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EMC Insurance Group 10-Q 2009 UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
S QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended MARCH 31, 2009
OR
£ 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.
x Yes ¨ No
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required
to submit and post such files).
¨ Yes ¨ No
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).
¨ Yes x No
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.
Total pages 46
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Unaudited)
See accompanying Notes to Consolidated Financial Statements.
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Unaudited)
See accompanying Notes to Consolidated Financial Statements.
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(Unaudited)
All balances presented below, with the exception of net investment income, realized investment losses, income tax expense (benefit) and other items specifically identified, 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
(Unaudited)
See accompanying Notes to Consolidated Financial Statements.
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS, CONTINUED
(Unaudited)
See accompanying Notes to Consolidated Financial Statements.
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
EMC Insurance Group Inc., a 59 percent owned subsidiary of Employers Mutual Casualty Company (Employers Mutual), is an insurance holding company with operations in property and casualty insurance and reinsurance. Both commercial and personal lines of insurance are written, with a focus on medium-sized commercial accounts. The
term “Company” is used interchangeably to describe EMC Insurance Group Inc. (Parent Company only) and EMC Insurance Group Inc. and its subsidiaries.
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, 2008 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 Company’s 2008 Form 10-K or the 2008 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 October 2008, the FASB issued Staff Position (FSP) FAS 157-3, “Determining the Fair Value of a Financial Asset When the Market For That Asset Is Not Active,” which was followed in
April 2009 by FSP FAS 157-4, “Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly.” Both of these FSPs are intended to clarify the application of SFAS 157 in markets that are not, at the measurement date, providing fair values representative of orderly transactions. FSP FAS 157-3 was effective upon issuance. Adoption of FSP FAS 157-3 did not have any effect
on the consolidated financial position or operating results of the Company. FSP FAS 157-4 is effective for interim and annual reporting periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009. The Company did not elect to early adopt FSP FAS 157-4, and the impact of adopting this pronouncement is yet to be determined.
In April 2009, the FASB issued FSP FAS 115-2 and FAS 124-2, “Recognition and Presentation of Other-Than-Temporary Impairments,” which is intended to make the guidance for “other-than-temporary” impairments for debt securities more operational, and to improve the presentation and disclosure of “other-than-temporary”
impairments on debt and equity securities in the financial statements. FSP FAS 115-2 and FAS 124-2 amends the criteria for “other-than-temporary” impairment on debt securities and requires that credit losses be recognized through earnings and losses due to other factors be recognized in other comprehensive income. In addition, this FSP introduces additional disclosure for debt and equity securities. This FSP is effective for interim and annual reporting periods ending
after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009. The Company did not elect to early adopt FSP FAS 115-2 and FAS 124-2, and the impact of adopting this pronouncement is yet to be determined.
In April 2009, the FASB issued FSP FAS 107-1 and APB 28-1, “Interim Disclosures about Fair Value of Financial Instruments,” which requires disclosure in interim financial statements of the fair value disclosures required annually by SFAS 107 “Disclosure about Fair Value of Financial Statements.” This FSP is effective
for interim and annual reporting periods ending after June 15, 2009. The adoption of FSP FAS 107-1 and APB 28-1 will result in additional disclosures, but will have no effect on the operating results of the Company.
In December 2008, the FASB issued FSP FAS 132(R)-1, “Employers’ Disclosures about Postretirement Benefit Plan Assets,” which provides guidance on employers’ disclosures about plan assets of defined benefit pension or other postretirement plans. This FSP is intended to address a lack of transparency surrounding
the types of assets and associated risks in an employer’s defined benefit pension or other postretirement plans. The plan asset disclosures required by this FSP are effective for fiscal years ending after December 15, 2009. The adoption of FSP FAS 132(R)-1 will result in additional disclosures, but will have no effect on the operating results of the Company.
In December 2007, the FASB issued SFAS No. 141 (revised 2007), “Business Combinations,” a replacement of SFAS No. 141, “Business Combinations”. SFAS 141(R) 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(R) 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 had no 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 ended March 31, 2009 and 2008 is presented below.
Individual lines in the above tables are defined as follows:
The Company’s operations consist of a property and casualty insurance segment and a reinsurance segment. The property and casualty insurance segment writes both commercial and personal lines of insurance, with a focus on medium-sized commercial accounts. The reinsurance segment provides reinsurance for other insurers
and reinsurers. The segments are managed separately due to differences in the insurance products sold and the business environments in which they operate.
Summarized financial information for the Company’s segments is as follows:
The following table displays the net premiums earned of the property and casualty insurance segment and the reinsurance segment for the three months ended March 31, 2009 and 2008, by line of business.
The actual income tax expense for the three months ended March 31, 2009 and 2008 differed from the “expected” income tax expense 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 March 31, 2009 or 2008. The Company did not recognize any interest or other penalties related to U.S. federal or state income taxes during the three months ended March 31, 2009 or 2008. It is the Company’s 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 2005.
The components of net periodic benefit cost for Employers Mutual’s pension and postretirement benefit plans is as follows:
Net periodic pension benefit cost allocated to the Company amounted to $1,250,089 and $353,337 for the three months ended March 31, 2009 and 2008, respectively. Net periodic postretirement benefit cost allocated to the Company amounted to $183,243 and $188,077 for the three months ended March 31, 2009 and 2008, respectively.
Employers Mutual plans to contribute approximately $2,800,000 to the VEBA trust and approximately $25,000,000 to the pension plan in 2009. As of March 31, 2009, Employers Mutual has not made a contribution to the pension plan or the postretirement benefit plan’s 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 stock option plans and its non-employee director stock purchase plan. Employers Mutual generally purchases common stock on the open market to fulfill its obligations under its employee stock purchase plan.
Employers Mutual maintains three separate 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 Company’s common stock have been reserved for issuance under the 1993 Employers Mutual Casualty Company Incentive Stock Option Plan (1993 Plan),
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) and a total of 2,000,000 shares have been reserved for issuance under the 2007 Employers Mutual Casualty Company Stock Incentive Plan (2007 Plan).
The 1993 Plan and the 2003 Plan provide for awards of incentive stock options only, while 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. All
three plans provide for 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 now that Employers Mutual is utilizing the 2007 Plan. Options granted under the plans generally have a vesting period of five years, with options becoming exercisable in equal annual cumulative increments commencing on the first anniversary of the option grant. Option prices cannot be less than the
fair value of the common stock on the date of grant.
The Senior Executive Compensation and Stock Option Committee (the “Committee”) of Employers Mutual’s Board of Directors (the “Board”) grants the awards and is the administrator of the plans. The Company’s Compensation Committee must consider and approve all awards granted to the Company’s
senior executive officers.
The Company recognized compensation expense from these plans of $144,276 ($108,127 net of tax) and $82,238 ($79,755 net of tax) for the three months ended March 31, 2009 and 2008, respectively. The Company recognized compensation expense of $9,360 ($6,084 net of tax) during the three months ended March 31, 2008, related to a separate
stock appreciation rights agreement that is accounted for as a liability-classified award. No compensation expense was recognized for this agreement during the three months ended March 31, 2009 due to the terms of the agreement. During the first three months of 2009, 304,400 non-qualified stock options with tandem stock appreciation rights were granted under the 2007 Plan to eligible participants at a price of $18.865. Up to one-half of the non-qualified stock options granted
may be exercised as stock appreciation rights, but only if done in conjunction with the exercise of a non-qualified stock option. During the three months ended March 31, 2009, 3,450 options were exercised under the plans at a price of $12.6875.
The weighted average fair value of options granted during the three months ended March 31, 2009 and 2008 amounted to $2.30 and $2.77, respectively. The fair value of each option grant is estimated on the date of grant using the Black-Scholes-Merton option-pricing model and the following weighted-average assumptions:
The expected term of the options granted in 2009 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 2.6 years.
The expected volatility in the price of the underlying shares for the 2009 option grant was computed by using the historical average high and low monthly prices of the Company’s common stock for a period covering 6.3 years, which approximates the average term of the options and produced an expected volatility of 22.7 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 23.4 percent to 43.8 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 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 Company’s 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 Company’s 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 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 Company’s portfolio that is on this list is classified as a Level 3 fair value measurement. At
March 31, 2009, the Company did not hold any fixed maturity securities that were priced solely from broker quotes.
A small number of the Company’s securities are not priced by the independent pricing service. These securities are reported as Level 3 fair value measurements, since no reliable observable inputs are used in their valuations. The largest of these investments is the Class B shares of Insurance Services Office Inc.
(ISO). Prior to the fourth quarter of 2008, the Company reported this investment at the fair value obtained from the Securities Valuation Office (SVO) of the NAIC. The SVO establishes a per share price for ISO Class B shares by averaging all Class B trades during the past year and reviewing the quarterly valuations of the Class A shares produced by a nationally recognized independent firm (the Class B shares were assigned a 40 percent marketability discount from the fair value of the Class
A shares). The SVO valuation is typically performed twice a year, and resulted in a fair value of $10,180,245 for the Class B shares held by the Company at December 31, 2007. During the fourth quarter of 2008, the Company modified the valuation process for this investment by implementing a 20 percent marketability discount from the fair value of the Class A shares. This reduction in the marketability discount was implemented in recognition of a Form S-1 filing made by ISO with
the Securities and Exchange Commission during 2008 in preparation for a planned initial public offering. At the completion of the initial public offering, ISO will continue to have two classes of stock; however, there will be a defined conversion plan that will result in all Class B shares being converted into Class A shares within 30 months. As a result, the marketability discount associated with the Class B shares will be well below the 20 percent discount utilized by the Company at year-end. In
addition, the Company has a commitment from ISO that the offering price for the initial public offering will not be less than the fair value of the shares as determined by the nationally recognized independent firm. Applying a 20 percent marketability discount to the third quarter valuation of the Class A shares performed by the nationally recognized independent firm resulted in a fair value of $14,965,502 for the Class B shares at December 31, 2008 and March 31, 2009. The other equity security
included in the Level 3 fair value measurement category continues to be reported at the fair value obtained from the SVO. The SVO establishes a per share price for this security based on an annual review of that company’s 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 December 31, 2008 and March 31, 2009.
The remaining two securities not priced by the Company’s independent pricing service at March 31, 2009 are fixed maturity securities. The two fixed maturity securities are classified as Level 2 fair value measurements and are carried at aggregate fair values of $7,245,646 at March 31, 2009 and $7,162,662 at December 31, 2008. The
fair values for these two fixed maturity securities were obtained from the Company’s investment custodian using an independent pricing service which utilizes similar pricing techniques as the Company’s independent pricing service.
The estimated fair values obtained from the independent pricing sources are reviewed by the Company for reasonableness and any discrepancies are investigated for final valuation. For fixed maturity securities, this includes comparing valuations from the independent pricing source, the Company’s investment custodian, the SVO,
and an analytical service for fixed maturity securities. For equity securities, a similar comparison is done between the valuations from the independent pricing service, the Company’s investment custodian, and the SVO. From these comparisons, material variances are identified and resolved to determine the final valuation used in the financial statements.
The Company’s fixed maturity and equity securities available-for-sale, as well as 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 Company’s assets that are
measured at fair value on a recurring basis, as of March 31, 2009.
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 months ended March 31, 2009. 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 net income.
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 Company’s share of case loss reserves eliminated by the purchase of these annuities was $1,881,645
at December 31, 2008. The Company has a contingent liability of $1,881,645 at December 31, 2008 should the issuers of these annuities fail to perform. The probability of a material loss due to failure of performance by the issuers of these annuities is considered remote. The Company’s 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 Company’s Board of Directors authorized a $15,000,000 stock repurchase program. This program became effective immediately and does not have an expiration date. The timing and terms of the purchases will be determined by management based on market conditions and will be 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. On October 31, 2008, the Company’s Board of Directors announced an extension of the stock repurchase program, authorizing an additional $10,000,000. As of March 31, 2009, 601,119 shares of common stock had been repurchased at a cost of $14,968,727.
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
(Unaudited)
The term “Company” is used below interchangeably to describe EMC Insurance Group Inc. (Parent Company only) and EMC Insurance Group Inc. and its subsidiaries. The following discussion and analysis of the Company’s 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 Management’s Discussion and Analysis of Financial Condition and Results of Operations section of the Company’s 2008 Form 10-K.
CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS
The Private Securities Litigation Reform Act of 1995 provides issuers the opportunity to make cautionary statements regarding forward-looking statements. Accordingly, any forward-looking statement contained in this report is based on management’s current beliefs, assumptions and expectations of the Company’s future
performance, taking into account all information currently available to management. These beliefs, assumptions and expectations can change as the result of many possible events or factors, not all of which are known to management. If a change occurs, the Company’s business, financial condition, liquidity, results of operations, plans and objectives may vary materially from those expressed in the forward-looking statements. The risks and uncertainties that may affect the
actual results of the Company include, but are not limited to, the following:
Management intends to identify forward-looking statements when using the words “believe”, “expect”, “anticipate”, “estimate”, “project” or similar expressions. Undue reliance should not be placed on these forward-looking statements.
COMPANY OVERVIEW
The Company, a 59.3 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 operations are conducted through three subsidiaries and represent the most significant segment of the Company’s business, totaling approximately 82 percent of consolidated premiums earned during the first three months of 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.
Reinsurance operations are conducted through EMC Reinsurance Company, and represented approximately 18 percent of consolidated premiums earned during the first three months of 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 Germany-based assumed reinsurance business on a direct basis as a result of regulatory changes in Germany.
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
The Company has historically reported on a quarterly basis the amount of development (both favorable and adverse) experienced on prior years’ reserves. Because of the potential for confusion among investors regarding the perceived impact development has on the Company’s results of operations, management has determined
that beginning in the second quarter, quarterly development amounts will not be disclosed.
To understand the rationale supporting this decision, it is necessary to have a proper understanding of the Company’s reserving process. Management does not use accident year loss picks to establish the Company’s carried reserves. Case loss and incurred but not reported (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. 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.
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 and certain 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 and bulk loss reserves. These components collectively comprise management’s best estimate of the loss and settlement expense reserve.
When an individual claim is settled, development occurs if the claim is settled for more or less than the carried reserve. The impact that development associated with prior accident year individual case loss reserves has on the Company’s results of operations may be misinterpreted, however, because management monitors the
overall adequacy of the case loss reserves on a quarterly basis and makes adjustments to the bulk case loss reserve, if necessary, to maintain a consistent level of overall case loss reserve adequacy.
Development associated with bulk reserves (i.e., IBNR reserves, bulk case loss reserves and settlement expense reserves) further complicates the issue because these reserves are established in total and are then allocated to the various accident years for financial reporting purposes. At each quarterly reporting date, a certain portion of
these bulk reserves are re-allocated from prior accident years to the current accident year. This re-allocation of the bulk reserves will generate development in each prior accident year’s results because the decrease in any prior accident year’s reserve amount will likely differ from the change in that prior accident year’s paid amount. As a result, development resulting from the re-allocation of bulk reserves between accident years is merely a by-product of that process
and does not have any impact on the Company’s combined ratio or results of operations, because the total amount of the bulk reserves has not changed.
It is management’s intention to continue to apply the current reserving methodology on a consistent basis. For that reason and the reasons noted above, management believes that the composition of the Company’s underwriting results between the current and prior accident years creates potential for misinterpretation and,
in any event, is not material or relevant to an understanding of the Company’s results of operations. From management’s perspective, the more important issue is where the Company’s reserves fall within the range of actuarial indications. In other words, if reserves are maintained at a consistent level of adequacy (and all else remains equal), then development should continue at roughly the same level in future years. Therefore, the source of earnings (current
or prior accident years) is not relevant.
CRITICAL ACCOUNTING POLICIES
The accounting policies considered by management to be critically important in the preparation and understanding of the Company’s financial statements and related disclosures are presented in the Management’s Discussion and Analysis of Financial Condition and Results of Operations section of the Company’s 2008
Form 10-K.
RESULTS OF OPERATIONS
Segment information and consolidated net income for the three months ended March 31, 2009 and 2008 are as follows:
The Company reported net income of $5,804,000 ($0.44 per share) for the three months ended March 31, 2009, compared to $8,219,000 ($0.60 per share) for the same period in 2008. This decline in net income is primarily attributed to a significant increase in “other-than-temporary” investment impairment losses, which totaled $8,357,000
($0.41 per share after tax) in the first quarter of 2009 compared to $2,902,000 ($0.14 per share after tax) in the first quarter of 2008. The large increase in investment impairment losses was partially offset by a decline in catastrophe and storm losses, which totaled $3,712,000 ($0.18 per share after taxes) in the first quarter of 2009, compared to $5,730,000 ($0.27 per share after taxes) in the first quarter of 2008.
Premiums Earned
Premiums earned decreased 2.7 percent to $92,455,000 for the three months ended March 31, 2009 from $94,978,000 for the same period in 2008. This decrease is primarily attributed to the moderate, but steady, decline in the property and casualty insurance segment’s overall premium rate levels that has occurred during the past
few years as a result of competitive market conditions associated with the current soft market. Premium rates showed some signs of stabilization toward the end of 2008 and that trend continued in the first quarter of 2009. Management expects premium rates to begin firming during the second half of 2009 due to the large decline in capital experienced by the insurance industry in 2008 and ongoing uncertainty of future investment returns; however, due to the lagging effect of prior
rate level reductions the Company’s overall premium rate level is expected to decline approximately 3.5 percent in 2009.
Premiums earned for the property and casualty insurance segment decreased 3.8 percent to $76,082,000 for the three months ended March 31, 2009 from $79,090,000 for the same period in 2008. This decrease in premium income is primarily the result of the continued decline in overall premium rate levels. Other contributing
factors are the lack of growth in insured exposures that has resulted from the economic recession and strategic decisions to reduce the Company’s personal lines presence in certain territories. New business policy counts are mixed for the first three months of 2009 as compared to 2008, with commercial lines down 9.9 percent and personal lines up 19.2 percent; however, both commercial lines and personal lines new business premium increased (4.1 percent and 18.8 percent, respectively). 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 declining slightly to 86.1 percent, and personal auto and property increasing to 88.3 percent and 86.8 percent, respectively. During the first three months of 2009, new business premium was not sufficient to offset the premium lost from declining rate levels and business
not retained, resulting in a 3.2 percent decline in written premiums.
Premiums earned for the reinsurance segment increased 3.1 percent to $16,373,000 for the three months ended March 31, 2009 from $15,888,000 for the same period in 2008. This increase is primarily associated with a moderate increase in reinsurance premium rates, an increase in reinstatement premium income and the addition of a few
new accounts. These increases were largely offset by a decline in business assumed from the Mutual Reinsurance Bureau (MRB) pool and a decrease in the estimate of earned but not reported (EBNR) premiums. Due to the loss of capital in the insurance industry from the economic recession, reinsurance premium rates have firmed (somewhat quicker than the firming in direct insurance premium rates) and the reinsurance segment obtained moderate increases on most of its renewals during the January
1st renewal season.
Losses and settlement expenses
Losses and settlement expenses decreased 10.4 percent to $53,777,000 for the three months ended March 31, 2009 from $60,007,000 for the same period in 2008. The loss and settlement expense ratio decreased to 58.2 percent for the three months ended March 31, 2009 from 63.2 percent for the same period in 2008. The decrease
in the loss and settlement expense ratio is attributed to a decline in catastrophe and storm losses to more normal levels (catastrophe and storm losses were elevated in each of the first three quarters of 2008 due to record storm activity) and improvements in the workers’ compensation and other commercial liability results for the property and casualty insurance segment. Partially offsetting these declines is the continued upward pressure on the loss and settlement expense ratio from past premium
rate declines becoming earned.
The loss and settlement expense ratio for the property and casualty insurance segment decreased to 53.7 percent for the three months ended March 31, 2009 from 60.2 percent for the same period in 2008. A return to more normal levels of catastrophe and storm losses and improved results in the workers’ compensation and other
commercial liability lines of business are the primary drivers of this improvement. Catastrophe and storm losses added 2.9 percentage points to the loss and settlement expense ratio during the first quarter of 2009 as compared to 7.1 percentage points for the same period in 2008. Past premium rate declines are estimated to have increased the loss and settlement expense ratio by approximately 2.4 percentage points in the first quarter of 2009, compared to approximately 4.0 percentage points
in the first quarter of 2008. Average claim frequency and severity were mixed for the first quarter of 2009, with average claim frequency down slightly and average claim severity up approximately 2 percentage points.
The loss and settlement expense ratio for the reinsurance segment increased to 79.0 percent for the three months ended March 31, 2009 from 77.9 percent for the same period in 2008. This increase reflects an increase in the amount of large losses reported through excess per risk contracts, which is consistent with industry trends
being experienced. Higher catastrophe and storm losses are also contributing to the increase in the loss and settlement expense ratio including, most notably, reported losses from two Kentucky storm events.
Acquisition and other expenses
Acquisition and other expenses increased 9.1 percent to $34,971,000 for the three months ended March 31, 2009 from $32,055,000 for the same period in 2008. The acquisition expense ratio increased to 37.8 percent for the three months ended March 31, 2009 from 33.7 percent for the same period in 2008. This increase is
attributed to the property and casualty insurance segment and primarily reflects higher expenses for policyholder dividends and postretirement benefits. A decline in commission and contingent commission expenses in the reinsurance segment partially offset the increase in expenses in the property and casualty insurance segment.
For the property and casualty insurance segment, the acquisition expense ratio increased to 41.4 percent for the three months ended March 31, 2009 from 35.0 percent for the same period in 2008. This increase is primarily attributed to higher expenses for policyholder dividends and postretirement benefits, which were partially offset
by a decline in agents’ contingent commission expense. The increase in policyholder dividend expense is largely due to increases in the estimated dividend payable on several of the Company’s safety dividend groups and an increase in the estimated aggregate total dividends payable on individual workers’ compensation policies. The increase in postretirement benefits expense is due to a significant increase in the amount of actuarial losses being amortized and a decrease in
the expected return on plan assets, both resulting from the severe decline in the financial markets during 2008.
For the reinsurance segment, the acquisition expense ratio decreased to 21.3 percent for the three months ended March 31, 2009 from 27.7 percent for the same period in 2008. The relatively high ratio in the first quarter of 2008 was caused by an increase in the estimate of commission expense on earned but not reported premiums. The
ratio for the first quarter of 2009 reflects a decline in contingent commissions.
Investment results
Net investment income increased 2.8 percent to $12,277,000 for the three months ended March 31, 2009 from $11,940,000 for the same period in 2008. This increase is primarily associated with the purchase of high quality commercial and residential mortgage-back securities at significantly discounted prices and the redeployment of
over $165 million of proceeds from called U.S. Government Agency securities into higher yielding corporate securities during 2008. During the first quarter of 2009, the Company again experienced a high level of call activity on its U.S. Government Agency securities as a result of the low interest rate environment. The proceeds from these called securities are being invested in short-term securities until attractive long-term opportunities can be identified.
The Company reported net realized investment losses of $8,592,000 and $2,912,000 for the three months ended March 31, 2009 and 2008, respectively. These losses are primarily comprised of “other-than-temporary” investment impairment losses totaling $8,357,000 on 24 equity securities and one fixed maturity security in
2009, and $2,902,000 on 13 equity securities in 2008. The impairment losses on the equity securities are a result of the severe and prolonged turmoil in the financial markets. The impairment loss on the fixed maturity security ($2,220,000) is attributed to a bankruptcy filing made by Great Lakes Chemical Corporation, now known as Chemtura Corporation.
The total rate of return on the Company’s equity portfolio for the first three months of 2009 was negative 8.9 percent, compared to a negative 11.0 percent for the S&P 500. The current annualized yield on the bond portfolio is 5.3 percent and the effective duration is 5.47 years, which are down from 5.6 percent and 5.57
years at December 31, 2008.
Income tax
Income tax expense decreased 60.5 percent to $1,123,000 for the three months ended March 31, 2009 from $2,841,000 for the same period in 2008. The effective tax rate for the three months ended March 31, 2009 was 16.2 percent, compared to 25.7 percent for the same period in 2008. The fluctuation in the effective tax rate
reflects the change in pre-tax income earned during these periods relative to the amount of tax-exempt interest income earned.
LIQUIDITY AND CAPITAL RESOURCES
Liquidity
Liquidity is a measure of a company’s ability to generate sufficient cash flows to meet cash obligations. The Company had negative cash flows from operations of $5,958,000 during the first three months of 2009 compared to positive cash flows of $5,368,000 for the same period in 2008. The negative cash flows of
2009 are largely due to the settlement of the pooling and qu | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||