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EMC Insurance Group 10-Q 2011 UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
For the quarterly period ended MARCH 31, 2011
OR
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 o 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).
o Yes o 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).
o 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.
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS>
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Unaudited)
All affiliated balances presented above are the result of related party transactions with Employers Mutual.
See accompanying Notes to Consolidated Financial Statements.
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Unaudited)
All affiliated balances presented above 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 INCOME
(Unaudited)
All affiliated balances presented above 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)
All affiliated balances presented above 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 CASH FLOWS
(Unaudited)
All affiliated balances presented above 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 CASH FLOWS, CONTINUED
All affiliated balances presented above are the result of related party transactions with Employers Mutual.
See accompanying Notes to Consolidated Financial Statements.
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
1. BASIS OF PRESENTATION
EMC Insurance Group Inc., a 61 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. The Company has evaluated all subsequent events through the date the financial statements were issued. 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, 2010 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 2010 Form 10-K or the 2010 Annual Report to Stockholders for more detailed footnote information.
2. NEW ACCOUNTING PRONOUNCEMENTS
In October 2010, the Financial Accounting Standards Board (FASB) updated its guidance related to Insurance Topic 944 of the FASB Accounting Standards Codification TM (ASC) to clarify which costs associated with the acquisition of insurance contracts should be capitalized and deferred for recognition during the coverage period. This guidance specifies that only incremental costs or costs directly related to the successful acquisition of new or renewal insurance contracts are to be capitalized as a deferred acquisition cost. Currently, industry practice is such that deferred costs typically also include costs related to unsuccessful insurance contract acquisitions. This guidance is effective for annual reporting periods (and interim reporting periods of those annual reporting periods) beginning on or after December 15, 2011, and may be adopted prospectively or retrospectively. Adoption of this guidance will have an impact on the consolidated financial position and operating results of the Company since certain costs associated with contract acquisition that are currently deferred will not likely meet the criteria for deferral under the new guidance. The Company has not yet established an estimate of the impact this statement will have on its financial statements.
In July 2010, the FASB updated its guidance related to Receivables Topic 310 of the ASC to require additional disclosures regarding credit risk exposures and the allowance for credit losses, as well as a description of the accounting policies and methodology used to estimate the liability for off-balance-sheet credit risk exposures and related charges. The additional disclosures required at the end of a reporting period were effective for interim and annual reporting periods ending on or after December 15, 2010, and the additional disclosures required about activity that occurs during a reporting period are effective for interim and annual reporting periods beginning on or after December 15, 2010. Adoption of this guidance resulted in some additional disclosures at year-end 2010, but had no effect on the consolidated financial position or operating results of the Company.
In January 2010, the FASB updated its guidance related to the Fair Value Measurements and Disclosures Topic 820 of the ASC to require additional disclosures regarding transfers in and out of fair value measurement Levels 1 and 2, the display of Level 3 activity on a gross basis (rather than net), fair value measurement disclosures for each class of assets and liabilities (rather than by line item within the statement of financial position), and additional disclosures about inputs and valuation techniques. This guidance was effective for interim and annual reporting periods beginning after December 15, 2009, except for the disclosures about purchases, sales, issuances, and settlements in the roll forward of activity in Level 3 fair value measurements, which is effective for fiscal years (and interim periods of those fiscal years) beginning after December 15, 2010. Adoption of this guidance had no effect on the consolidated financial position or operating results of the Company.
3. REINSURANCE
The effect of reinsurance on premiums written and earned, and losses and settlement expenses incurred, for the three months ended March 31, 2011 and 2010 is presented below.
Individual lines in the above tables are defined as follows:
4. SEGMENT INFORMATION>
The Company’s operations consist of a property and casualty insurance segment and a reinsurance segment. The property and casualty insurance segment writes both commercial and personal lines of insurance, with a focus on medium-sized commercial accounts. The reinsurance segment provides reinsurance for other insurers and reinsurers. The segments are managed separately due to differences in the insurance products sold and the business environment in which they operate.
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, 2011 and 2010, by line of insurance.
The actual income tax expense for the three months ended March 31, 2011, and 2010 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) as follows:
As a result of the Patient Protection and Affordable Care Act (H.R. 3590) and the follow-up Health Care and Education Reconciliation Act of 2010 (H.R. 4872) signed into law on March 23, 2010 and March 30, 2010, respectively (the “Acts”), beginning in 2013 the Company will no longer be able to claim a tax deduction for drug expenses that are reimbursed under the Medicare Part D retiree drug subsidy program. Although this tax change does not take effect until 2013, the Company was required to recognize the financial impact of this tax change in the period in which the Acts were signed. As a result of the Acts, the Company recognized a decrease in its deferred tax asset of $794,383 during the first quarter of 2010.
The Company had no provision for uncertain tax positions at March 31, 2011 or December 31, 2010. 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, 2011 or 2010. It is the Company’s accounting policy to reflect income tax penalties as other expense, and interest as interest expense.
The Company files a U.S. federal tax return, 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 Company’s U.S. federal tax returns for tax years 2005 through 2008 are currently being audited. No additional tax liability is expected from these audits.
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 $797,973 and $1,017,441 for the three months ended March 31, 2011 and 2010, respectively. Net periodic postretirement benefit cost allocated to the Company amounted to $527,794 and $409,932 for the three months ended March 31, 2011 and 2010, respectively.
Employers Mutual plans to contribute approximately $22,000,000 to the pension plan and $4,000,000 to the VEBA trust in 2011. The Company’s share of these contributions would be approximately $6,750,000 and $1,122,000, respectively. As of March 31, 2011, 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 permit the issuance of incentive stock options only, while the 2007 Plan permits the issuance 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 awards. 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 executive officers.
The Company recognized compensation expense from these plans of $70,243 ($50,104 net of tax) and $67,361 ($54,617 net of tax) for the three months ended March 31, 2011 and 2010, respectively. No compensation expense was recognized during the three months ended March 31, 2011 and 2010 related to a separate stock appreciation rights agreement that is accounted for as a liability-classified award because the fair value of the award did not exceed the floor contained in the agreement. During the first three months of 2011, 302,180 non-qualified stock options were granted under the 2007 Plan to eligible participants at a price of $24.405. During the three months ended March 31, 2011, 26,431 options were exercised under the plans at prices ranging from $11.38 to $20.68.
The weighted average fair value of options granted during the three months ended March 31, 2011 and 2010 amounted to $4.44 and $1.77, respectively. Employers Mutual estimated the fair value of each option grant 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 2011 was estimated using historical data that excluded certain option exercises that occurred prior to the normal vesting period due to the retirement of the option holders. 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 2.99 years.
The expected volatility of options for the 2011 option grant was computed by using the historical daily prices of the Company’s common stock for a period covering 6.4 years, which approximates the average term of the options, which produced an expected volatility of 43.7 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 daily prices for the period approximating the expected term of those options. This produced expected volatility ranging from 20.9 percent to 51.2 percent. Prior to 2011, expected volatilities were calculated, in most instances, using historical high and low average monthly prices of the Company’s common stock. This produced expected volatilities that were typically lower than those calculated in 2011 using daily prices. Due to the higher expected volatilities used in the valuations of the options in the 2011 grant, the fair values of the granted options are higher, which in turn produces higher stock compensation expense.
8. DISCLOSURES ABOUT THE FAIR VALUE OF FINANCIAL INSTRUMENTS>
The carrying amount and the estimated fair value of the Company’s financial instruments is summarized below.
The estimated fair value of fixed maturity securities, equity securities and short-term investments is based on quoted market prices, where available. In cases where quoted market prices are not available, fair values are based on a variety of valuation techniques depending on the type of security.
Other long-term investments, consisting primarily of holdings in limited partnerships and limited liability companies, are valued by the various fund managers. In management’s opinion, these values reflect fair value at March 31, 2011 and December 31, 2010.
The fair value of the surplus notes is estimated using discounted cash flow analysis based on what the Company’s current incremental borrowing rate would be for similar debt obligations.
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. The following fair value hierarchy prioritizes inputs to valuation techniques used to measure fair value:
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, if any, 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, 2011, 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. One is an equity security that is reported as a Level 3 fair value measurement at March 31, 2011 and December 31, 2010, since no reliable observable inputs are used in its valuation. This equity security continues to be reported at the fair value obtained from the Securities Valuation Office (SVO) of the National Association of Insurance Commissioners (NAIC). 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 $2,130 at March 31, 2011 and December 31, 2010. The remaining securities not priced by the Company’s independent pricing service are fixed maturity securities. These fixed maturity securities are classified as Level 2 fair value measurements and are carried at aggregate fair values of $2,958,676 at March 31, 2011 and $12,914,542 at December 31, 2010. The fair values for these fixed maturity securities were obtained from the Company’s investment custodian using independent pricing services which utilize 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. This includes comparing valuations from the independent pricing source, the Company’s investment custodian and the SVO. From these comparisons, material variances are identified and resolved to determine the final valuations 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, 2011 and December 31, 2010.
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