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EMC Insurance Group 10-Q 2012 UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
For the quarterly period ended MARCH 31, 2012
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).
x 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.
TABLE OF CONTENTS
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS>
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
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
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
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
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
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, 2011 has been derived from the audited financial statements at that date; however, certain amounts have been adjusted as discussed below. The December 31, 2011 consolidated balance sheet does not include all of the information and notes required by GAAP for complete financial statements.
Certain amounts previously reported in the prior year’s consolidated financial statements have been reclassified or adjusted to conform to current year presentation. Most notable is a retrospective adjustment resulting from adoption of new accounting guidance related to deferred policy acquisition costs (see note 2 to these interim consolidated financial statements). The following tables provide a summary of the adjusted financial information.
In reading these financial statements, reference should be made to the Company’s 2011 Form 10-K or the 2011 Annual Report to Stockholders for more detailed footnote information.
2. TRANSACTIONS WITH AFFILIATES
Due to the large number of catastrophic events that exceeded the $3,000,000 retention amount contained in the excess of loss agreement between EMC Reinsurance Company and Employers Mutual in 2011, the terms of the agreement have been changed for fiscal year 2012. Effective January 1, 2012, the retention amount increased to $4,000,000 per event, while the cost of the protection remained at 10.0 percent of total assumed reinsurance premiums written.
3. REINSURANCE
The effect of reinsurance on premiums written and earned, and losses and settlement expenses incurred, for the three months ended March 31, 2012 and 2011 is presented below. The classification of the assumed and ceded reinsurance amounts between affiliates and nonaffiliates is based on the participants in the underlying reinsurance agreements, and is intended to provide a clear understanding of the true source of the reinsurance activities. This presentation differs from the classification used in the consolidated financial statements, where “affiliated balances” represent the net amount of all transactions flowing through the pooling and quota share agreements with Employers Mutual.
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, 2012 and 2011, by line of insurance.
5. INCOME TAXES
The actual income tax expense for the three months ended March 31, 2012 and 2011 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:
The Company had no provision for uncertain tax positions at March 31, 2012 or December 31, 2011. 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, 2012 or 2011. 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 2009.
6. EMPLOYEE RETIREMENT PLANS
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 $1,099,398 and $797,973 for the three months ended March 31, 2012 and 2011, respectively. Net periodic postretirement benefit cost allocated to the Company amounted to $821,796 and $527,794 for the three months ended March 31, 2012 and 2011, respectively.
Employers Mutual plans to contribute approximately $22,000,000 to the pension plan and $5,500,000 to the Voluntary Employee Beneficiary Association trust in 2012. The Company’s share of these contributions, if made, will be approximately $6,731,000 and $1,590,000, respectively.
7. STOCK-BASED COMPENSATION
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 option plan. Employers Mutual generally purchases common stock on the open market to fulfill its obligations under its employee stock purchase plan.
Stock Option Plans
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 permitted 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 $77,287 ($52,695 net of tax) and $70,243 ($50,104 net of tax) for the three months ended March 31, 2012 and 2011, respectively. During the first quarter of 2012, 263,161 non-qualified stock options were granted under the 2007 Plan to eligible participants at a price of $20.98, and 13,440 options were exercised under the plans at prices ranging from $16.88 to $19.35.
The weighted average fair value of options granted during the three months ended March 31, 2012 and 2011 amounted to $3.83 and $4.44, 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 2012 to individuals who were not eligible to retire as of the grant date 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 used for options granted to individuals who were eligible to retire as of the grant date was three months, reflecting the fact that upon retirement all unvested options immediately become vested, and the option holder has 90 days to exercise his or her outstanding options. This produced a weighted-average expected term of 3.53 years.
The expected volatility of options granted in 2012 to individuals who were not eligible to retire as of the grant date 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. This produced an expected volatility of 44.7 percent. The expected volatility of options granted to individuals who were eligible to retire as of the grant date was computed by using the historical daily prices for a three month period. This produced an expected volatility of 25.2 percent. The weighted-average volatility of the 2012 option grant was 35.61 percent.
Stock Appreciation Rights (SAR) agreement
No compensation expense was recognized during the three months ended March 31, 2012 and 2011 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 amount contained in the agreement.
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, 2012 and December 31, 2011.
The estimated fair value of the surplus notes is derived by discounting future expected cash flows at a rate deemed appropriate. The discount rate was set at the average of current yields-to-maturity on several insurance company surplus notes that are traded in observable markets, adjusted upward by 50 basis points to reflect illiquidity and perceived risk premium differences. Other assumptions include a 25 year term for the surplus notes (the surplus notes have no stated maturity date) and an interest rate that continues at the current rate (the rate is typically adjusted every five years and is based upon the then-current Federal Home Loan Bank borrowing rate for 5-year funds available to Employers Mutual).
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, subject to an internal validation. 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. Fixed maturity securities in the Company’s portfolio may 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 source 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. For these securities, fair value may be determined using the broker quotes, or by the Company using similar pricing techniques as the Company’s independent pricing service. Depending on the level of observable inputs, these securities would be classified as Level 2 or Level 3 fair value measurements. At March 31, 2012 and December 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, 2012 and December 31, 2011, 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 $2,250 at March 31, 2012 and December 31, 2011. The other securities not priced by the Company’s independent pricing service at March 31, 2012 are two fixed maturity securities (one fixed maturity security was not priced by the Company’s independent pricing service at December 31, 2011). These fixed maturity securities are classified as Level 2 fair value measurements. 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 Company’s fixed maturity and equity securities available-for-sale, as well as short-term investments, are measured and reported in the Consolidated Balance Sheets 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 estimated fair values of the Company’s financial instruments as of March 31, 2012 and December 31, 2011.
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