 2008 and 3.75 years at December 31, 2007.
The Company reported an income tax benefit of $2,640,000 for the three months ended June 30, 2008 compared to income tax expense of $5,986,000 for the same period in 2007. For the six months ended June 30, 2008, income tax expense declined to $201,000 from $12,172,000 in 2007. The effective tax rates for the six months ended June 30, 2008 and 2007 were 2.7 percent and 29.8 percent, respectively. The large decline in the effective tax rate for the first six months of 2008 reflects the change in pre-tax income relative to the amount of tax-exempt interest income earned.
LIQUIDITY AND CAPITAL RESOURCES
Liquidity is a measure of a companys ability to generate sufficient cash flows to meet cash obligations. The Company had positive cash flows from operations of $5,077,000 during the first six months of 2008, compared to negative cash flows from operations of $4,572,000 during the same period of 2007. The negative cash flows during the first six months of 2007 were primarily due to large income tax payments made by the Companys insurance subsidiaries. Income taxes are initially paid by Employers Mutual, and the Companys insurance subsidiaries reimburse Employers Mutual for their share of the payment through the settlement of inter-company balances. The Company typically generates substantial positive cash flows from operations because cash from premium payments is generally received in advance of cash payments made to settle claims. These positive cash flows provide the foundation of the Companys asset/liability management program and are the primary drivers of the Companys liquidity. When investing funds made available from operations, the Company invests in securities with maturities that approximate the anticipated payments of losses and settlement expenses of the underlying insurance policies. In addition, the Company maintains a portion of its investment portfolio in relatively short-term and highly liquid assets as a secondary source of liquidity should net cash flows from operating activities prove inadequate to fund current operating needs. As of June 30, 2008, the Company did not have any significant variations between the maturity dates of its investments and the expected payments of its loss and settlement expense reserves.
The Company is a holding company whose principal asset is its investment in its insurance subsidiaries. As a holding company, the Company is dependent upon cash dividends from its insurance company subsidiaries to meet all obligations, including cash dividends to stockholders and the funding of the Companys stock repurchase program. State insurance regulations restrict the maximum amount of dividends insurance companies can pay without prior regulatory approval. The maximum amount of dividends that the insurance company subsidiaries can pay to the Company in 2008 without prior regulatory approval is approximately $46,779,000. The Company received $22,505,000 and $2,500,000 of dividends from its insurance company subsidiaries and paid cash dividends to its stockholders totaling $4,935,000 and $4,679,000 in the first six months of 2008 and 2007, respectively. The large increase in dividends received from the insurance company subsidiaries during 2008 is being used to fund the Companys $15,000,000 stock repurchase program.
The Companys insurance company subsidiaries must have adequate liquidity to ensure that their cash obligations are met; however, because of their participation in the pooling agreement and the quota share agreement, they do not have the daily liquidity concerns normally associated with an insurance or reinsurance company. This is due to the fact that under the terms of the pooling and quota share agreements, Employers Mutual receives all premiums and pays all losses and expenses associated with the insurance business produced by the pool participants and the assumed reinsurance business ceded to the Companys reinsurance subsidiary, and then settles the inter-company balances generated by these transactions with the participating companies within 45 days after the end of each quarter.
At the insurance company subsidiary level, the primary sources of cash are premium income, investment income and maturing investments. The principal outflows of cash are payments of claims, commissions, premium taxes, operating expenses, income taxes, dividends, interest and principal payments on debt, and investment purchases. Cash outflows can be variable because of uncertainties regarding settlement dates for unpaid losses and because of the potential for large losses, either individually or in the aggregate. Accordingly, the insurance company subsidiaries maintain investment and reinsurance programs generally intended to provide adequate funds to pay claims without forced sales of investments. In addition, Employers Mutual has a line of credit available to provide additional liquidity if needed. The insurance company subsidiaries have access to this line of credit through Employers Mutual.
The Company maintains a portion of its investment portfolio in relatively short-term and highly liquid investments to ensure the availability of funds to pay claims and expenses. At June 30, 2008, approximately 38 percent of the Companys fixed maturity securities were in U.S. government or U.S. government-sponsored agency securities. This is down from approximately 55 percent at December 31, 2007 due to a significant amount of call activity on the Companys U.S. government agency securities that occurred during the first half of 2008 due to the declining interest rate environment. The proceeds from these called securities were initially invested in short-term securities, and much of the proceeds were subsequently reinvested in other types of fixed maturity securities (as discussed above). A variety of maturities are maintained in the Companys portfolio to assure adequate liquidity. The maturity structure of the fixed maturity securities is also established by the relative attractiveness of yields on short, intermediate and long-term securities. The Company does not invest in high-yield, non-investment grade debt securities. Any non-investment grade securities held by the Company are the result of rating downgrades that occurred subsequent to their purchase.
The Company considers itself to be a long-term investor and generally purchases fixed maturity securities with the intent to hold them to maturity. Despite this intent, the Company currently classifies purchases of fixed maturity securities as available-for-sale to provide flexibility in the management of its investment portfolio. The Company had net unrealized holding gains, net of deferred taxes, on fixed maturity securities available-for-sale totaling $6,917,000 and $12,298,000 at June 30, 2008 and December 31, 2007, respectively. The fluctuation in the market value of these investments is primarily due to changes in the interest rate environment during this time period, but also reflects a decline in credit quality of many of the U.S. government-sponsored agency securities. Since the Company does not actively trade in the bond market, such fluctuations in the fair value of these investments are not expected to have a material impact on the operations of the Company, as forced liquidations of investments is not anticipated. The Company closely monitors the bond market and makes appropriate adjustments in its portfolio as conditions warrant.
The majority of the Companys assets are invested in fixed maturity securities. These investments provide a substantial amount of investment income that supplements underwriting results and contributes to net earnings. As these investments mature, or are called, the proceeds are reinvested at current rates, which may be higher or lower than those now being earned; therefore, more or less investment income may be available to contribute to net earnings depending on the interest rate level.
The Company participates in a securities lending program administered by Mellon Bank, N.A. whereby certain fixed maturity securities from the investment portfolio are loaned to other institutions for short periods of time. The Company receives a fee for each security loaned out under this program and requires initial collateral, primarily cash, equal to 102 percent of the market value of the loaned securities. The cash collateral that secures the Companys loaned securities is invested in a Delaware business trust that is managed by Mellon Bank. The earnings from this trust are used, in part, to pay the fee the Company receives for each security loaned under the program.
The Company held $84,000 and $102,000 in minority ownership interests in limited partnerships and limited liability companies at June 30, 2008 and December 31, 2007, respectively. The Company does not hold any other unregistered securities.
The Companys cash balance was negative $55,000 at June 30, 2008 and $263,000 at December 31, 2007, respectively.
During the first six months of 2008, Employers Mutual made $1,200,000 in contributions to the postretirement benefit plans VEBA trust, and did not make any contributions to the pension plans. In 2008, Employers Mutual expects to make contributions totaling $10,000,000 to the pension plans and $2,700,000 to the postretirement benefit plans VEBA trust. The Company will reimburse Employers Mutual $343,000 for its share of the 2008 postretirement benefit plans contribution upon settlement of the second quarter inter-company balances.
Employers Mutual contributed $3,500,000 to its pension plans and $3,800,000 to its postretirement benefit plans in 2007. During the first six months of 2007, Employers Mutual contributed $3,300,000 to the postretirement benefit plans VEBA trust, but did not make any contributions to the pension plans. The Company reimbursed Employers Mutual $1,069,000 for its share of the pension contribution in 2007 (no reimbursement was paid in the first six months of 2007) and $1,083,000 for its share of the postretirement benefit plans contributions in 2007 (including $941,000 during the first six months of 2007).
Capital resources consist of stockholders equity and debt, representing funds deployed or available to be deployed to support business operations. For the Companys insurance subsidiaries, capital resources are required to support premium writings. Regulatory guidelines suggest that the ratio of a property and casualty insurers annual net premiums written to its statutory surplus should not exceed three to one. On an annualized basis, all of the Companys property and casualty insurance subsidiaries were well under this guideline at June 30, 2008.
The Companys insurance subsidiaries are required to maintain a certain minimum level of surplus on a statutory basis, and are subject to regulations under which the payment of dividends from statutory surplus is restricted and may require prior approval of their domiciliary insurance regulatory authorities. The Companys insurance subsidiaries are also subject to Risk Based Capital (RBC) requirements that may further impact their ability to pay dividends. RBC requirements attempt to measure minimum statutory capital needs based upon the risks in a companys mix of products and investment portfolio. At December 31, 2007, the Companys insurance subsidiaries had total adjusted statutory capital of $344,260,000, which was well in excess of the minimum RBC requirement of $55,526,000.
The Company had total cash and invested assets with a carrying value of $1.0 billion as of June 30, 2008 and December 31, 2007. The following table summarizes the Companys cash and invested assets as of the dates indicated:
The amortized cost and estimated fair value of fixed maturity and equity securities at June 30, 2008 were as follows: