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Mercer Insurance Group 10-K 2009 Documents found in this filing:
U.S. SECURITIES AND EXCHANGE
COMMISSION
Washington, D.C.
20549
Commission file number
000-25425
10 North Highway 31
P.O. Box 278
Pennington, NJ 08534
(Address of principal executive
offices)
Registrant’s telephone number, including area code:
(609) 737-0426
SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE
ACT:
None
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE
ACT:
Common Stock (no par value)
Title of Each Class:
Indicate by check mark if the registrant is a well-known
seasoned issuer, as defined in Rule 405 of the Securities
Act. Yes o No þ
If this report is an annual or transition report, indicate by
check mark if the registrant is not required to file reports
pursuant to Section 13 or 15(d) of the Securities Exchange
Act of
1934. Yes o No þ
Indicate by check mark whether the registrant (1) has filed
all reports required to be filed by Section 13 or 15(d) of
the Securities Exchange Act of 1934 during the preceding
12 months and (2) has been subject to such filing
requirements for the past
90 days. Yes þ No o
Indicate by check mark if disclosure of delinquent filers
pursuant to Item 405 of
Regulation S-K
is not contained herein, and will not be contained, to the best
of registrant’s knowledge, in definitive proxy or
information statements incorporated by reference in
Part III of this
Form 10-K
or any amendment to this
Form 10-K. o
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. (Check one):
Indicate by check mark whether the registrant is a shell company
(as defined in
Rule 12b-2
of the Exchange
Act). Yes o No þ
The aggregate market value of the voting and non-voting common
stock held by non-affiliates (computed by reference to the price
at which the common stock was last sold) as of the last business
day of the Registrant’s most recently completed second
fiscal quarter was: $113,262,359.
Indicate the number of shares outstanding of each of the
registrant’s classes of common stock as of March 2,
2009. Common Stock, no par value: 6,443,560.
Portions of the definitive Proxy Statement for the 2009 Annual
Meeting of Shareholders are incorporated by reference in
Part III of this
Form 10-K.
FORM 10-K
For the
Year Ended December 31, 2008
PART I
Mercer Insurance Group, Inc. (the “Holding Company”,
the “Company”, or “MIG”) is a holding
company which resulted from the conversion of Mercer Mutual
Insurance Company from the mutual to the stock form of
organization on December 15, 2003 (the
“Conversion”). Prior to the Conversion, and since
1844, Mercer Mutual Insurance Company was engaged in the
business of selling property and casualty insurance. Mercer
Mutual Insurance Company, a Pennsylvania domiciled company,
changed its name to Mercer Insurance Company immediately after
the Conversion, and became a subsidiary of the Holding Company.
Mercer Insurance Group, Inc. and subsidiaries (collectively, the
Group) includes Mercer Insurance Company (MIC), its subsidiaries
Queenstown Holding Company, Inc. (QHC) and its subsidiary Mercer
Insurance Company of New Jersey, Inc. (MICNJ), Franklin Holding
Company, Inc. (FHC) and its subsidiary Franklin Insurance
Company (FIC), and BICUS Services Corporation (BICUS), Financial
Pacific Insurance Group, Inc. (FPIG) and its subsidiaries,
Financial Pacific Insurance Company (FPIC) and Financial Pacific
Insurance Agency (FPIA), which is currently inactive. FPIG also
holds an interest in three statutory business trusts that were
formed for the purpose of issuing Floating Rate Capital
Securities.
MIG, through its property and casualty insurance subsidiaries,
provides a wide array of property and casualty insurance
products designed to meet the insurance needs of individuals in
New Jersey and Pennsylvania, and small and medium-sized
businesses throughout Arizona, California, Nevada, New Jersey,
Oregon and Pennsylvania. A limited amount of business is written
in New York to support accounts in adjacent states.
The Group’s operating subsidiaries are licensed
collectively in twenty two states, but are currently focused on
doing business in seven states; Arizona, California, Nevada, New
Jersey, New York, Pennsylvania and Oregon. MIC and MICNJ are
licensed to write property and casualty insurance in New York,
and write business there which supports existing accounts FPIC
holds an additional fifteen state licenses outside of the
Group’s current focus area. Currently, only direct mail
surety policies are being written in some of these states.
The insurance affiliates within the Group participate in a
reinsurance pooling arrangement (the “Pool”) whereby
each insurance affiliate’s underwriting results are
combined and then distributed proportionately to each
participant. FPIC joined the Pool effective January 1,
2006, after receiving regulatory approvals. Each insurer’s
share in the Pool is based on their respective statutory surplus
from the most recently filed statutory annual statement as of
the beginning of each year.
All insurance companies in the Group have been assigned a group
rating of “A” (Excellent) by A.M. Best. The Group
has been assigned that rating for the past 8 years. An
“A” rating is the third highest rating of
A.M. Best’s 16 possible rating categories.
The Group is subject to regulation by the insurance regulators
of each state in which it is licensed to transact business. The
primary regulators are the Pennsylvania Insurance Department,
the California Department of Insurance, and the New Jersey
Department of Banking and Insurance, because these are the
regulators for the states of domicile of the Group’s
insurance subsidiaries, as follows: MIC
(Pennsylvania-domiciled), FPIC (California-domiciled), MICNJ
(New Jersey-domiciled), and FIC (Pennsylvania-domiciled).
We manage our business and report our operating results in three
operating segments: commercial lines insurance, personal lines
insurance and the investment function. Assets are not allocated
to segments and are reviewed in the aggregate for
decision-making purposes. Our commercial lines insurance
business consists primarily of multi-peril, general liability,
commercial auto, surety and related insurance coverages. Our
personal lines insurance business consists primarily of
homeowners (in New Jersey and Pennsylvania) and private
passenger automobile (in Pennsylvania only) insurance coverages.
The Group markets its products through a network of
approximately 561 independent agents, of which approximately 277
are located in New Jersey and Pennsylvania, 224 in California,
and the balance in Arizona, Nevada and Oregon.
OUR
INSURANCE COMPANIES
MIC is a stock Pennsylvania insurance company originally
incorporated under a special act of the legislature of the State
of New Jersey in 1844 as a mutual insurance company. On
October 16, 1997, it filed Articles of Domestication with
Pennsylvania which changed its state of domicile from New Jersey
to Pennsylvania, and then subsequently changed its name to
Mercer Insurance Company after the Conversion in 2003. MIC owns
all of the issued and outstanding capital stock of QHC, which
owns all of the issued and outstanding capital stock of MICNJ.
MIC also owns 49% of the issued and outstanding stock of FHC,
which owns all of the issued and outstanding capital stock of
FIC. The remaining 51% of FHC is owned by MIG.
MIC is a property and casualty insurer of primarily small and
medium-sized businesses and property owners located in New
Jersey and Pennsylvania. It markets commercial multi-peril and
homeowners policies, as well as other liability, workers’
compensation, fire, allied, inland marine and commercial
automobile insurance. MIC does not market private passenger
automobile insurance in New Jersey. MIC is subject to
examination and comprehensive regulation by the Pennsylvania
Insurance Department. See “Business —
Regulation.”
MICNJ is a stock property and casualty insurance company that
was incorporated in 1981. It writes the same lines of business
as MIC, with its book of business predominantly located in New
Jersey. MICNJ is subject to examination and comprehensive
regulation by the New Jersey Department of Banking and
Insurance. See “Business — Regulation.”
FIC is a stock property and casualty insurance company that was
incorporated in 1997. MIC acquired 49% of FIC in 2001, with the
remaining 51% acquired by MIG as part of the Conversion
transaction in 2003. FIC currently offers private passenger
automobile and homeowners insurance to individuals located in
Pennsylvania. FIC is subject to examination and comprehensive
regulation by the Pennsylvania Insurance Department. See
“Business — Regulation.”
FPIC is a stock property and casualty company that was
incorporated in California in 1986 and commenced business in
1987. The Group acquired all of the outstanding stock of FPIG,
the holding company for FPIC, on October 1, 2005. FPIC is
based in Rocklin, California, and writes primarily commercial
package policies for small to medium-sized businesses in
targeted classes. It has developed specialized underwriting and
claims handling expertise in a number of classes of business,
including apartments, restaurants, artisan contractors and
ready-mix operators. FPIC’s business is heavily weighted
toward the liability lines of business (commercial multi-peril
liability, commercial auto) but also includes commercial
multi-peril property, commercial auto physical damage and surety
for small and medium-sized businesses. FPIC is licensed in
nineteen western states, and actively writes insurance (other
than its direct-marketed surety business) in four (Arizona,
California, Nevada and Oregon). FPIC is subject to examination
and comprehensive regulation by the California Department of
Insurance. See “Business — Regulation.”
The acquisition of FPIG has moved the Group closer to its goals
of a higher proportion of commercial lines premiums as well as
product and geographic diversity. As a west coast-based
commercial writer, the addition of FPIG resulted in an expansion
of our geographic scope and a meaningful line of business
diversification. We will
continue our efforts to pursue geographic and product line
diversification in order to diminish the importance of any one
line of business, class of business or territory.
In recent years, and including the FPIG acquisition, the Group
has taken steps to increase commercial premium volume, and we
will continue our focus on this goal. Growth in commercial lines
reduces our personal lines exposure as a percentage of our
overall exposure, which reduces the relative adverse impact that
weather-related property losses can have on us. Increased
commercial lines business also benefits us because we have
greater flexibility in establishing rates for these lines.
In order to attract and retain commercial insurance business, we
have developed insurance products and underwriting guidelines
specifically tailored to meet the needs of particular types of
businesses. These programs are continually refined and, if
successful, expanded based on input from our producers and our
marketing personnel. We are continually looking for new types of
business where we can apply this focus.
We have specialized pricing approaches
and/or
products designed for religious institutions, contracting,
apartment, restaurant, condominium and “main street”
accounts as well as various other types of risks. The products,
rates and eligibilities vary based on our opinion of the local
market opportunities for products in a given area.
We believe that there is an opportunity to increase our volume
of commercial business by working with our existing producers of
commercial lines business and forming and developing
relationships with new producers that focus on commercial
business. We believe an increasing share of this market is
desirable and attainable given our existing relationships with
our producers and our insureds.
For selected commercial lines products, we have developed
technology that will allow our agents to rate and bind
transactions via an internet-based rating system. Based on the
success of this technology, our goal would be to expand the
process to other products at some point in the future. We
launched this process in late 2008 in California and launched a
similar process for New Jersey and Pennsylvania agents in
January, 2009. We believe that there is an opportunity to
increase our commercial lines writings by expanding the use of
internet-based processing in 2009 and beyond.
We began writing our business owners policy in the California
territory in the fourth quarter of 2008. This product targets
small to medium sized businesses which we believe are somewhat
less price sensitive than larger accounts. This product will
also help to balance FPIC’s business between property and
casualty exposures. Additionally, a new contracting product
which specializes in covering artisan contractors is being
developed for Arizona, California, Nevada and Oregon and is
targeted for introduction in early 2009. Artisan contractors
primarily provide repair and maintenance services, and this
segment tends to experience less severe market fluctuations
compared to the real estate construction industry.
Both the California business owners and western states artisan
product will be transacted using an internet-based rating
process where agents will be able to rate and bind these
products, subject to pre-programmed underwriting criteria.
As of December 31, 2008, 2007 and 2006 our direct written
premiums were distributed as follows:
We hold twenty two state licenses, and we are currently focused
on doing business in primarily seven of these states (including
New York, where our activity is currently limited to supporting
accounts located in adjacent states). These state licenses
provide additional opportunity for future growth when market
opportunities dictate utilization of those licenses. If market
opportunities indicate desirable growth is available through the
acquisition of additional state licenses, we will pursue
licenses in new states.
We believe our insurance companies have a strong reputation with
producers and insureds for personal attention and prompt,
efficient service. This reputation has allowed us to foster our
relationships with many high volume producers. Several of these
producers focus primarily on commercial business and are located
in areas we have targeted as growth opportunities within our
territories. We intend to focus our marketing efforts on
maintaining and improving our relationships with these
producers, as well as on attracting new high-quality producers
in areas with a substantial potential for growth. We also intend
to continue to develop and tailor our commercial programs to
enable our products to meet the needs of the customers served by
our producers.
We are committed to improving our profitability by reducing
expenses through the use of enhanced technology, by increasing
our net premium revenue through the strategic deployment of our
capital and by prudently deploying our workforce to build
efficiencies in our processes.
We continue to reduce our reliance on reinsurance by increasing
our retention of business written by our insurance companies on
individual property and casualty risks. Our capital is best
utilized by retaining as much profitable business as practical.
We continually evaluate our reinsurance program to reduce the
cost and achieve the optimal balance between cost and protection.
We determine the appropriate level of reinsurance based on a
number of factors, which include:
A decrease in the use of reinsurance would result in a decrease
in ceded premiums and a corresponding increase in net premium
revenue, but would also potentially increase our losses from
claims that would previously have been reinsured. See
“Business — Reinsurance” for a description
of our reinsurance program.
COMMERCIAL
LINES PRODUCTS
The following table sets forth the direct premiums written, net
premiums earned, net loss ratios, expense ratios and combined
ratios of our commercial lines products on a consolidated basis
for the periods indicated. In 2007, the Group evaluated its
methodology for allocating costs to its lines of business and
adopted changes to such methodology in order to more accurately
reflect the allocation of joint costs. This resulted in
allocating less joint cost to the personal lines of business and
more joint cost to the commercial lines of business, but with no
net change in cost allocated to personal lines and commercial
lines in the aggregate. Related 2006 amounts have been
reclassified to reflect this change in allocation methodology:
We write a number of multi-peril policies providing property and
liability coverage. Various risk classes are written on this
policy.
We offer a business owners policy that provides property and
liability coverages to small businesses. This product is
marketed to several distinct groups: (i) apartment building
owners; (ii) condominium associations; (iii) business
owners who lease their buildings to tenants;
(iv) mercantile business owners, such as florists,
delicatessens, and beauty parlors; and (v) offices with
owner and tenant occupancies. We began writing this product in
our California territory in the fourth quarter of 2008.
We offer in New Jersey and Pennsylvania a specialized
multi-peril policy specifically designed for religious
institutions. This enhanced product offers directors and
officers coverage, religious counseling coverage and equipment
breakdown coverage (through a reinsurance arrangement). Coverage
for child care centers and schools is also available. We offer
versions of this product to individual religious institutions as
well as to denomination groups who seek coverage for
participating member institutions. This product is also
available in New York on a limited basis.
A custom underwritten commercial multi-peril package policy is
written in the western states for select contracting classes, as
well as small to medium-sized businesses within specified niche
markets. This product is focused on commercial accounts
primarily in non-urban areas that do not easily fit within a
generic business owner policy. The target markets for this
product include apartments, artisan and construction
contractors, farm labor operations, service contractors, and
mercantile (including restaurants) as well as various other risk
types. We expect to introduce a new specialized product for
artisan contractors in Arizona, California, Oregon and Nevada in
early 2009.
This product is designed to cover primarily trucks used in
business, as well as company-owned private passenger type
vehicles. Other specialty classes such as church vans, funeral
director vehicles and farm labor buses can also be covered. The
policy is marketed as a companion offering to our business
owners, commercial multi-peril, religious institution,
commercial property or general liability policies.
We also write heavy and extra heavy trucks through our refuse
hauler, aggregate hauler and ready-mix programs offered
principally in the western states and in Pennsylvania.
We write liability coverage for insureds who do not have
property exposure or whose property exposure is insured
elsewhere. The majority of these policies are written for
contractors such as carpenters, painters or electricians, who
often self-insure small property exposures. Coverage for both
premises and products liability exposures are regularly
provided. Coverage is available for other exposures such as
vacant land and habitational risks.
Commercial umbrella coverage and following form excess coverage
is available for insureds that insure their primary general
liability exposures with us through a business owners,
commercial multi-peril, religious institution or commercial
general liability policy. This coverage typically has limits of
$1 million to $10 million, but higher limits are
available if needed. To improve processing efficiencies and
maintain underwriting standards, we prefer to offer this
coverage as an endorsement to the underlying liability policy
rather than as a separate stand-alone policy, but both versions
are available.
We typically write workers’ compensation policies in
conjunction with an otherwise eligible business owners,
commercial multi-peril, religious institution, commercial
property or general liability policy. As of December 31,
2008, most of our workers’ compensation insureds have other
policies with us. Workers’ compensation is written
principally in New Jersey and Pennsylvania, with availability in
New York on a limited basis.
The Group, through FPIC, writes a mix of contract and
subdivision bonds as well as miscellaneous license and permit
bonds in our western states. Our bonds are distributed through
both our independent agents as well as a direct marketing effort
that includes on-line sales via our web-site Bondnow.com.
Fire and allied lines insurance generally covers fire, lightning
and extended perils. Inland marine coverage insures merchandise
or cargo in transit and business and personal property. We offer
these coverages for property exposures in cases where we are not
insuring the companion liability exposures. Generally, the rates
charged on these policies are higher than those for the same
property exposures written on a multi-peril or business owners
policy.
PERSONAL
LINES PRODUCTS
The following table sets forth the direct premiums written, net
premiums earned, net loss ratios, expense ratios and combined
ratios of our personal lines products on a consolidated basis
for the periods indicated. In 2007, the Group evaluated its
methodology for allocating costs to its lines of business and
adopted changes to such methodology in order to more accurately
reflect the allocation of joint costs. This resulted in
allocating less joint cost to the personal lines of business and
more joint cost to the commercial lines of business, but with no
net change in cost allocated to personal lines and commercial
lines in the aggregate. Related 2006 amounts have been
reclassified to reflect this change in allocation methodology:
Our homeowners policy is a multi-peril policy providing property
and liability coverages and optional inland marine coverage. The
homeowners policy is sold to provide coverage for an
insured’s residence. We market both a standard and a
preferred homeowner product. The preferred product is offered at
a discount to our standard rates to our customers who have a
lower risk of loss. This product is sold only in New Jersey and
Pennsylvania.
We write comprehensive personal automobile coverage including
liability, property damage and all state required insurance
minimums for individuals domiciled in Pennsylvania only. This
product is multi-tiered with an emphasis placed on individuals
with lower than average risk profiles. During 2008, we
introduced a new online rating system for agents to make it
easier for them to quote, sell, bind and service business.
Our combination dwelling product is a flexible, multi-line
package of insurance coverages. It is targeted to be written on
an owner or tenant occupied dwelling of no more than two
families. The dwelling policy combines property and liability
insurances but also may be written on a monoline basis. The
property portion is considered a fire, allied lines and inland
marine policy, and the liability portion is considered an other
liability policy. This product is available in both New Jersey
and Pennsylvania.
We write personal lines excess liability, or
“umbrella,” policies covering personal liabilities in
excess of amounts covered under our homeowners policies. These
policies are available generally with limits of $1 million
to $5 million. We do not market excess liability policies
to individuals unless we also write an underlying primary
liability policy.
A small portion of our workers’ compensation premiums are
considered personal lines insurance because our New Jersey
homeowners policy is required to include workers’
compensation coverage for domestic employees.
We market our insurance products exclusively through independent
producers, with the exception of a relatively small amount of
business within our surety book of business marketed online and
by direct mail. All of these producers represent multiple
carriers and are established businesses in the communities in
which they operate. They generally market and write the full
range of our insurance companies’ products. We consider our
relationships with our producers to be good. For the year ending
December 31, 2008, 2007 and 2006, there were no agents in
the Group that individually produced greater than 5% of the
Group’s direct written premiums.
We emphasize personal contact between our producers and the
policyholders. We believe that our producers’ fast and
efficient service and name recognition, as well as our
policyholders’ loyalty to and satisfaction with producer
relationships are the principal sources of new customer
referrals, cross-selling of additional insurance products and
policyholder retention.
Our insurance companies depend upon their producer force to
produce new business, to provide customer service, and to be
selective underwriters in their screening of risks for our
insurance companies to consider underwriting. The network of
independent producers also serves as an important source of
information about the needs of the communities served by our
insurance companies. We use this information to develop new
products and new product features.
Producers are compensated through a fixed base commission often
with an opportunity for profit sharing depending on the
producer’s aggregate premiums earned and loss experience.
Profit sharing opportunities are for a producer’s entire
book of business with the Group and not specifically for any
individual policy. The Group does not
have any marketing services agreements, placement services
agreements, or similar arrangements. By contract, our producers
represent one or more of the Group’s carriers. They are
monitored and supported by our marketing representatives, who
are employees of the Group. These marketing representatives also
have principal responsibility for recruiting and training new
producers.
Our insurance companies manage their producers through periodic
business reviews (with underwriter and marketing participation)
and establishment of benchmarks/goals for premium volume and
profitability. Our insurance companies in recent years have
terminated a number of underperforming producers.
Our marketing efforts are further supported by our claims
philosophy, which is designed to provide prompt and efficient
service, resulting in a positive experience for producers and
policyholders. We believe that these positive experiences are
then conveyed by producers and policyholders to many potential
customers.
Our insurance companies write their personal and commercial
lines by evaluating each risk with consistently applied
standards. We maintain information on all aspects of our
business that is regularly reviewed to determine product line
profitability. We also employ a staff of underwriters, who
specialize in either personal or commercial lines, and have
experience as underwriters in their specialized areas. Specific
information is monitored with regard to individual insureds to
assist us in making decisions about policy renewals or
modifications. New property risks are frequently inspected to
insure they are as desirable as suggested by the application
process.
We have recently introduced, for selected products, an automated
process for acceptance and rejection of small accounts through
an internet-based rating system. Based on the success of this
process, our goal would be to expand the process to other
products at some point in the future. Though there will be less
direct underwriter involvement, we are confident that
underwriting standards will continue to be maintained as risks
will continue to be subject to our standardized underwriting
verification processes, including physical inspections.
We rely on information provided by our independent producers.
Subject to certain guidelines, producers also pre-screen policy
applicants. The producers have the authority to sell and bind
insurance coverages in accordance with pre-established
guidelines in some, but not all cases, provided their historic
underwriting performance warrants such authority.
Producers’ results are continuously monitored, and
continued poor loss ratios often result in agency termination.
Claims on insurance policies are received directly from the
insured or through our independent producers. Claims are then
assigned to either an in-house adjuster or an independent
adjuster, depending upon the size and complexity of the claim.
The adjuster investigates and settles the claim. Our trend is to
manage an increasing higher proportion of our claims internally
without the use of independent adjusters where scale permits.
The Group also has a contingency plan for adjusting and
processing claims resulting from a natural catastrophe.
Claims settlement authority levels are established for each
claims adjuster based upon his or her level of experience.
Multi-line teams exist to handle all claims. The claims
department is responsible for reviewing all claims, obtaining
necessary documentation, estimating the loss reserves and
resolving the claims.
We attempt to minimize claims and related legal costs by
encouraging the use of alternative dispute resolution
procedures. Litigated claims are assigned to outside counsel for
many types of claims, however most litigated claims files
handled in our western state operations are managed by in-house
attorneys who have specialized training relating to construction
liability issues and other casualty risks. We believe this
arrangement reduces dramatically the cost of managing these
types of claims, as the use of in-house attorneys dramatically
reduces the cost of defense work.
The Group seeks to transact much of its business using
technology wherever possible and, in recent years, has made
significant investments in information technology platforms,
integrated systems and internet-based applications.
The focus of our ongoing information technology effort is:
We believe that our technology initiative may increase revenues
by making it easier for our insurance companies and producers to
exchange information and do business. Increased ease of use is
also an opportunity for us to lower expenses, eliminating the
need to operate more than one system once the transition is
complete. This will further reduce technology expense and
simplify information technology management.
We take reasonable steps to protect information we are entrusted
with in the ordinary course of business. As a core part of our
disaster recovery planning, we have implemented a secure and
reliable off-site
disk-to-disk
backup and restore capability.
Our insurance companies are parties to a Reinsurance Pooling
Agreement. Under this agreement, all premiums, losses and
underwriting expenses of our insurance companies are combined
and subsequently shared based on each individual company’s
statutory surplus from the most recently filed statutory annual
statement. The Pool has no impact on our consolidated results.
The Group’s insurance subsidiaries are parties to a
Services Allocation Agreement. Pursuant to this agreement, any
and all employees of the Group are employees of, BICUS, a wholly
owned subsidiary of MIC. BICUS has agreed to perform all
necessary functions and services required by the subsidiaries of
the Group in conducting their respective operations. In turn,
the subsidiaries of the Group have agreed to reimburse BICUS for
its costs and expenses incurred in rendering such functions and
services in an amount determined by the parties. The Services
Allocation Agreement has no impact on our consolidated results.
The Group and its subsidiaries are parties to a consolidated Tax
Allocation Agreement that allocates to each company a pro rata
share of the consolidated income tax expense based upon its
contribution of taxable income to the consolidated group. The
Tax Allocation Agreement has no impact on our consolidated
results.
Our insurance companies are required by applicable insurance
laws and regulations to maintain reserves for the payment of
losses and loss adjustment expenses (LAE). These reserves are
established for both reported claims and for claims incurred but
not reported (IBNR), arising from the policies that have been
issued related to the premiums that have been earned. The
provision must be made for the ultimate cost of those claims
that have occurred through the date of the balance sheet without
regard to how long it takes to settle them or the time value of
money. The determination of reserves involves actuarial
projections of what our insurance companies expect to be the
cost of the ultimate settlement and administration of such
claims. The reserves are set based on facts and circumstances
then known, estimates of future trends in claims severity, and
other variable factors such as inflation and changing judicial
theories of liability.
In light of such uncertainties, the Group also relies on policy
language, developed by the Group and by others, to exclude or
limit coverage where not intended. If such language is held by a
court to be invalid or unenforceable, it could materially
adversely affect the Group’s results of operations and
financial position. The possibility of
expansion of an insurer’s liability, either through new
concepts of liability or through a court’s refusal to
accept restrictive policy language, contributes to the inherent
uncertainty of reserving for claims.
Unpaid losses and loss adjustment expenses, also referred to as
loss reserves, are the largest liability of our property and
casualty subsidiaries. Our loss reserves include case reserve
estimates for claims that have been reported and bulk reserve
estimates for (a) the expected aggregate differences
between the case reserve estimates and the ultimate cost of
reported claims and (b) claims that have been incurred but
not reported as of the balance sheet date, less estimates of the
anticipated salvage and subrogation recoveries. Each of these
categories also includes estimates of the loss adjustment
expenses associated with processing and settling all reported
and unreported claims. Estimates are based upon past loss
experience modified for current and expected trends as well as
prevailing economic, legal and social conditions.
The amount of loss and loss adjustment expense reserves for
reported claims is based primarily upon a
case-by-case
evaluation of the type of risk involved, specific knowledge of
the circumstances surrounding each claim, and the insurance
policy provisions relating to the type of loss. The amounts of
loss reserves for unreported losses and loss adjustment expenses
are determined using historical information by line of business,
adjusted to current conditions. Inflation is ordinarily provided
for implicitly in the reserving function through analysis of
costs, trends, and reviews of historical reserving results over
multiple years. Our loss reserves are not discounted to present
value.
Reserves are closely monitored and recomputed periodically using
the most recent information on reported claims and a variety of
projection techniques. Specifically, on at least a quarterly
basis, we review, by line of business, existing reserves, new
claims, changes to existing case reserves, and paid losses with
respect to the current and prior accident years. We use
historical paid and incurred losses and accident year data to
derive expected ultimate loss and loss adjustment expense ratios
(to earned premiums) by line of business. We then apply these
expected loss and loss adjustment expense ratios to earned
premiums to derive a reserve level for each line of business. In
connection with the determination of the reserves, we also
consider other specific factors such as recent weather-related
losses, trends in historical paid losses, economic conditions,
and legal and judicial trends with respect to theories of
liability. Any changes in estimates are reflected in operating
results in the period in which the estimates are changed.
We perform a comprehensive annual review of loss reserves for
each of the lines of business we write in connection with the
determination of the year end carried reserves. The review
process takes into consideration the variety of trends and other
factors that impact the ultimate settlement of claims in each
particular class of business. A similar review is performed
prior to the determination of the June 30 carried reserves.
Prior to the determination of the March 31 and September 30
carried reserves, we review the emergence of paid and reported
losses relative to expectations and make necessary adjustments
to our carried reserves. There are also a number of analyses of
claims experience and reserves undertaken by management on a
monthly basis.
When a claim is reported to us, our claims personnel establish a
“case reserve” for the estimated amount of the
ultimate payment. This estimate reflects an informed judgment
based upon general insurance reserving practices and the
experience and knowledge of the estimator. The individual
estimating the reserve considers the nature and value of the
specific claim, the severity of injury or damage, and the policy
provisions relating to the type of loss. Case reserves are
adjusted by our claims staff as more information becomes
available. It is our policy to periodically review and revise
case reserves and to settle each claim as expeditiously as
possible.
We maintain bulk and IBNR reserves (usually referred to as
“IBNR reserves”) to provide for claims already
incurred that have not yet been reported (and which often may
not yet be known to the insured) and for future developments on
reported claims. The IBNR reserve is determined by estimating
our insurance companies’ ultimate net liability for both
reported and incurred but not reported claims and then
subtracting both the case reserves and payments made to date for
reported claims; as such, the “IBNR reserves”
represent the difference between the estimated ultimate cost of
all claims that have occurred or will occur and the reported
losses and loss adjustment expenses. Reported losses include
cumulative paid losses and loss adjustment expenses plus
aggregate case reserves. A large proportion of our gross and net
loss reserves, particularly for long tail liability classes, are
reserves for IBNR losses. More than 74% and 75% of our aggregate
loss reserves at December 31, 2008 and 2007, respectively,
were bulk and IBNR reserves.
Some of our business relates to coverage for short-tail risks
and, for these risks, the development of losses is comparatively
rapid and historical paid losses and case reserves, adjusted for
known variables, have been a reliable guide for purposes of
reserving. “Tail” refers to the time period between
the occurrence of a loss and the settlement of the claim. The
longer the time span between the incidence of a loss and the
settlement of the claim, the more the ultimate settlement amount
can vary. Some of our business relates to long-tail risks, where
claims are slower to emerge (often involving many years before
the claim is reported) and the ultimate cost is more difficult
to predict. For these lines of business, more sophisticated
actuarial techniques, such as the Bornhuetter-Ferguson method,
are employed to project an ultimate loss expectation, and then
the related loss history must be regularly evaluated and loss
expectations updated, with a likelihood of variability from the
initial estimate of ultimate losses. A substantial portion of
the business written by FPIC is this type of longer-tailed
casualty business. Please see the discussion under
“Liabilities for Loss and Loss Adjustment Expenses of the
Critical Accounting Policies” section of ITEM 7.
“Management’s Discussion and Analysis of Financial
Condition and Results of Operations” for further
information relating to methods used to estimate reserves.
Because the establishment of loss reserves is an inherently
uncertain process, we cannot be certain that ultimate losses
will not exceed the established loss reserves and have a
material adverse effect on the Group’s results of
operations and financial condition. We do not believe our
insurance companies are subject to any material potential
asbestos or environmental liability claims.
The charts below display the Company’s case and IBNR
reserves by line of business as of December 31, 2008 and
2007:
As of
December 31, 2008
As of
December 31, 2007
The following table shows the development of our consolidated
reserves for unpaid losses and LAE from 1998 through 2008 as
determined under U.S. generally accepted accounting
principles (GAAP). The top line of each table shows the
liabilities, net of reinsurance, at the balance sheet date,
including losses incurred but not yet reported. The upper
portion of each table shows the cumulative amounts subsequently
paid as of successive years with respect to the liability. The
lower portion of each table shows the re-estimated amount of the
previously recorded liability based on experience as of the end
of each succeeding year. The estimates change as additional
information becomes known about the frequency and severity of
claims for individual years. A redundancy exists when the
re-estimated liability at each December 31 is less than the
prior liability estimate. A deficiency exists when the
re-estimated liability at each December 31 is greater than the
prior liability estimate. The “cumulative
redundancy” depicted in the tables, for any particular
calendar year, represents the aggregate change in the initial
estimates over all subsequent calendar years.
Amounts shown in the 2005 column of the table include both 2005
and prior to 2005 accident year development for FPIC, which was
acquired on October 1, 2005, and accounted for as a
purchase business combination.
In each of the years ended December 31, 2008, 2007 and
2006, reinsurance retentions were increased. An increase in
retention means that the Company retains responsibility for
losses and loss adjustment expenses to a higher initial
threshold before which reinsurance attaches and becomes
responsible for the amount of a claim exceeding the threshold,
subject to the terms of the reinsurance agreement. The impact of
such an increase in retention is generally to cause the net
liability for losses and loss adjustment expenses to increase,
since fewer losses are ceded to reinsurers, although the direct
liability for losses and loss adjustment expenses will be
unchanged by a change in retention. This increase in retention
will result in a decline over time in the amount of the
difference between the Net Liability and Gross Liability totals
in the ten-year chart above.
18
For further information about the Company’s reinsurance
program and retentions, please see the “Reinsurance”
heading in this ITEM 1. “Business” section.
Prior
Year Development
As a result of changes in estimates for losses on insured events
occurring in prior years, the liability for losses and loss
adjustment expenses increased by $6.1 million,
$8.2 million and $8.4 million in 2008, 2007 and 2006,
respectively.
The following table presents, by line of business, the change in
the liability for unpaid losses and loss adjustment expenses
incurred in the years ended December 31, 2008, 2007 and
2006, for insured events of prior years.
Prior year favorable (unfavorable) development, by line of
business, reported in:
We evaluate our estimated ultimate liability by line of business
on a quarterly basis. The establishment of loss and loss
adjustment expense reserves is an inherently uncertain process,
and reserve uncertainty stems from a variety of sources. Court
decisions, regulatory changes and economic conditions, among
other factors, can affect the ultimate cost of claims that
occurred in the past as well as create uncertainties regarding
future loss cost trends. Similarly, actual experience, including
the number of claims and the severity of claims, to the extent
it varies from data previously used or projected, will be used
to update the projected ultimate liability for losses, by
accident year and line of business. Changes in estimates, or
differences between estimates and amounts ultimately paid, are
reflected in the operating results of the period during which
such changes are made. A discussion of factors contributing to
an (increase) decrease in the liability for unpaid losses and
loss adjustment expenses (as shown in the chart immediately
above) for the Group’s major lines, representing 92% of net
loss and loss adjustment reserves at December 31, 2008,
follows:
Commercial
multi-peril
With $163.0 million, $140.0 million, and
$120.1 million of recorded reserves, net of reinsurance, at
December 31, 2008, 2007 and 2006, respectively, commercial
multi-peril is the line of business that carries the largest net
loss and loss adjustment expense reserves, representing 75%,
73%, and 73%, respectively, of the Group’s total carried
net loss and loss adjustment expense reserves at
December 31, 2008, 2007, and 2006.
The commercial multi-peril line of business experienced adverse
prior year development of $9.2 million in 2008,
$5.9 million in 2007 and $9.6 million in 2006. The
majority of this development relates to the west coast
contractor liability book of business. Contractor liability
claims, particularly construction defect claims, are long-tailed
in nature and develop over a period of ten to twelve years.
The adverse development in 2008 and 2007 was driven by higher
than expected reported construction defect claim activity,
particularly on the 1998 through 2002 accident years. The
adverse development in 2006 was driven by increases in case
reserve estimates on claims reported prior to 2006. The adverse
development in 2008, 2007 and 2006 includes ($0.4) million,
$0.7 million and $2.8 million, respectively, in
reserve (decreases) increases related to
accident years 1997 and prior which are pre-Montrose
claims (see discussion of Montrose under the heading
of Description of Ultimate Loss Estimation Methods in the
Critical Accounting Policies section of ITEM 7.
Management’s Discussion and Analysis of Financial Condition
and Results of Operations).
The adverse development in 2008, 2007 and 2006 also includes
$1.9 million, $0.5 million and $1.1 million,
respectively, in post-commutation reserve increases for losses
formerly subject to reinsurance treaties.
In 2008 there was $3.5 million in favorable development on
accident years 2003 through 2005, due to lower than expected
loss emergence. In 2007 and 2006 there was no development on the
2003 through 2005 accident years. The favorable development was
driven by a decrease in claim frequency for accident years 2003
through 2005 which reflects the impact of both rate increases
and changes in underwriting.
The variances from previous expectations in the loss activity
described above were taken into account in evaluating the
ultimate liability for losses and loss adjustment expenses.
Commercial
automobile
With $21.6 million, $16.6 million, and
$13.4 million of recorded reserves, net of reinsurance, at
December 31, 2008, 2007, and 2006, respectively, commercial
automobile is the Group’s second largest reserved line of
business, representing 10%, 9%, and 8%, respectively, of the
Group’s total carried net loss and loss adjustment expense
reserves at December 31, 2008, 2007 and 2006.
The commercial automobile line of business experienced favorable
prior year development of $3.0 million in 2008,
$2.5 million in 2007 and $2.0 million in 2006.
The favorable development on the commercial automobile line of
business reflects a reduction in claims frequency for the recent
accident years and a lower than expected emergence of losses,
particularly on the Group’s heavy truck programs like Ready
Mix and Aggregate Haulers.
The variances from previous expectations in the loss activity
described above were taken into account in evaluating the
ultimate liability for losses and loss adjustment expenses.
Other
liability
With $8.9 million, $12.4 million, and
$9.3 million of recorded reserves, net of reinsurance, at
December 31, 2008, 2007, and 2006, respectively, other
liability is the Group’s third largest reserved line of
business, representing 4%, 6%, and 6%, respectively, of the
Group’s total carried net loss and loss adjustment expense
reserves at December 31, 2008, 2007 and 2006.
The other liability line of business experienced favorable prior
year development of $0.9 million in 2008, adverse
development of $4.4 million in 2007, and favorable
development of $0.3 million in 2006.
The adverse development on the other liability line of business
in 2007 was primarily the result of an increase in litigation
activity resulting in larger than expected settlements and
increased litigation expense.
The variances from previous expectations in the loss activity
described above were taken into account in evaluating the
ultimate liability for losses and loss adjustment expenses.
Workers
compensation
With $7.6 million, $7.6 million, and $7.3 million
of recorded reserves, net of reinsurance, at December 31,
2008, 2007, and 2006, respectively, workers compensation
represents 3%, 4%, and 4%, respectively, of the Group’s
total carried net loss and loss adjustment expense reserves at
December 31, 2008, 2007 and 2006. A portion of this
business is assumed from the National Involuntary Pool managed
by the National Council on Compensation Insurance (NCCI).
Workers compensation reserves developed favorably in 2008 by
$0.4 million, and in 2007 by $0.8 million, and
developed adversely in 2006 by $0.5 million. The adverse
development in 2006 occurred predominantly on
business assumed from the National Involuntary Pool managed by
the National Council on Compensation Insurance (NCCI).
The actuarial data reported to us by the NCCI is very volatile
with significant upward and downward swings.
Workers compensation losses are impacted heavily by medical cost
increases which have been significant recently.
The variances from previous expectations in the loss activity
described above were taken into account in evaluating the
ultimate liability for losses and loss adjustment expenses.
All
Other lines
The remaining lines of business, which collectively contributed
approximately $1.2 million, $1.2 million, and
$0.5 million of adverse development for the years ended
December 31, 2008, 2007, and 2006, respectively, do not
individually reflect any significant trends related to prior
year development.
The following table provides a reconciliation of beginning and
ending consolidated loss and LAE reserve balances of the Group
for the years ended December 31, 2008, 2007 and 2006,
prepared in accordance with U.S. generally accepted
accounting principles.
The following table presents, by line of business, the
(increase) decrease in the liability for unpaid losses and loss
adjustment expenses attributable to insured events of prior
years incurred in the year ended December 31, 2008. Amounts
shown in the 2005 column of the table include both 2005 and
prior to 2005 accident year development for FPIC, which was
acquired on October 1, 2005, and accounted for as a
purchase business combination.
Prior
Year Development in 2008:
The Company has concluded that in its judgment the range of
reasonable estimates of loss and loss expense reserves, on a net
basis, is likely to range from 169.2 million to
227.9 million as of December 31, 2008. Similarly, the
Company concluded that in its judgment the range of reasonable
estimates of loss and loss expense reserves, on a net basis,
ranged from $153.5 million to $200.3 million as of
December 31, 2007. The Group’s net loss and loss
adjustment expense reserves are carried at $218.0 million
as of December 31, 2008, and $192.0 million as of
December 31, 2007, toward the upper ends of the ranges for
the respective years. We have not performed stochastic modeling
of the reserves; however, management believes that it is
probable that the final outcome will fall within the range
specified above.
The table below summarizes the impact on net loss and loss
adjustment expense reserves and stockholders’ equity of
variances from the selected carried reserves to either extreme
of the management-selected range of estimates of loss and loss
adjustment expense reserves, net of reinsurance, based on
reasonably likely changes in the variables considered in
establishing loss and loss adjustment expense reserves. The
range of reasonably likely changes was established based on a
review of changes in accident year development by line of
business and applied to loss reserves as a whole. The asymmetry
of the range of estimates reflects the general shape of the
probability distribution for liability loss reserves (i.e., it
is typical to have smaller redundancies more often than larger
deficiencies) and the fact that the consequences of deficiencies
are more severe. The selected range of changes does not indicate
what could be the potential best or worst case or likely
scenarios:
The following paragraphs discuss considerations taken into
account for the Company’s major lines of business in
selecting reserves for losses and loss adjustment expenses (note
that in the discussions below reserves relating to
FPIC are discussed in the context of their actual accident
years, notwithstanding that they are shown in the ten-year
development chart and prior development charts above as
attributable under purchase accounting to 2005, the year of
FPIC’s acquisition by the Group).
Commercial
multi-peril
The Company’s selection of an estimate towards the upper
end of the range is related primarily to its commercial multiple
peril liability book, and is due to a number of factors,
including the fact that historically generally accepted
actuarial projection techniques have proved somewhat inadequate
in estimating loss reserves for CMP liability (more
specifically, in the Company’s case, contractors’
liability). Trends in legal, economic, and social factors have
caused development patterns for CMP liability to become more
protracted; that is, claims, especially construction defect
claims, are being reported much longer after the occurrence of
the event giving rise to the claim. This effect causes the use
of historical development patterns to understate loss reserves
for more recent accident year periods. It also makes the
investigation and defense of the claim more difficult and
costly. We have therefore applied alternative techniques in our
analysis (and segregated contractors’ policies from all
other policies in the analysis) and have judgmentally selected
our best estimate of the loss reserves to reflect our
expectation that such trends will continue.
Commercial
automobile
The loss and loss adjustment expense reserves for commercial
automobile liability have experienced favorable trends in the
last few years. Prior to 1998, the development of reported
losses was effectively complete (claims were reported and case
reserves were at or near ultimate values) by about four years
after the beginning of an accident year. For accident years 1998
through 2001, the development pattern extended as long as seven
years. Since accident year 2003, however, the development
pattern has shortened to about five years. At the same time,
claims frequencies have decreased. Reliance on historical
emergence patterns have produced redundancies in the loss and
loss adjustment expense reserves in recent accident years.
Other
liability
Reserves for other liability developed adversely in 2007 for
accident years 2003 through 2006. This adverse development was
due to the increased litigation activity in this line. This
increase in litigation has resulted in higher settlements and
higher legal expenses. We will continue to monitor the higher
development trends we have observed since 2007 to determine if
we will place greater emphasis on the more recent data.
Workers
Compensation
The development in workers compensation reserves is almost
entirely due to our experience on assumed business from the
national involuntary pool, which has been volatile. We
continuously review the trends in this experience and use our
best judgment in estimating assumed reserves.
Sensitivity
of key assumptions in reserve selection
Our process of establishing loss reserves for long-tailed
classes of business takes into account a variety of key
assumptions, including, but not limited to, the following:
The relative significance of any individual assumption depends
upon several considerations, such as the line of business and
the accident year. If the actual experience emerges differently
than the assumptions used in the process of establishing
reserves, then it is possible that there will be changes in the
reserve estimates (prior year
development) that may be material to the results of operations
in future periods. Set forth below is a discussion of the
potential impact of using certain key assumptions that differ
from those used in our latest reserve analysis. It is important
to note that the following discussion considers each assumption
individually without any consideration of the correlation (or
the lack thereof) between lines of business and accident years
or between assumptions, and therefore does not constitute an
actuarial range. While the following discussion represents
possible volatility due to variations in key assumptions
identified by management, there is no assurance that future
emergence of our loss experience will be consistent with either
our current or alternative sets of assumptions. By the very
nature of the insurance business, it is normal for loss
development patterns to have a certain amount of variability.
As an illustration of the potential volatility, consider the
impact of the use of the different assumptions described below
in setting reserves for the Commercial multiple peril liability
line, the Company’s biggest line of business and the one
for which reserves have been the most volatile. CMP comprises
about 75% of the Group’s net reserves; 98% of the reserves
for CMP relate to liability; and about 80% of the CMP liability
business is related to contractors.
Another example of potential variability is in the Other
liability line, where losses have developed at a much higher
rate since 2006. We continue to monitor this line in order to
determine if the recent trends will continue or if the losses
will develop closer to the historical trends. Relying only on
development factors observed since 2006 could lead to
significant redundancies. Conversely, it is possible that higher
development factors may continue.
In light of the many uncertainties involved in the estimation of
reserves, we monitor the reserves monthly, quarterly, and
semi-annually, and perform a comprehensive review of our reserve
estimates at least twice a year. These reviews could result in
the identification of information and trends that would require
us to increase or decrease some reserves for prior periods and
could materially affect our results of operations, equity,
business, financial strength and ratings. In 2008, we
experienced adverse development of $6.1 million, comprised
of adverse development of $9.2 million for commercial
multiple peril, offset by a redundancy of $3.0 million for
commercial automobile liability and relatively small amounts of
redundancies and deficiencies for other lines of business.
There are no material differences between the Company’s
loss and loss expense reserves under Statutory Accounting
Principles and its loss reserves under U.S. Generally
Accepted Accounting Principles at December 31, 2008, and
2007.
See additional discussion of loss and loss adjustment expense
reserves in the section “Management’s Discussion and
Analysis of Financial Condition and Results of Operations,
Critical Accounting Policies” under the sections titled
“Liabilities for Loss and Loss Adjustment Expenses”,
“Methods Used to Estimate Loss and Loss Adjustment Expense
Reserves” and “Description of Ultimate Loss Estimation
Methods”.
The table below summarizes for 2008, 2007 and 2006, the premiums
and losses and loss adjustment expenses assumed and ceded under
the Group’s reinsurance programs in place for those years:
Reinsurance
Ceded
In accordance with insurance industry practice, our insurance
companies reinsure a portion of their exposure and pay to the
reinsurers a portion of the premiums received on all policies
reinsured. Insurance policies written by our companies are
reinsured with other insurance companies principally to:
Reinsurance can be facultative reinsurance or treaty
reinsurance. Under facultative reinsurance, each policy or
portion of a policy is reinsured individually. Under treaty
reinsurance, an
agreed-upon
portion of a class of business is automatically reinsured.
Reinsurance also can be classified as quota share reinsurance,
pro-rata reinsurance or excess of loss reinsurance. Under quota
share reinsurance and pro-rata reinsurance, the ceding company
cedes a
percentage of its insurance liability to the reinsurer in
exchange for a like percentage of premiums less a ceding
commission. The ceding company in turn recovers from the
reinsurer the reinsurer’s share of all losses and loss
adjustment expenses incurred on those risks. Under excess
reinsurance, an insurer limits its liability to all or a
particular portion of the amount in excess of a predetermined
deductible or retention. Regardless of type, reinsurance does
not legally discharge the ceding insurer from primary liability
for the full amount due under the reinsured policies. However,
the assuming reinsurer is obligated to reimburse the ceding
company to the extent of the coverage ceded.
The amount and scope of reinsurance coverage we purchase each
year is determined based on a number of factors. These factors
include the evaluation of the risks accepted, consultations with
reinsurance representatives and a review of market conditions,
including the availability and pricing of reinsurance.
Reinsurance arrangements are placed with non-affiliated
reinsurers, and are generally renegotiated annually. The
decrease in ceded premium in 2008 and 2007 relates primarily to
the increases in underlying retentions in 2008, 2007, and 2006,
and the related decrease in ceding rates.
The largest exposure retained in 2008, 2007, and 2006 on any one
individual property risk was $850,000, $750,000, and $500,000,
respectively. Individual property risks in excess of these
amounts are covered on an excess of loss basis pursuant to
various reinsurance treaties. All property lines of business,
including commercial automobile physical damage, are reinsured
under the same treaties.
Except for umbrella liability, individual casualty risks that
are in excess of $850,000, $750,000, and $500,000, respectively,
in 2008, 2007, and 2006 are covered on an excess of loss basis
up to $1.0 million per occurrence. Casualty losses in
excess of $1.0 million arising from workers’
compensation claims are reinsured up to $10.0 million per
occurrence per insured. Umbrella liability losses (except for
non-business owner policies issued by FPIC) are reinsured on a
75% quota share basis up to $1.0 million and a 100% quota
share basis in excess of $1.0 million. FPIC’s umbrella
program is 100% reinsured (except for business owner policies).
For the surety line of business, written exclusively by FPIC,
the Group maintains an excess of loss contract under which it
retains the first $500,000 and 10% of the next $4.0 million
resulting in a maximum retention of $900,000 per principal.
Catastrophic reinsurance protects the ceding insurer from
significant aggregate loss exposure. Catastrophic events include
windstorms, hail, tornadoes, hurricanes, earthquakes, riots,
blizzards, terrorist activities and freezing temperatures. We
purchase layers of excess treaty reinsurance for catastrophic
property losses. We reinsure 100% of losses per occurrence in
excess of $5.0 million for 2008 and 2007, and
$2.0 million for 2006 and, up to a maximum of
$55.0 million for 2008 and 2007, and $32.0 million for
2006.
The Group also carries coverage on commercial lines of business
for acts of terrorism of $10.0 million excess of
$3.0 million in 2008 and 2007, and excess of
$2.0 million for 2006. This coverage does not apply to
nuclear, chemical or biological events.
Prior to 2007, FPIC had a separate reinsurance program from the
other insurance companies in the Group, which was largely a
continuation of the program it had in place immediately prior to
its acquisition by the Group. Commercial multi-peril property
and auto physical damage coverage was reinsured, through a
$1,650,000 excess of $350,000 excess of loss contract. Excess of
$2.0 million, FPIC had a semi-automatic facultative
agreement, which provided $8.0 million of coverage. On
casualty business FPIC maintained two reinsurance layers,
$250,000 excess of $250,000, and $500,000 excess of $500,000,
respectively, for commercial multiple peril liability and
commercial automobile liability with a syndicate of reinsurers.
The maximum exposure on any one casualty risk was $250,000.
Excess of $1.0 million, there was a semi-automatic
facultative agreement, which provided $5.0 million of
coverage.
Effective January 1, 2008, the Group renewed its
reinsurance coverages with the following changes. The retention
on any individual property or casualty risk was increased to
$850,000 from $750,000. Pollution coverage written by FPIC is
fully retained with a standard sub-limit of $150,000 (and up to
$300,000 on an exception basis). Prior to 2008, FPIC reinsured
100% of its pollution coverage, which in 2007 represented
$1.8 million of ceded written premium. The Group also
purchased an additional $1.0 million of surety coverage
(subject to a 10% retention) which results in an increased
reinsurance coverage to $4.5 million from $3.5 million
per principal and a maximum retention of $900,000 per principal
as compared to the previous $800,000. The Group continued its
primary treaties (i.e., treaties covering risk limits less than
$1.0 million on casualty lines, less than $7.5 million
on property lines and less than $10 million on
workers’ compensation) with General Reinsurance
Corporation, rated A++ (Superior) by A.M. Best, their
highest rating.
In conjunction with the renewal of the reinsurance program for
both 2008 and 2007, the prior year reinsurance treaties were
terminated on a run-off basis, requiring that for policies in
force as of December 31, 2007 and 2006, respectively, these
reinsurance agreements continue to cover losses occurring on
these policies in the future. Therefore, the Group will remit
premiums to and collect reinsurance recoverables from the
reinsurers on these prior year treaties as the underlying
business runs off.
As of January 1, 2006, FPIC terminated its 2005 property
quota share and casualty excess of loss reinsurance contracts on
a cut-off basis and restructured its reinsurance program to the
structure described above. The restructuring also included the
assumption of ceded unearned premiums by FPIC from the 2005
property quota share and casualty excess of loss agreements.
These assumed premiums were then ceded into the respective 2006
treaties, which due to the reduced ceding rates, resulted in a
$5.6 million increase in net written and earned premiums
for the year ending December 31, 2006.
During the third quarter of 2006, the Group commuted all
reinsurance agreements with Alea North America Insurance Company
(Alea). These reinsurance agreements included participation in
the property quota share and casualty excess of loss treaties.
As a result of the commutation the Group received a cash payment
of $4.5 million, and recorded a pre-tax net loss on
commutation of $160,000.
During the fourth quarter of 2008, the Group commuted all
reinsurance agreements with St Paul Fire and Marine Insurance
Company. These reinsurance agreements included participation in
the property quota share and casualty excess of loss treaties.
As a result of the commutation the Group received a cash payment
of $2.5 million, and recorded a pre-tax net gain on
commutation of $0.9 million.
Prior to 2007, some of the Group’s reinsurance treaties
(primarily FPIC treaties) have included provisions that
establish minimum and maximum cessions and allow limited
participation in the profit of the ceded business. Generally,
the Group shares on a limited basis in the profitability through
contingent ceding commissions. Exposure to the loss experience
is contractually defined at minimum and maximum levels, and the
terms of such contracts are fixed at inception. Since estimating
the emergence of claims to the applicable reinsurance layers is
subject to significant uncertainty, the net amounts that will
ultimately be realized may vary significantly from the estimated
amounts presented in the Group’s results of operations.
The Group’s significant reinsurance treaties as of
December 31, 2008 are summarized below:
Property
Excess of Loss
The Property Excess of Loss program consists of three layers
with coverage of $6,650,000 above an $850,000 retention. The
first layer is $150,000 excess of $850,000 with a per occurrence
limit of $450,000. The second layer is $4.0 million excess
of $1.0 million with a per occurrence limit of
$8.0 million. The third layer is $2.5 million excess
of $5.0 million with a per occurrence limit of
$2.5 million. The first and second layers have no annual
aggregate limit or reinstatement premium. The third layer has a
$5.0 million annual aggregate limit and a reinstatement
premium based on the reinsurance premium multiplied by the
percentage of reinstated limit. The Group purchases facultative
coverage in excess of these limits. Effective January 1,
2009, this program was renewed with the Group increasing its
retention to $1.0 million from $850,000 and thereby
eliminating the first layer of coverage. There will be no change
to coverage excess of $1.0 million for 2009.
Property
Catastrophe Excess of Loss
The Property Catastrophe Excess of Loss program consists of
three layers with coverage of $50.0 million above a
$5.0 million retention. The first layer is
$5.0 million excess of $5.0 million with a per
occurrence limit of $5.0 million. The second layer is
$10.0 million excess of $10.0 million with a per
occurrence limit of $10.0 million. The third layer is
$35.0 million excess of $20.0 million with a per
occurrence limit of $35.0 million. There is an annual
aggregate limit of $10.0 million on the first layer,
$20.0 million on the second layer and $70.0 million on
the
third layer. There is a reinstatement premium on each layer
based on 50% of the reinsurance premium multiplied by the
percentage of reinstated limit. There will be no change to this
program’s structure for 2009.
Casualty
Excess of Loss
The Casualty Excess of Loss program consists of four layers with
coverage of $9,150,000 above an $850,000 retention. The first
layer is $150,000 excess of $850,000 with a per occurrence limit
of $150,000. The second layer is $1.0 million excess of
$1.0 million with a per occurrence limit of
$1.0 million. The third layer is $3.0 million excess
of $2.0 million with a per occurrence limit of
$3.0 million. The fourth layer is only for the
workers’ compensation line of business and is
$5.0 million excess of $5.0 million with a per
occurrence limit of $5.0 million. The first layer has no
annual aggregate limit or reinstatement premium. The second,
third and fourth layers have a $5.0 million,
$6.0 million and $10.0 million annual aggregate limit
and no reinstatement premium, respectively. Effective
January 1, 2009, this program was renewed with the Group
increasing its retention to $1.0 million from $850,000 and
thereby eliminating the first layer of coverage. There will be
no change to coverage excess of $1.0 million for 2009.
Umbrella
Liability Quota Share
The Umbrella Liability Quota Share program consists of two
treaties, one for MIC, MICNJ, and FIC, and one for FPIC. The
East coast treaty reinsures losses on a 75% quota share basis up
to $1.0 million and on a 100% quota share basis in excess
of $1.0 million. The FPIC treaty reinsures losses on a 100%
quota share basis with the exception of business owner policies,
which are reinsured 75% up to $1.0 million and then on a
100% quota share basis in excess of $1.0 million. The East
coast treaty provides for up to $10.0 million in limit, and
the FPIC treaty provides for $5.0 million. The Group
purchases facultative coverage in excess of these limits. For
2009 the FPIC treaty will be reinsuring all policies on a 75%
quota share basis up to $1.0 million and on a 100% quota
share basis in excess of $1.0 million.
Surety
Excess of Loss
The Surety Excess of Loss program consists of four layers with
coverage of $4.0 million above a $500,000 retention. The
first layer is $1.5 million excess of $500,000 with a 10%
retention and a per occurrence limit of $1,350,000. The second
layer is $1.5 million excess of $2.0 million with a
10% retention and a per occurrence limit of $1,350,000. The
third layer is $500,000 excess of $3.5 million with a 10%
retention and a per occurrence limit of $450,000. The fourth
layer is $500,000 excess of $4.0 million with a 10%
retention and a per occurrence limit of $450,000. The first and
second layers have a $2.7 million annual aggregate limit
and a 25% and 50%, respectively, reinstatement premium. The
third and fourth layers each have a $450,000 annual aggregate
and no reinstatement premium. The Group’s maximum retention
is $900,000 per principal. There will be no change to this
program’s structure for 2009.
Terrorism
The Terrorism program consists of three treaties. The first
treaty is $10.0 million above a $3.0 million retention
for commercial lines of business. This coverage does not apply
to nuclear, chemical or biological events. The annual aggregate
limit is $10.0 million. The second treaty is the Property
Terrorism Excess treaty with coverage of $6,650,000 above a
$850,000 retention. This coverage does not apply to nuclear,
chemical or biological events. The annual aggregate limit is
$6,650,000. The third treaty is the Workers’ Compensation
Terrorism treaty with coverage of $4,150,000 above a $850,000
retention. This coverage does not apply to nuclear, chemical or
biological events. The annual aggregate limit is $4,150,000.
Effective January 1, 2009, this program was renewed with
the Group increasing its retention to $1.0 million from
$850,000. There will be no change to coverage excess of
$1.0 million for 2009.
We generally do not assume risks from other insurance companies.
However, we are required by statute to participate in certain
residual market pools. This participation requires us to assume
business for workers’
compensation and for property exposures that are not insured in
the voluntary marketplace. We participate in these residual
markets pro rata on a market share basis, and as of
December 31, 2008, our participation is not material. For
the years ended December 31, 2008, 2007 and 2006, our
insurance companies assumed $1.1 million, $1.4 million
and $2.4 million of written premiums, respectively.
The insolvency or inability of any reinsurer to meet its
obligations to us could have a material adverse effect on our
results of operations or financial condition. As of
December 31, 2008, the Group’s five largest reinsurers
based on percentage of ceded premiums are set forth in the
following table:
The following table sets forth the five largest amounts of loss
and loss expenses recoverable from reinsurers on unpaid claims
as of December 31, 2008.
The A++, A+ and A ratings are the top three highest of
A.M. Best’s 16 ratings. According to A.M. Best,
companies with a rating of “A++” or “A+” are
rated “Superior”, with “...a superior ability to
meet their ongoing obligations to policyholders.” Companies
with a rating of “A” are rated “Excellent”,
with “...an excellent ability to meet their ongoing
obligations to policyholders.”
On a consolidated basis, all of our investments in fixed income
and equity securities are classified as available for sale and
are carried at fair value.
An important component of our consolidated operating results has
been the return on invested assets. Our investment objectives
are to: (i) maximize current yield, (ii) maintain
safety of capital through a balance of high quality, diversified
investments that minimize risk, (iii) maintain adequate
liquidity for our insurance operations, (iv) meet
regulatory requirements, and (v) increase surplus through
appreciation. However, in order to enhance the yield on our
fixed income securities, our investments generally have a longer
duration than the duration of our insurance liabilities. See
“Management’s Discussion and Analysis of Financial
Condition and Results of Operations” under the subsection
entitled “Quantitative and Qualitative Information about
Market Risk.”
Our investment policy requires that investments be made in a
portfolio consisting of bonds, equity securities, and short-term
money market instruments. Our equity investments are
concentrated in companies with larger capitalizations. The
investment policy does not permit investment in unincorporated
businesses, private placements or direct mortgages, foreign
denominated securities, financial guarantees or commodities. The
Board of Directors of the Group has developed this investment
policy and reviews it periodically.
The following table sets forth consolidated information
concerning our investments.
The following table shows our Industrial and miscellaneous fixed
income securities and equity holdings by industry sector:
The table below contains consolidated information concerning the
investment ratings of our fixed maturity investments at
December 31, 2008.
The table below sets forth the maturity profile of our
consolidated fixed maturity investments as of December 31,
2008 (note that mortgage-backed securities in the below table
include securities backed by the U.S. government and
agencies):
As of December 31, 2008, the average maturity of our fixed
income investment portfolio (excluding mortgage-backed
securities) was 5.0 years and the average duration was
3.5 years. Our fixed maturity investments include
U.S. government bonds, securities issued by government
agencies, obligations of state and local governments and
governmental authorities, corporate bonds and mortgage-backed
securities, most of which are exposed to changes in prevailing
interest rates. We carry these investments as available for
sale. This allows us to manage our exposure to risks associated
with interest rate fluctuations through active review of our
investment portfolio by our management and board of directors
and consultation with our portfolio advisor.
We continue to maintain a conservative, diversified investment
portfolio, with fixed maturity investments representing 97% of
invested assets. As of December 31, 2008, the fixed income
portfolio consists of 99.6% investment grade securities, with
the remaining 0.4% non-investment grade rated securities. The
0.4% includes three corporate securities held with a combined
market value of $1.2 million, and one asset-backed security
held with a market value of $0.2 million. The fixed income
portfolio has an average rating of Aa2/AA and an average tax
equivalent book yield of 5.40%.
Among its portfolio holdings, the Group’s only direct
subprime exposure consists of asset-backed securities (ABS)
within the home equity subsector. The ABS home equity subsector
totaled $0.6 million (book value) on December 31,
2008, representing 4.1% of the ABS holdings, 0.7% of the total
structured product holdings, and 0.2% of total fixed income
portfolio holdings. The subprime related exposure consists of
three individual securities, of which two are insured by a
monoline insurere against default of principal and interest.
However, since FGIC and AMBAC have been downgraded from their
previous AAA status, the two insured securities are now rated
according to the higher of the underlying collateral or the
monoline rating. One bond is rated Baa1/A while the other is
rated Baa3/BB. With regard to the remaining security without
monoline insurance, it is rated Aa2/AA by Moody’s and
S&P, respectively. See “Management’s Discussion
and Analysis of Financial Condition and Results of
Operations” under the subsection entitled
“Quantitative and Qualitative Information about Market
Risk.”
Our consolidated average cash and invested assets, net
investment income and return on average cash and invested assets
for the years ended December 31, 2008, 2007 and 2006 were
as follows:
A.M. Best rates insurance companies based on factors of
concern to policyholders. All companies in the Group participate
in the intercompany pooling agreement (see “Intercompany
Agreements” above) and have been assigned a group rating of
“A” (Excellent) by A.M. Best. The Group has been
assigned that rating for the past 8 years. An “A”
rating is the third highest of A.M. Best’s 16 possible
rating categories.
According to the A.M. Best guidelines, A.M. Best
assigns “A” ratings to companies that have, on
balance, excellent balance sheet strength, operating performance
and business profiles. Companies rated “A” are
considered by A.M. Best to have “an excellent ability
to meet their ongoing obligations to policyholders.” In
evaluating a company’s financial and operating performance,
A.M. Best reviews:
The property and casualty insurance market is very highly
competitive. Our insurance companies compete with stock
insurance companies, mutual companies, local cooperatives and
other underwriting organizations. Some of these competitors have
substantially greater financial, technical and operating
resources than our insurance companies. Within our
producer’s offices we compete to be a preferred market for
desirable business, as well as competing with other carriers to
attract and retain the best producers. Our ability to compete
successfully in our principal markets is dependent upon a number
of factors, many of which are outside our control. These factors
include market and competitive conditions. Many of our lines of
insurance are subject to significant price competition. Some
companies may offer insurance at lower premium rates through the
use of salaried personnel or other distribution methods, rather
than through independent producers paid on a commission basis
(as our insurance companies do). In addition to price,
competition in our lines of insurance is based on quality of the
products, quality and speed of service, financial strength,
ratings, distribution systems and technical expertise.
Pricing in the property and casualty insurance industry
historically has been and remains cyclical. During a soft market
cycle, price competition becomes prevalent, which makes it
difficult to write and retain properly priced personal and
commercial lines business. In response to the current soft
market, the marketplace is populated with some competitors who
are significantly reducing their prices
and/or
offering coverage terms that are generous in relation to the
premiums being charged. We believe that in some instances the
prices and terms being offered, if matched by us, would not
provide us with an adequate rate of return, if any.
Our policy is to maintain disciplined underwriting during soft
markets, declining business which is inadequately priced for its
level of risk. The market has become very highly competitive,
with increasing competition being seen in virtually all classes
of commercial and personal accounts. This affects our new
business opportunities and creates more challenges for renewals,
which can adversely impact premium revenue levels for the Group.
We continue to focus on long-term profitability rather than
short-term revenue. We also continue to work with our agents to
target classes of business and accounts compatible with our
underwriting appetite, which includes certain types of religious
institutions risks, contracting risks, small business risks and
property risks.
Many of our competitors offer internet-based quoting
and/or
policy issuance systems to their producers. In response to this
improvement in marketplace technology, we have developed
technology that will allow our agents to rate and bind
transactions via an internet-based rating system for some
products and lines of business. We launched this process in late
2008 in California and launched a similar process for New Jersey
and Pennsylvania agents in January 2009. We intend on expanding
the use of internet-based processing in 2009 and beyond.
A new form of competition may enter the marketplace as
reinsurers attempt to diversify their insurance risk by writing
business in the primary marketplace. The Group also faces
competition, primarily in the commercial insurance market, from
entities that may desire to self-insure their own risks.
REGULATION
Insurance companies are subject to supervision and regulation in
the states in which they do business. State insurance
authorities have broad administrative powers to administer
statutes and regulations with respect to all aspects of our
insurance business including:
State insurance laws and regulations require our insurance
companies to file financial statements with insurance
departments everywhere they do business, and the operations of
our insurance companies and accounts are subject to examination
by those departments at any time. Our insurance companies
prepare statutory financial statements in accordance with
accounting practices and procedures prescribed or permitted by
these departments.
Financial examinations are conducted by the Pennsylvania
Insurance Department, the California Department of Insurance,
and the New Jersey Department of Banking and Insurance every
three to five years. The Pennsylvania Insurance
Department’s last completed examination of MIC was as of
December 31, 2004. Their last completed examination of FIC
was as of December 31, 2004. The New Jersey Department of
Banking and Insurance’s last completed examination of MICNJ
was as of December 31, 2004. The last examination of FPIC
by the California Department of Insurance was as of
December 31, 2003. These examinations did not result in any
adjustments to the financial position of any of our insurance
companies. In addition, there were no substantive qualitative
matters indicated in the examination reports that had a material
adverse impact on the operations of our insurance companies.
In 2008, the Pennsylvania Insurance Department began an
examination which will be a coordinated examination with both
the New Jersey Department of Banking and Insurance and the
California Department of Insurance for MICNJ and FPIC,
respectively. That examination was ongoing as of
December 31, 2008.
In 1990, the NAIC began an accreditation program to ensure that
states have adequate procedures in place for effective insurance
regulation, especially with respect to financial solvency. The
accreditation program requires that a state meet specific
minimum standards in over five regulatory areas to be considered
for accreditation. The accreditation program is an ongoing
process and once accredited, a state must enact any new or
modified standards approved by the NAIC within two years
following adoption. As of December 31, 2008, Pennsylvania,
New Jersey, and California, the states in which our insurance
company subsidiaries are domiciled, were accredited.
Pennsylvania, New Jersey and California impose the NAIC’s
risk-based capital requirements that require insurance companies
to calculate and report information under a risk-based formula.
These risk-based capital requirements attempt to measure
statutory capital and surplus needs based on the risks in a
company’s mix of products and investment portfolio. Under
the formula, a company first determines its “authorized
control level” risk-based capital ( “RBC”). This
authorized control level takes into account (i) the risk
with respect to the insurer’s assets; (ii) the risk of
adverse insurance experience with respect to the insurer’s
liabilities and obligations, (iii) the interest rate risk
with respect to the insurer’s business; and (iv) all
other business risks and such other relevant risks as are set
forth in the RBC instructions. A company’s “total
adjusted capital” is the sum of statutory capital and
surplus and such other items as the risk-based capital
instructions may provide. The formula is designed to allow state
insurance regulators to identify weakly capitalized companies.
The requirements provide for four different levels of regulatory
attention. The “company action level” is triggered if
a company’s total adjusted capital is less than 2.0 times
its authorized control level but greater than or equal to 1.5
times its authorized control level. At the company action level,
the company must submit a comprehensive plan to the regulatory
authority that discusses proposed corrective actions to improve
the capital position. The “regulatory action level” is
triggered if a company’s total adjusted capital is less
than 1.5 times but greater than or equal to 1.0 times its
authorized control level. At the regulatory action level, the
regulatory authority will perform a special examination of the
company and issue an order specifying corrective actions that
must be
followed. The “authorized control level” is triggered
if a company’s total adjusted capital is less than 1.0
times but greater than or equal to 0.7 times its authorized
control level; at this level the regulatory authority may take
action it deems necessary, including placing the company under
regulatory control. The “mandatory control level” is
triggered if a company’s total adjusted capital is less
than 0.7 times its authorized control level; at this level the
regulatory authority is mandated to place the company under its
control. The capital levels of our insurance companies have
never triggered any of these regulatory capital levels. We
cannot assure you, however, that the capital requirements
applicable to the business of our insurance companies will not
increase in the future.
State insurance laws and regulations include numerous provisions
governing trade practices and the marketplace activities of
insurers, including provisions governing the form and content of
disclosure to consumers, illustrations, advertising, sales
practices and complaint handling. State regulatory authorities
generally enforce these provisions through periodic market
conduct examinations, which the Group is subject to from time to
time. No material issues have been raised in the market conduct
exams performed on the Group’s insurance subsidiaries.
Our property and casualty operations are subject to rate and
policy form approval. All of the rates and policy forms that we
use that require regulatory approval have been filed with and
approved by the appropriate insurance regulator. Our operations
are also subject to laws and regulations covering a range of
trade and claim settlement practices. To our knowledge, we are
currently in compliance with these laws and regulations. State
insurance regulatory authorities have broad discretion in
approving an insurer’s proposed rates. The extent to which
a state restricts underwriting and pricing of a line of business
may adversely affect an insurer’s ability to operate that
business profitably in that state on a consistent basis.
State insurance laws and regulations require us to participate
in mandatory property-liability “shared market,”
“pooling” or similar arrangements that provide certain
types of insurance coverage to individuals or others who
otherwise are unable to purchase coverage voluntarily provided
by private insurers. Shared market mechanisms include assigned
risk plans; fair access to insurance requirements or
“FAIR” plans; and reinsurance facilities, such as the
New Jersey Unsatisfied Claim and Judgment Fund. In addition,
some states require insurers to participate in reinsurance pools
for claims that exceed specified amounts. Our participation in
these mandatory shared market or pooling mechanisms generally is
related to the amounts of our direct writings for the type of
coverage written by the specific arrangement in the applicable
state. For the three years ended December 31, 2008, 2007
and 2006, we received earned premiums from these arrangements in
the amounts of $1,233,000, $1,801,000, and $2,539,000,
respectively, and incurred losses and loss adjustment expenses
from these arrangements in the amounts of $1,043,000,
$1,185,000, and $3,908,000, respectively. Because we do not have
a significant amount of direct writings in the coverages written
under these arrangements, we do not anticipate that these
arrangements will have a material effect on us in the future.
However, we cannot predict the financial impact of our
participation in any shared market or pooling mechanisms that
may be implemented in the future by the states in which we do
business.
All states have guaranty fund laws under which insurers doing
business in the state can be assessed to fund policyholder
liabilities of insolvent insurance companies. The states in
which our insurance companies do business have such laws. Under
these laws, an insurer is subject to assessment depending upon
its market share in the state of a given line of business. For
the years ended December 31, 2008, 2007 and 2006, we
incurred approximately $98,000, $(180,000), and $105,000,
respectively, in assessments pursuant to state insurance
guaranty association laws. We establish reserves relating to
insurance companies that are subject to insolvency proceedings
when we are notified of assessments by the guaranty
associations. We cannot predict the amount and timing of any
future assessments on our insurance companies under these laws.
The Terrorism Risk Insurance Act of 2002 (TRIA) established a
program that provides a backstop for insurance-related losses
resulting from any act of terrorism as defined. Under this law,
coverage provided by an insurer for losses caused by certified
acts of terrorism is partially reimbursed by the United States
under a formula under which the government pays 85% (beginning
in 2007) of covered terrorism losses, exceeding a
prescribed deductible. Therefore, the act limits an
insurer’s exposure to certified terrorist acts (as defined
by the act) to the deductible formula. The deductible is based
upon a percentage of direct earned premiums for commercial
property and casualty policies. Coverage under the act must be
offered to all property, casualty and surety insureds. On
December 26, 2007, the President of the United States
signed into law the Terrorism Risk Insurance Program
Reauthorization Act of 2007 which extends TRIA through
December 31, 2014. The law extends the temporary federal
program that provides for a transparent system of shared public
and private compensation for insured losses resulting from acts
of terrorism.
We are currently charging a premium for terrorism coverage on
our businessowners, commercial automobile, commercial
workers’ compensation, tenant-occupied dwelling, special
contractors, special multi-peril, monoline commercial fire,
monoline general liability and religious institution policies.
Insureds that are charged a terrorism premium have the option
(except workers’ compensation) of deleting terrorism
coverage to reduce their premium costs; however many do not do
so. Insureds under commercial workers’ compensation
policies do not have the option to delete the terrorism
coverage. Most other policies include terrorism coverage at no
additional cost. Where allowed, we exclude coverage for losses
that are from events not certified as terrorism events, with no
buyback option available to the policyholder.
We are unable to predict the extent to which this legislation
may affect the demand for our products or the risks that will be
available for us to consider underwriting. We do not know the
extent to which insureds will elect to purchase this coverage
when available.
The property and casualty insurance industry continues to
receive a considerable amount of publicity related to pricing,
coverage terms, the lack of availability of insurance, and the
issue of paying profit-sharing commissions to agents.
Regulations and legislation are being proposed to limit damage
awards, to control plaintiffs’ counsel fees, to bring the
industry under regulation by the federal government and to
control premiums, policy terminations and other policy terms. We
are unable to predict whether, in what form, or in what
jurisdictions, any regulatory proposals might be adopted or
their effect, if any, on our insurance companies.
Our insurance companies are restricted by the insurance laws of
their respective states of domicile regarding the amount of
dividends or other distributions they may pay without notice to
or the prior approval of the state regulatory authority.
All dividends from MIC to MIG require prior notice to the
Pennsylvania Insurance Department. All “extraordinary”
dividends require advance approval. A dividend is deemed
“extraordinary” if, when aggregated with all other
dividends paid within the preceding 12 months, the dividend
exceeds the greater of (a) statutory net income (excluding
realized capital gains) for the preceding calendar year or
(b) 10% of statutory surplus as of the preceding
December 31. As of December 31, 2008, the amount
available for payment of dividends from MIC in 2009, without the
prior approval, is approximately $5.7 million.
All dividends from FPIC to FPIG (wholly owned by MIG) require
prior notice to the California Department of Insurance. All
“extraordinary” dividends require advance approval. A
dividend is deemed “extraordinary” if, when aggregated
with all other dividends paid within the preceding
12 months, the dividend exceeds the greater of
(a) statutory net income for the preceding calendar year or
(b) 10% of statutory surplus as of the preceding
December 31. As of December 31, 2008, the amount
available for payment of dividends from FPIC in 2009, without
the prior approval, is approximately $6.4 million.
Most states have enacted legislation that regulates insurance
holding company systems. Each insurance company in a holding
company system is required to register with the insurance
supervisory agency of its state of domicile and furnish certain
information. This includes information concerning the operations
of companies within the holding company system that may
materially affect the operations, management or financial
condition of the insurers within the system. Pursuant to these
laws, the respective insurance departments may examine our
insurance companies and their holding companies at any time,
require disclosure of material transactions by our insurance
companies and their holding companies and require prior notice
of approval of certain transactions, such as “extraordinary
dividends” distributed by our insurance companies.
All transactions within the holding company system affecting our
insurance companies and their holding companies must be fair and
equitable. Notice of certain material transactions between our
insurance companies and any person or entity in our holding
company system will be required to be given to the applicable
insurance commissioner. In some states, certain transactions
cannot be completed without the prior approval of the insurance
commissioner.
All of our employees are employed directly by BICUS, a wholly
owned subsidiary of MIC. Our insurance companies do not have any
employees. BICUS provides management services to all of our
insurance companies. As of December 31, 2008, the total
number of full-time equivalent employees of BICUS was 198. None
of these employees are covered by a collective bargaining
agreement, and BICUS believes that its employee relations are
good.
The Company maintains a website at www.mercerins.com. Our annual
report on
Form 10-K,
quarterly reports on
Form 10-Q
and current reports on
Form 8-K,
and amendments to those reports, filed or furnished pursuant to
Section 13(a) or 15(d) of the Securities Exchange Act of
1934, are available free of charge on our website as soon as
practicable after electronic filing of such material with, or
furnishing it to, the Securities and Exchange Commission.
Risks
Relating to Our Business and Industry
A disruption in world financial markets could adversely affect
demand for the Group’s products, and credit risk associated
with agents, customers, and reinsurers, as well as adversely
affecting the Group’s investment portfolio value and
investment income. Disrupted markets could also adversely affect
the Group’s ability to raise additional capital if it
needed to do so in the future.
A prolonged downturn in the construction segment of the economy
would have a continued negative effect on the Group’s
premium volume through fewer construction risks to insure and
reduced premiums for those contractors that remain in business.
During the second half of 2008, there were significant
disruptions to the financial and equity markets. This resulted
from, in part, failures of financial institutions on an
unprecedented scale, and caused a significant reduction in
liquidity and trading flows in the credit markets in addition to
a dramatic widening in credit spreads. Such impacts affected the
valuations of both the fixed income and equity securities held
by the Group. If the financial and equity markets continue their
adverse performance, the Group’s business and
stockholders’ equity could be adversely affected.
As a property and casualty insurer, we are subject to claims
from catastrophes that may have a significant negative impact on
operating and financial results. We have experienced catastrophe
losses, and can be expected to experience catastrophe losses in
the future. Catastrophe losses can be caused by various events,
including coastal storms, snow storms, ice storms, freezing,
hurricanes, earthquakes, tornadoes, wind, hail, fires, and other
natural or man-made disasters. We also face exposure to losses
resulting from acts of war, acts of terrorism and political
instability. The frequency, number and severity of these losses
are unpredictable. The extent of losses from a catastrophe is a
function of both the total amount of insured exposure in the
area affected by the event and the severity of the event.
We attempt to mitigate catastrophe risk by reinsuring a portion
of our exposure. However, reinsurance may prove inadequate if:
In addition, because accounting regulations do not permit
insurers to reserve for catastrophic events until they occur,
claims from catastrophic events could cause substantial
volatility in our financial results for any fiscal quarter or
year and could have a material adverse affect on our financial
condition or results of operations. Our ability to write new
business also could be adversely affected.
We maintain reserves to cover amounts we estimate will be needed
to pay for insured losses and for the expenses necessary to
settle claims. Estimating loss and loss expense reserves is a
difficult and complex process involving many variables and
subjective judgments. Estimates are based on management
assessment of the known facts and circumstances, prediction of
future events, claims severity and frequency and other
subjective factors. We regularly review our reserving techniques
and our overall amount of reserves. We review historical data
and consider the impact of various factors such as:
Our estimated loss reserves could be incorrect and potentially
inadequate. If we determine that our loss reserves are
inadequate, we will have to increase them. This adjustment would
reduce income during the period in which the adjustment is made,
which could have a material adverse impact on our financial
condition and results of operation. There is no precise way to
determine the ultimate liability for losses and loss settlements
prior to final settlement of the claim.
The threat of terrorism, both within the United States and
abroad, and military and other actions and heightened security
measures in response to these types of threats, may cause
significant volatility and declines in the equity markets in the
United States, Europe and elsewhere, as well as loss of life,
property damage, additional disruptions to commerce and reduced
economic activity. Actual terrorist attacks could cause losses
from insurance claims related to the property and casualty
insurance operations of the Group as well as a decrease in our
stockholders’ equity, net income
and/or
revenue. The Terrorism Risk Insurance Reauthorization and
Extension Act of 2007 requires that some coverage for terrorist
loss be offered by primary property insurers and provides
Federal assistance for recovery of claims. In addition, some of
the assets in our investment portfolio may be adversely
affected by declines in the equity markets and economic activity
caused by the continued threat of terrorism, ongoing military
and other actions and heightened security measures.
We cannot predict at this time whether and the extent to which
industry sectors in which we maintain investments may suffer
losses as a result of terrorism-related decreases in commercial
and economic activity, or how any such decrease might impact the
ability of companies within the affected industry sectors to pay
interest or principal on their securities, or how the value of
any underlying collateral might be affected.
We can offer no assurances that the threats of future
terrorist-like events in the United States and abroad or
military actions by the United States will not have a material
adverse effect on our business, financial condition or results
of operations.
Our ability to manage our exposure to underwriting risks depends
on the availability and cost of reinsurance coverage.
Reinsurance is the practice of transferring part of an insurance
company’s liability and premium under an insurance policy
to another insurance company. We use reinsurance arrangements to
limit and manage the amount of risk we retain, to stabilize our
underwriting results and to increase our underwriting capacity.
The availability and cost of reinsurance are subject to current
market conditions and may vary significantly over time.
Significant variation in reinsurance availability and cost could
result in us being unable to maintain our desired reinsurance
coverage or to obtain other reinsurance coverage in adequate
amounts and at favorable rates. If we are unable to renew our
expiring coverage or obtain new coverage, it will be difficult
for us to manage our underwriting risks and operate our business
profitably.
It is also possible that the losses we experience on risks we
have reinsured will exceed the coverage limits on the
reinsurance. If the amount of our reinsurance coverage is
insufficient, our insurance losses could increase substantially.
If our reinsurers do not pay our claims in a timely manner, we
may incur losses. We are subject to loss and credit risk with
respect to the reinsurers with whom we deal because buying
reinsurance does not relieve us of our liability to
policyholders. If our reinsurers are not capable of fulfilling
their financial obligations to us, our insurance losses would
increase.
Our investment portfolio contains a significant amount of
fixed-income securities, including at different times bonds,
mortgage-backed securities (MBSs) and other securities. The
market values of all of our investments fluctuate depending on
economic conditions and other factors. The market values of our
fixed-income securities are particularly sensitive to changes in
interest rates.
We may not be able to prevent or minimize the negative impact of
interest rate changes. Additionally, we may, from time to time,
for business, regulatory or other reasons, elect or be required
to sell certain of our invested assets at a time when their
market values are less than their original cost, resulting in
realized capital losses, which would reduce net income.
If we fail to comply with insurance industry regulations, or if
those regulations become more burdensome, we may not be able to
operate profitably.
Our insurance companies are regulated by government agencies in
the states in which we do business, as well as by the federal
government. Most insurance regulations are designed to protect
the interests of policyholders rather than shareholders and
other investors. These regulations are generally administered by
a department of insurance in each state in which we do business.
State insurance departments conduct periodic examinations of the
affairs of insurance companies and require the filing of annual
and other reports relating to financial condition, holding
company issues and other matters.
These regulatory requirements may adversely affect or inhibit
our ability to achieve some or all of our business objectives.
In addition, regulatory authorities have relatively broad
discretion to deny or revoke licenses for various reasons,
including the violation of regulations. In some instances, we
follow practices based on our interpretations of regulations or
practices that we believe may be generally followed by the
industry. These practices may turn out to be different from the
interpretations of regulatory authorities. If we do not have the
requisite licenses and approvals or do not comply with
applicable regulatory requirements, insurance regulatory
authorities could preclude or temporarily suspend us from
carrying on some or all of our activities or otherwise penalize
us. This could adversely affect our ability to operate our
business. Further, changes in the level of regulation of the
insurance industry or changes in laws or regulations themselves
or interpretations by regulatory authorities could adversely
affect our ability to operate our business.
We are also subject to various accounting and financial
requirements established by the NAIC. If we fail to comply with
these laws, regulations and requirements, it could result in
consequences ranging from a regulatory examination to a
regulatory takeover of one or more of our insurance companies.
This would make our business less profitable. In addition, state
regulators and the NAIC continually re-examine existing laws and
regulations, with an emphasis on insurance company solvency
issues and fair treatment of policyholders. Insurance laws and
regulations could change or additional restrictions could be
imposed that are more burdensome and make our business less
profitable.
We are subject to the application of U.S. generally accepted
accounting principles (GAAP), which are periodically revised
and/or
expanded. As such, we are periodically required to adopt new or
revised accounting standards issued by recognized authoritative
bodies, including the Financial Accounting Standards Board. It
is possible that future changes required to be adopted could
change the current accounting treatment that we apply and such
changes could result in a material adverse impact on our results
of operations and financial condition.
Due to the geographic concentration of our business
(principally, Arizona, California, Nevada, New Jersey, Oregon
and Pennsylvania, and a limited amount in New York) catastrophe
and natural peril losses may have a greater adverse effect on us
than they would on a more geographically diverse property and
casualty insurer.
We could be significantly affected by legislative, judicial,
economic, regulatory, demographic and other events and
conditions in these states. In addition, we have significant
exposure to property losses caused by severe weather that
affects any of these states. Those losses could adversely affect
our results.
Additionally, a significant portion of our direct premium
writings are written in the construction contractor markets,
primarily in California. A significant downturn in the United
States or California construction industry could adversely
affect our direct written premiums.
The property and casualty insurance market in which we operate
is very highly competitive. Competition in the property and
casualty insurance business is based on many factors. These
factors include the perceived financial strength of the insurer,
premiums charged, policy terms and conditions, services
provided, reputation, financial ratings assigned by independent
rating agencies and the experience of the insurer in the line of
insurance to be written. We compete with stock insurance
companies, mutual companies, local cooperatives and other
underwriting organizations. Many of these competitors have
substantially greater financial, technical and operating
resources than we have.
We pay producers on a commission basis to produce business. Some
of our competitors may offer higher commissions or insurance at
lower premium rates through the use of salaried personnel or
other distribution methods that do not rely on independent
producers. Increased competition could adversely affect our
ability to attract and retain business and thereby reduce our
profits from operations.
We believe that our current marketplace is experiencing
significant pressure to reduce prices
and/or
increase coverage that is generous in relation to the premium
being charged. This pricing pressure could result in fewer new
business opportunities for us and possibly fewer renewals
retained, which could lead to reduced direct written premium
levels.
Many of our competitors offer internet-based quoting
and/or
policy issuance systems to their agents. Our ability to compete
with marketplace technology advances could adversely affect our
ability to write business and service accounts with the agency
force, and could adversely impact its results of operations and
financial condition.
A new form of competition may enter the marketplace as
reinsurers attempt to diversify their insurance risk by writing
business in the primary marketplace. We also face competition,
primarily in the commercial insurance market, from entities that
may desire to self-insure their own risks. The Group’s
ability to compete with reinsurers and self-insurers could
adversely impact our results of operations and financial
condition.
A reduction in our A.M. Best rating could affect our
ability to write new business or renew our existing business.
Ratings assigned by the A.M. Best Company, Inc. are an
important factor influencing the competitive position of
insurance companies. A.M. Best ratings represent an
independent opinion of financial strength and ability to meet
obligations to policyholders and are not directed toward the
protection of investors. If our financial position deteriorates,
we may not maintain our favorable financial strength rating from
A.M. Best. A downgrade of our rating could severely limit
or prevent us from writing desirable business or from renewing
our existing business.
Our results of operations may be adversely affected by any loss
of business from key producers. Our products are marketed by
independent producers. Other insurance companies compete with us
for the services and allegiance of these producers. These
producers may choose to direct business to our competitors, or
may direct less desirable risks to us which could have a
material adverse effect on us.
Our subsidiaries may declare and pay dividends to MIG (the
holding company) only if they are permitted to do so under the
insurance regulations of their respective state of domicile. If
our insurance subsidiaries are unable to pay adequate dividends
to us through their respective holding companies, our ability to
pay shareholder dividends would be affected. All of the states
in which our subsidiaries are domiciled regulate the payment of
dividends. States, including New Jersey, Pennsylvania, and
California require that we give notice to the relevant state
insurance commissioner prior to its subsidiaries making any
dividends and distributions to the parent. During the notice
period, the state insurance commissioner may disallow all or
part of the proposed dividend upon determination that:
(i) the insurer’s surplus is not reasonable in
relation to its liabilities and adequate to its financial needs
and those of the policyholders, or (ii) in the case of New
Jersey, the insurer is otherwise in a hazardous financial
condition. In addition, insurance regulators may block dividends
or other paments to affiliates that would otherwise be permitted
without prior approval upon determination that, because of the
financial condition of the insurance subsidiary or otherwise,
payment of a dividend or any other payment to an affiliate would
be detrimental to an insurance subsidiary’s policyholders
or creditors.
We began paying a quarterly dividend in the second quarter of
2006. However, future cash dividends will depend upon our
results of operations, financial condition, cash requirements
and other factors, including the ability of our subsidiaries to
make distributions to us, which ability is restricted in the
manner previously discussed in this section. Also, there can be
no assurance that we will continue to pay dividends even if the
necessary financial conditions are met and if sufficient cash is
available for distribution.
Our business is increasingly dependent on computer and
internet-enabled technology. Our ability to anticipate or manage
problems with technology associated with scalability, security,
functionality or reliability could
adversely affect its ability to write business and service
accounts, and could adversely impact our results of operations
and financial condition.
We made an acquisition in 2005 and intend to grow our business
in part through acquisitions in the future as part of its long
term business strategy. These type of transactions involve
significant challenges and risks that the acquisition will not
advance our business strategy, that we won’t realize a
satisfactory return on the investment we make, or that we may
experience difficulty in the integration of new employees,
business systems, and technology or diversion of
management’s attention from our other businesses. These
factors could adversely affect our operating results and
financial condition.
We could be adversely affected by the loss of our key personnel.
The success of our business is dependent, to a large extent, on
the efforts of certain key management personnel, and the loss of
key personnel could prevent us from executing our business
strategy and could significantly and negatively affect our
financial condition and results of operations. As we continue to
grow, we will need to recruit and retain additional qualified
management personnel, and our ability to do so will depend upon
a number of factors, such as our results of operations and
prospects and the level of competition then prevailing in the
market for qualified personnel. Recruiting key personnel can be
a difficult challenge.
None
Our main office and corporate headquarters is located at 10
North Highway 31, Pennington, New Jersey in a facility of
approximately 25,000 square feet owned by MIC. We also own
a tract of land adjacent to our main office property.
MIC also owns a 32,000 square foot office facility in Lock
Haven, Pennsylvania. MIC sub-leases a portion of this facility.
FPIC leases approximately 25,000 square feet for the
Group’s west coast operations in Rocklin, California. That
lease expires on December 31, 2009, subject to extension.
FPIC began construction on a new 41,000 square foot
building on the 2.9 acres of land it owns adjacent to the
leased building, to which the Rocklin operations will be moved.
The cost of the project is expected to be $6.7 million,
including improvements and building permits and fees. The land
is carried at $1.3 million. FPIC also owns a townhouse,
used for corporate purposes, in Rocklin, California carried at
$0.4 million.
Our insurance companies are parties to litigation in the normal
course of business. Based upon information presently available
to us, we do not consider any litigation to be material.
Nonetheless, given the often large or indeterminate amounts
sought in litigation, and the inherent unpredictability of
litigation, an adverse outcome in certain matters could, from
time to time, have a material adverse effect on our financial
position, consolidated results of operations, or cash flows.
None.
The Group’s common stock trades on the NASDAQ National
Market under the symbol “MIGP”. As of March 2,
2009, the Group had 293 certificated shareholders holding
approximately .7 million shares, with the balance of the
outstanding shares held in street name.
The payment of shareholder dividends is subject to the
discretion of the MIG’s Board of Directors which considers,
among other factors, the Group’s operating results, overall
financial condition, capital requirements and general business
conditions. MIG began paying quarterly dividends of $0.05 per
common share in the second quarter of 2006. On April 16,
2008, MIG’s Board of Directors increased the quarterly
dividend from $0.05 per share of common stock to $0.075 per
share of common stock, effective with the payment of the
June 27, 2008 dividend. The amount of dividends paid during
2008 and 2007 totaled $1.7 million and $1.3 million,
respectively. The shareholder dividend was funded from the
Group’s insurance companies, for which approval was sought
and received (where necessary) from each of the insurance
companies’ primary regulators. We currently expect that the
present quarterly dividend of $0.075 per common share will
continue through 2009.
The Group’s ability to receive dividends, loans or advances
from its insurance subsidiaries is subject to the approval
and/or
review of the insurance regulators in the respective domiciliary
states of the insurance subsidiaries. Such approval and review
is made under the respective domiciliary states’ insurance
holding company act, which generally requires that any
transaction between currently related companies be fair and
equitable to the insurance company and its policyholders. The
Group does not believe that such restrictions reasonably limit
the ability of the insurance subsidiaries to pay dividends to
the Group now or in the foreseeable future.
Information regarding restrictions and limitations on the
payment of cash dividends can be found in Item 1,
“Business — Regulation” in the
“Dividends” section.
The range of closing prices of the Group’s stock, traded on
the NASDAQ National Market, during 2008 was between $10.91 and
$17.94 per share. The range of closing prices during each of the
quarters in 2008 and 2007 is shown below:
Information relating to the Company’s stock repurchase
program and activity in the most recent quarter is presented
below:
Note 1 — On April 16, 2008, the Group’s
Board of Directors authorized the repurchase of up to 5% of
outstanding common shares of the Group. The repurchased shares
will be held as treasury shares available for issuance in
connection with Mercer Insurance Group’s 2004 Stock
Incentive Plan. In addition to the shares described above, the
Group purchased 1,729 shares from employees in connection
with the vesting of restricted stock in 2008. These repurchases
were made to satisfy tax withholding obligations with respect to
those employees and the vesting of their restricted stock. These
tax-withholding shares were purchased at the current market
value of the Group’s common stock on the date of purchase,
and were not purchased as part of the publicly announced program.
Performance
Graph
Set forth below is a line graph comparing the cumulative total
shareholder return on the Group’s Common Stock to the
cumulative total return of the Nasdaq Stock Market
(U.S. Companies) and the Nasdaq Insurance Index for the
period commencing December 31, 2003 and ended
December 31, 2008.
The graph assumes $100 was invested on December 31, 2003,
in the Group’s Common Stock and each of the indices, and
that dividends were reinvested. The comparisons in the graph are
not intended to forecast or be indicative of possible future
performance of our common stock.
The following table sets forth selected consolidated financial
data for MIG at and for each of the years in the five year
period ended December 31, 2008. You should read this data
in conjunction with the Group’s consolidated financial
statements and accompanying notes, “Management’s
Discussion and Analysis of Financial Condition and Results of
Operations” and other financial information included
elsewhere in this report.
The following presents management’s discussion and analysis
of our financial condition and results of operations as of the
dates and for the periods indicated. You should read this
discussion in conjunction with the consolidated financial
statements and notes thereto included in this report, and the
“Description of Business” contained in Item 1 of
this report. This discussion contains forward-looking
information that involves risks and uncertainties. Actual
results could differ significantly from these forward-looking
statements.
MIG, through its property and casualty insurance subsidiaries,
provides a wide array of property and casualty insurance
products designed to meet the insurance needs of individuals in
New Jersey and Pennsylvania, and small and medium-sized
businesses throughout Arizona, California, Nevada, New Jersey,
Oregon and Pennsylvania. The Group also writes a limited amount
of business in New York which supports accounts in adjacent
states.
The Group manages its business in three segments: commercial
lines insurance, personal lines insurance, and investments. The
commercial lines insurance and personal lines insurance segments
are managed based on underwriting results determined in
accordance with U.S. generally accepted accounting
principles, and the investment segment is managed based on
after-tax investment returns. In determining the results of each
segment, assets are not allocated to segments and are reviewed
in the aggregate for decision-making purposes.
The Group’s net income is primarily determined by five
elements:
Variations in premium earned are subject to a number of factors,
including:
Variations on investment income are subject to a number of
factors, including:
Loss and loss adjustment expenses are affected by a number of
factors, including:
The Group seeks to manage each of the foregoing to the extent
within its control. Many of the foregoing factors are partially,
or entirely, outside the control of the Group.
CRITICAL
ACCOUNTING POLICIES
We are required to make estimates and assumptions in certain
circumstances that affect amounts reported in our consolidated
financial statements and related footnotes. We evaluate these
estimates and assumptions on an on-going basis based on
historical developments, market conditions, industry trends and
other information that we believe to be reasonable under the
circumstances. There can be no assurance that actual results
will conform to our estimates and assumptions, and that reported
results of operations will not be materially adversely affected
by the need to make accounting adjustments to reflect changes in
these estimates and assumptions from time to time. We believe
the following policies are the most sensitive to estimates and
judgments.
Unpaid losses and loss adjustment expenses, also referred to as
loss reserves, are the largest liability of our property and
casualty subsidiaries. Our loss reserves include case reserve
estimates for claims that have been reported and bulk reserve
estimates for (a) the expected aggregate differences
between the case reserve estimates and the ultimate cost of
reported claims and (b) claims that have been incurred but
not reported as of the balance sheet date, less estimates of the
anticipated salvage and subrogation recoveries. Each of these
categories also includes estimates of the loss adjustment
expenses associated with processing and settling all reported
and unreported claims. Estimates are based upon past loss
experience modified for current and expected trends as well as
prevailing economic, legal and social conditions.
The amount of loss and loss adjustment expense reserves for
reported claims is based primarily upon a
case-by-case
evaluation of the type of risk involved, specific knowledge of
the circumstances surrounding each claim, and the insurance
policy provisions relating to the type of loss. The amounts of
loss reserves for unreported losses and loss adjustment expenses
are determined using historical information by line of business,
adjusted to current conditions. Inflation is ordinarily provided
for implicitly in the reserving function through analysis of
costs, trends, and reviews of historical reserving results over
multiple years. Our loss reserves are not discounted to present
value.
Reserves are closely monitored and recomputed periodically using
the most recent information on reported claims and a variety of
projection techniques. Specifically, on at least a quarterly
basis, we review, by line of business, existing reserves, new
claims, changes to existing case reserves, and paid losses with
respect to the current and prior accident years. We use
historical paid and incurred losses and accident year data to
derive expected ultimate loss and loss adjustment expense ratios
(to earned premiums) by line of business. We then apply these
expected loss and loss adjustment expense ratios to earned
premiums to derive a reserve level for each line of business. In
connection with the determination of the reserves, we also
consider other specific factors such as recent weather-related
losses, trends in historical paid losses, economic conditions,
and legal and judicial trends with respect to theories of
liability. Any changes in estimates are reflected in operating
results in the period in which the estimates are changed.
We perform a comprehensive annual review of loss reserves for
each of the lines of business we write in connection with the
determination of the year end carried reserves. The review
process takes into consideration the
variety of trends and other factors that impact the ultimate
settlement of claims in each particular class of business. A
similar review is performed prior to the determination of the
June 30 carried reserves. Prior to the determination of the
March 31 and September 30 carried reserves, we review the
emergence of paid and reported losses relative to expectations
and make necessary adjustments to our carried reserves. There
are also a number of analyses of claims experience and reserves
undertaken by management on a monthly basis.
When a claim is reported to us, our claims personnel establish a
“case reserve” for the estimated amount of the
ultimate payment. This estimate reflects an informed judgment
based upon general insurance reserving practices and the
experience and knowledge of the estimator. The individual
estimating the reserve considers the nature and value of the
specific claim, the severity of injury or damage, and the policy
provisions relating to the type of loss. Case reserves are
adjusted by our claims staff as more information becomes
available. It is our policy to periodically review and revise
case reserves and to settle each claim as expeditiously as
possible.
We maintain bulk and IBNR reserves (usually referred to as
“IBNR reserves”) to provide for claims already
incurred that have not yet been reported (and which often may
not yet be known to the insured) and for future developments on
reported claims. The IBNR reserve is determined by estimating
our insurance companies’ ultimate net liability for both
reported and incurred but not reported claims and then
subtracting both the case reserves and payments made to date for
reported claims; as such, the “IBNR reserves”
represent the difference between the estimated ultimate cost of
all claims that have occurred or will occur and the reported
losses and loss adjustment expenses. Reported losses include
cumulative paid losses and loss adjustment expenses plus
aggregate case reserves. A relatively large proportion of our
gross and net loss reserves, particularly for long tail
liability classes, are reserves for IBNR losses. More than 74%
and 75% of our aggregate loss reserves at December 31, 2008
and 2007, respectively, were bulk and IBNR reserves.
Some of our business relates to coverage for short-tail risks
and, for these risks, the development of losses is comparatively
rapid and historical paid losses and case reserves, adjusted for
known variables, have been a reliable guide for purposes of
reserving. “Tail” refers to the time period between
the occurrence of a loss and the settlement of the claim. The
longer the time span between the incidence of a loss and the
settlement of the claim, the more the ultimate settlement amount
can vary. Some of our business relates to long-tail risks, where
claims are slower to emerge (often involving many years before
the claim is reported) and the ultimate cost is more difficult
to predict. For these lines of business, more sophisticated
actuarial methods, such as the Bornhuetter-Ferguson loss
development method, are employed to project an ultimate loss
expectation, and then the related loss history must be regularly
evaluated and loss expectations updated, with a likelihood of
variability from the initial estimate of ultimate losses. A
substantial portion of the business written by FPIC is this type
of longer-tailed casualty business.
We apply the following general methods in projecting loss and
loss adjustment expense reserves for the Group:
1. Paid loss development;
2. Paid Bornhuetter-Ferguson loss development;
3. Reported loss development;
4. Reported Bornhuetter-Ferguson loss development; and
5. Separate developments of claims frequency and severity.
In addition, we apply several diagnostic ratio tests of the
reserves for long-tailed liability lines of business, including
but not limited to:
1. Retrospective tests of the ratios of IBNR reserves to
earned premiums and to estimated ultimate incurred losses;
2. Retrospective tests of the ratios of the loss reserves
to earned premiums and to estimated ultimate incurred losses;
3. Ratios of cumulative and incremental incurred and paid
losses to earned premiums and to estimated ultimate incurred
losses;
4. Ratios of cumulative and incremental paid losses to
cumulative incurred losses and ratios of incremental paid losses
to prior case loss and LAE reserves;
5. Ratios of cumulative average incurred loss per claim and
cumulative average incurred loss per reported claim; and
6. Ratios of cumulative average paid loss per claim closed
with payment and average case reserve per pending claim.
The reported loss development method relies on the assumption
that, at any given state of maturity, ultimate losses can be
predicted by multiplying cumulative reported losses (paid losses
plus case reserves) by a cumulative development factor. The
validity of the results of this method depends on the stability
of claim reporting and settlement rates, as well as the
consistency of case reserve levels. Case reserves do not have to
be adequately stated for this method to be effective; they only
need to have a fairly consistent level of adequacy at comparable
stages of maturity. Historical “age-to-age” loss
development factors are calculated to measure the relative
development of an accident year from one maturity point to the
next. We then select appropriate age-to-age loss development
factors based on these historical factors and use the selected
factors to project the ultimate losses.
The paid loss development method is mechanically identical to
the incurred loss development method described above with the
exception that paid losses replace incurred losses. The paid
method does not rely on case reserves or their adequacy in
making projections.
The validity of the results from using a loss development
approach can be affected by many conditions, such as internal
claim department processing changes, a shift between single and
multiple claim payments, legal changes, or variations in a
company’s mix of business from year to year. Also, since
the percentage of losses paid for immature years is often low,
development factors are volatile. A small variation in the
number of claims paid can have a leveraging effect that can lead
to significant changes in estimated ultimates. Therefore,
ultimate values for immature accident years are often based on
alternative estimation techniques.
The Bornhuetter-Ferguson expected loss projection method based
on reported loss data relies on the assumption that remaining
unreported losses are a function of the total expected losses
rather than a function of currently reported losses. The
expected losses used in this analysis are selected judgmentally
based upon the historical relationship between premiums and
losses for more mature accident years, adjusted to reflect
changes in average rates and expected changes in claims
frequency and severity. The expected losses are multiplied by
the unreported percentage to produce expected unreported losses.
The unreported percentage is calculated as one minus the
reciprocal of the selected incurred loss development factors.
Finally, the expected unreported losses are added to the current
reported losses to produce ultimate losses.
The calculations underlying the Bornhuetter-Ferguson expected
loss projection method based on paid loss data are similar to
the incurred Bornhuetter-Ferguson calculations with the
exception that paid losses and unpaid percentages replace
reported losses and unreported percentages.
The Bornhuetter-Ferguson method is most useful as an alternative
to other models for immature accident years. For these immature
years, the amounts reported or paid may be small and unstable
and therefore not predictive of future development. Therefore,
future development is assumed to follow an expected pattern that
is supported by more stable historical data or by emerging
trends. This method is also useful when changing reporting
patterns or payment patterns distort the historical development
of losses.
For the property lines of business (special property, personal
auto physical damage, and commercial auto physical damage) the
results of the reserve calculations were similar and we
generally rely on an averaging of the methods utilized.
For the homeowners and commercial multi-peril lines of business
(excluding California CMP business for policy years 1996 and
prior) we generally rely on the incurred loss development and
incurred Bornhuetter-Ferguson methods in estimating loss
reserves. These two methods yield more consistent results
although the two paid methods yielded reserves that were similar
in total to the incurred methods.
In July of 1995, the California Supreme Court rendered its
Opinion in Admiral Insurance Company vs. Montrose Chemical
Corporation (the Montrose Decision). In that decision,
the California Supreme Court ruled that in the case of a
continuous and progressively deteriorating loss, such as
pollution liability (or construction defect liability), an
insurance company has a definitive duty to defend the
policyholder until all uncertainty related to the severity and
cause of the loss is extinguished.
After the Montrose Decision, FPIC (a subsidiary of the
Group since October 1, 2005) experienced a significant
increase in construction defect liability cases impacting our
West Coast commercial multi-peril liability lines of business,
to which it would not have been subject under the old
interpretation of the law. In response, FPIC (prior to its
acquisition by the Group) implemented a series of underwriting
measures to limit the prospective exposure to Montrose
and construction defect liability claims. These changes to
coverage and risk selection resulted in an improvement in the
post-Montrose underwriting results.
FPIC evaluates commercial multi-peril liability reserves by
segregating pre- and post-Montrose activity as well as
segregating contractor versus non-contractor experience. An
inception to date
ground-up
incurred loss database was created as the basis for this new
analysis. The pre-Montrose activity is evaluated on a
report year basis, which eliminates the accident year
development distortions caused by the effects of the Montrose
Decision. For policy years 1997 and later, the reserves are
analyzed using the more traditional accident year analysis.
For the casualty lines (commercial multi-peril liability, other
liability, personal auto liability, commercial auto liability,
workers’ compensation) the paid loss development method
yielded less than reliable results for the immature years, and
we did not use the method in selecting ultimate losses and
reserves. For these lines we primarily relied on the incurred
Bornhuetter-Ferguson method for the most recent accident years
and both of the incurred loss development methods for the
remaining years.
The property and casualty industry has incurred substantial
aggregate losses from claims related to asbestos-related
illnesses, environmental remediation, product and mold, and
other uncertain or environmental exposures. We have not
experienced significant losses from these types of claims.
We compute our estimated ultimate liability using these
principles and procedures applicable to the lines of business
written. However, because the establishment of loss reserves is
an inherently uncertain process, we cannot be certain that
ultimate losses will not exceed the established loss reserves
and have a material adverse effect on the Group’s results
of operations and financial condition. Changes in estimates, or
differences between estimates and amounts ultimately paid, are
reflected in the operating results of the period during which
such adjustments are made.
Reserves are estimates because there are uncertainties inherent
in the determination of ultimate losses. Court decisions,
regulatory changes and economic conditions can affect the
ultimate cost of claims that occurred in the past as well as
create uncertainties regarding future loss cost trends.
Accordingly, the ultimate liability for unpaid losses and loss
settlement expenses will likely differ from the amount recorded
at December 31, 2008.
For further information relating to the determination of loss
and loss adjustment expense reserves, please see the discussion
under “Loss and Loss Adjustment Expense Reserves”
contained in ITEM 1. “Business” of this
Form 10-K.
Unrealized investment gains or losses on investments carried at
fair value, net of applicable income taxes, are reflected
directly in stockholders’ equity as a component of
accumulated other comprehensive income and, accordingly, have no
effect on net income. A decline in fair value of an investment
below its cost that is deemed other than temporary is charged to
earnings as a realized loss. We monitor our investment portfolio
and review investments that have experienced a decline in fair
value below cost to evaluate whether the decline is other than
temporary. These evaluations involve judgment and consider the
magnitude and reasons for a decline and the prospects for the
fair value to recover in the near term. Adverse investment
market conditions, poor operating performance, or other
adversity encountered by companies whose stock or fixed maturity
securities we own could result in impairment charges in the
future. Our policy on impairment of value of investments is as
follows: if a security has a market value below cost it is
considered impaired. For any such security a review of the
financial condition and prospects of the company will be
performed by the Investment Committee to determine if the
decline in market value is other than temporary. If it is
determined that the decline in market value is “other than
temporary”, the carrying value of the security will be
written down to “realizable value” and the amount of
the write down accounted for as a realized loss.
“Realizable value” is defined for this purpose as the
market price of the security. Write down to a value other than
the market price requires objective evidence in support of that
value.
In evaluating the potential impairment of fixed income
securities, the Investment Committee will evaluate relevant
factors, including but not limited to the following: the
issuer’s current financial condition and ability to make
future scheduled principal and interest payments, relevant
rating history, analysis and guidance provided by rating
agencies and analysts, the degree to which an issuer is current
or in arrears in making principal and interest payments, and
changes in price relative to the market.
In evaluating the potential impairment of equity securities, the
Investment Committee will evaluate certain factors, including
but not limited to the following: the relationship of market
price per share versus carrying value per share at the date of
acquisition and the date of evaluation, the price-to-earnings
ratio at the date of acquisition and the date of evaluation, any
rating agency announcements, the issuer’s financial
condition and near-term prospects, including any specific events
that may influence the issuer’s operations, the independent
auditor’s report on the issuer’s financial statements;
and any buy/sell/hold recommendations or price projections by
outside investment advisors.
In the years ended December 31, 2008, 2007 and 2006, we
recorded a pre-tax charge to earnings of $6.2 million,
$0.1 million and $0.1 million, respectively, for
write-downs of other than temporarily impaired securities (OTTI).
During the second half of 2008, there were significant
disruptions to the financial and equity markets. This resulted
from, in part, failures of financial institutions on an
unprecedented scale, and caused a significant reduction in
liquidity and trading flows in the credit markets in addition to
a dramatic widening in credit spreads. Such impacts affected the
valuations of both the fixed income and equity securities we
held. The loss of confidence and the so-called, “credit
freeze” in the capital markets during 2008 led to several
significant events, including the conservatorship of Fannie Mae
and Freddie Mac, the bankruptcy filing of Lehman Brothers, and
an agreement for Merrill Lynch to be acquired by Bank of
America, among others.
Of the $6.2 million in 2008 OTTI write-downs,
$3.9 million related to 11 fixed-income securities
including the following:
Of the $6.2 million in 2008 OTTI write-downs,
$2.3 million related to 33 equity securities, including the
following:
We defer policy acquisition costs, such as commissions, premium
taxes and certain other underwriting expenses that vary with and
are primarily related to the production of business. These costs
are amortized over the effective period of the related insurance
policies. The method followed in computing deferred policy
acquisition costs limits the amount of deferred costs to their
estimated realizable value, which gives effect to the premium to
be earned, related investment income, loss and loss adjustment
expenses, and certain other costs expected to be incurred as the
premium is earned. Future changes in estimates, the most
significant of which is expected loss and loss adjustment
expenses, may require acceleration of the amortization of
deferred policy acquisition costs. If the estimation of net
realizable value indicates that the acquisition costs are
unrecoverable, further analyses are completed to determine if a
reserve is required to provide for losses that may exceed the
related unearned premiums.
Amounts recoverable from property and casualty reinsurers are
estimated in a manner consistent with the claim liability
associated with the reinsured policy. Amounts paid for
reinsurance contracts are expensed over the contract period
during which insured events are covered by the reinsurance
contracts.
Ceded unearned premiums and reinsurance balances recoverable on
paid and unpaid loss and loss adjustment expenses are reported
separately as assets, instead of being netted with the related
liabilities, because reinsurance does not relieve us of our
legal liability to our policyholders. Reinsurance balances
recoverable are subject to credit risk associated with the
particular reinsurer. Additionally, the same uncertainties
associated with estimating unpaid loss and loss adjustment
expenses affect the estimates for the ceded portion of these
liabilities.
We continually monitor the financial condition of our reinsurers.
Many of the reinsurance treaties participated in by the Group
prior to 2007, and primarily FPIC treaties, have included
provisions that establish minimum and maximum cessions and allow
limited participation in the profit of the ceded business.
Generally, the Group shares on a limited basis in the
profitability of our reinsurance treaties through contingent
ceding commissions. The Group’s exposure in the loss
experience is contractually defined at minimum and maximum
levels. The terms of such contracts are fixed at inception.
Since estimating the emergence of claims to the applicable
reinsurance layers is subject to significant uncertainty, the
net amounts that will ultimately be realized may vary
significantly from the estimated amounts presented in the
Group’s results of operations.
We use the asset and liability method of accounting for income
taxes. Deferred income taxes arise from the recognition of
temporary differences between financial statement carrying
amounts and the tax bases of our assets and liabilities.
Deferred tax assets and liabilities are measured using enacted
tax rates expected to apply to taxable income in the years in
which those temporary differences are expected to be recovered
or settled. A valuation allowance is provided when it is more
likely than not that some portion of the deferred tax asset will
not be realized. The effect of a change in tax rates is
recognized in the period of the enactment date.
Besides claims related to its insurance products, the Group is
subject to proceedings, lawsuits and claims in the normal course
of business. The Group assesses the likelihood of any adverse
outcomes to these matters as well as potential ranges of
probable losses. There can be no assurance that actual outcomes
will be consistent with those assessments.
RESULTS
OF OPERATIONS
Revenue and income by segment is as follows for the years ended
December 31, 2008, 2007 and 2006. In 2007, the Group
evaluated its methodology for allocating costs to its lines of
business and adopted changes to such methodology in order to
more accurately reflect the allocation of joint costs. This
resulted in allocating less joint cost to the personal lines of
business and more joint cost to the commercial lines of
business, but with no net change in cost allocated to personal
lines and commercial lines in the aggregate. Related 2006
amounts have been reclassified to reflect this change in
allocation methodology:
Our results of operations are influenced by factors affecting
the property and casualty insurance industry in general. The
operating results of the United States property and casualty
insurance industry are subject to significant variations due to
competition, weather, catastrophic events, regulation, the
availability and cost of satisfactory reinsurance, general
economic conditions, judicial trends, fluctuations in interest
rates and other changes in the investment environment.
The availability of reinsurance at reasonable pricing is an
important part of our business. Effective January 1, 2008,
we increased our retention to $850,000 (from a maximum retention
of $750,000 and $500,000 in 2007 and 2006, respectively) on the
casualty, property and workers’ compensation lines of
business. As we increase the net retention of the business we
write, net premiums written and earned will increase and ceded
losses will decrease. The impact of increased retentions under
our reinsurance program in 2008 and 2007 was offset in part by a
decline in direct written premiums due to the increasingly
competitive marketplace and the contraction of the economy in
our markets, particularly as it relates to new construction
contractors we insure. As older reinsurance treaties run off,
the impact described above of the new reinsurance program will
become more evident in net premiums written and net premiums
earned.
We write homeowners insurance only in New Jersey and
Pennsylvania, and personal automobile insurance only in
Pennsylvania. Personal lines insurance is not written in any
other states in which we do business.
The key elements of our business model are the sales of properly
priced and underwritten personal and commercial property and
casualty insurance through independent agents and the investment
of the premiums in a manner designed to assure that claims and
expenses can be paid while providing a return on the capital
employed. Loss trends and investment performance are critical
factors in influencing the success of the business model. These
factors are affected by the factors impacting the insurance
industry in general and factors unique to us as described in the
following discussion.
YEAR
ENDED DECEMBER 31, 2008 COMPARED TO YEAR ENDED DECEMBER 31,
2007
The components of income for 2008 and 2007, and the change and
percentage change from year to year, are shown in the charts
below. The accompanying narrative refers to the statistical
information displayed in the chart immediately above the
narrative.
(N/M means “not meaningful”)
As previously disclosed in our SEC filings, we paid an aggregate
of $3.5 million, including accrued interest, to the New
Jersey Division of Taxation (the “Division”) in
retaliatory premium tax for the years
1999-2004.
In conjunction with making such payments, we filed notices of
protest with the Division with respect to the retaliatory tax
imposed. The payments were made in response to notices of
deficiency issued by the Division of taxation.
We received $4.3 million in 2007 as a reimbursement of
protested payments of retaliatory tax, including accrued
interest thereon, previously made by us for the periods
1999-2004.
The refund was recorded, after reduction for Federal income tax,
in the amount of $2.8 million in the 2007 consolidated
statement of earnings. The allocation of the refund to 2007
pre-tax earnings included an increase to net investment income
of $720,000 for the interest received on the refund, and
$3.6 million as a reduction to other expense to recognize
the recovery of amounts previously charged to other expense.
This is a non-recurring item which significantly affected the
earnings for the year ended December 31, 2007, and related
performance metrics such as the combined ratio.
Our GAAP combined ratio for 2008 was 98.1%, as compared to a
combined ratio for the prior year of 95.8%. On a pro-forma
basis, after removing the effect of the non-recurring
retaliatory tax refund described above, the GAAP combined ratio
for 2007 was 98.3%. The statutory combined ratio for 2008 and
2007 was 98.5% and 94.4%, respectively. See the discussion below
relating to commercial and personal lines performance.
Net investment income increased $0.9 million or 6.8% to
$13.9 million in 2008 as compared to $13.1 million in
2007. This increase was driven by an increase in average cash
and invested assets. Net investment income for
2007 included $720,000 of interest income as a result of the
non-recurring impact of the retaliatory tax refund. Average cash
and invested assets totaled $367 million for 2008 as
compared to $333 million for 2007, representing an increase
of $34 million, driven by operating cash flow.
Net realized investment losses amounted to $7.1 million in
2008, which is primarily driven by other than temporary
impairment write-downs on investment securities, a realized loss
on the mark-to-market valuation on the interest rate swaps for
the trust preferred securities, offset in part by realized gains
on the sales of investments. Net realized investment gains
amounted to $24,000 in 2007, which is primarily realized gains
on the sales of investments, offset in part by other than
temporary impairments on investment securities and a realized
loss on the mark-to-market valuation on the interest rate swaps
for the trust preferred securities. See the discussion of other
than temporary impairments on investment securities in the
“Critical Accounting Policies” section. Other revenue
of $2.0 million and $1.9 million in 2008 and 2007,
respectively, represents primarily service charges recorded on
insurance premium payment plans. Interest expense of
$1.3 million and $1.2 million in 2008 and 2007,
respectively, represents interest charges on the trust preferred
obligations of FPIG.
Charts and discussion relating to each of our segments
(commercial lines underwriting, personal lines underwriting, and
the investment segment) follow with further discussion below.
(N/M means “not meaningful”)
Total revenues remained consistent at $161.5 million and
$161.7 million in 2008 and 2007, respectively. Revenues
were flat
year-on-year
due to the significant realized loss on OTTI write-downs in
2008, which offset the growth in net premiums earned and net
investment income. Net premiums earned totaled
$152.6 million in 2008 as compared to $146.7 million
in 2007, representing a 4.0% or $5.9 million increase. Net
premiums written decreased $12.3 million or 7.7% to
$147.4 million in 2008 as compared to $159.7 million
in 2007. Net premiums earned increased 4.0% despite the 7.7%
decline in net premiums written. The decline in net premiums
written is attributable to the 9.6% decline in direct premiums
written, offset by the positive impact on net premiums written
of the change in reinsurance structure (in 2007 retention
increased to $750,000 from $250,000 and $350,000 in 2006 on
FPIC’s casualty and property lines, respectively, and from
$500,000 on MIC’s, MICNJ’s and FIC’s 2006
property, casualty and workers’ compensation lines, and in
2008 to $850,000 from $750,000). Direct premiums written and
earned were negatively impacted by the reduction in audit
premium recorded during 2008, which is earned immediately upon
booking (see the discussion below for discussion of audit
premium and changes in reinsurance arrangements).
Net investment income totaled $13.9 million in 2008, as
compared to $13.1 million in 2007, representing a 6.8% or
$0.9 million increase. Net investment income for 2007 was
impacted by the $720,000 non-recurring impact of the retaliatory
tax refund. Net realized investment losses amounted to
$7.1 million in 2008 as compared to net realized investment
gains of $24,000 in 2007. The net realized investment loss in
2008 is primarily driven by other than temporary impairments on
investment securities, a realized loss on the mark-to-market
valuation on the interest rate swaps for the trust preferred
securities, offset in part by realized gains on the sales of
investments. The net realized investment gain in 2007 is
primarily driven by realized gains on the sales of investments,
offset in part by other than temporary impairments on investment
securities and a realized loss on the mark-to-market valuation
on the interest rate swaps for the trust preferred securities.
See the discussion of other than temporary impairments on
investment securities in the “Critical Accounting
Policies” section.
In 2008, direct premiums written declined $17.5 million or
9.6% to $165.4 million as compared to $182.9 million
in 2007. The decline in direct premiums written is attributable
to a more difficult economic environment and competitive market
conditions. A decline in construction related activity and
related audit premium in California, increased competition on
large accounts, as well as the return of a number of competitors
to the California contractor market and the East Coast
habitational market contributed to this decline.
The decline in audit premium, as compared to the prior year,
relates to a general decline in construction related activity
and failing businesses in the construction industry,
specifically in California, driven by a slowdown of the
residential housing market. Approximately 50% of FPIC’s
business (and approximately one-third of our business in total)
is related to contractor liability.
Commercial multiple peril policies constitute a majority of the
business written in FPIC’s contractor book of business. The
premium on these policies is estimated at policy inception based
on a prediction of the volume of the insured’s business
operations during the policy period. In addition to endorsing
the policy throughout the policy period based on known
information, at policy expiration FPIC conducts an audit of the
insured’s business operations in order to adjust the policy
premium from an estimate to actual. Contractor liability policy
premium tends to vary with local construction activity as well
as changes in the nature of the contractor’s operations.
The decline in construction related activity and failing
businesses in the construction industry has impacted both the
volume of premium for the contractor in-force book of business
(and related exposures) and the related audit premium on
expiring policies. Audits, primarily of construction related
policies, generated return premium of $2.6 million in 2008,
representing a decline of $5.7 million as compared to
$3.1 million of additional premium that was generated in
2007.
The decline in year-to-date direct premiums written reflects a
continuing competitive marketplace and declining levels of
economic activity in our operating territories. The current
market is highly competitive, with pricing and coverage
competition being seen in virtually all classes of commercial
accounts, package policies, commercial automobile policies and
in the Pennsylvania personal auto market and Pennsylvania and
New Jersey homeowners markets, all of which makes it more
challenging to retain our accounts on renewal, or to renew a
policy at the expiring premium. Competition also continues on
large accounts, particularly in the East Coast habitational and
California construction contracting programs, as competitors
aggressively compete for these higher premium accounts. Pricing
in the property and casualty insurance industry historically has
been and remains cyclical. During a soft market cycle, such as
the current market condition, price competition is prevalent,
which makes it challenging to write and retain properly priced
personal and commercial lines business. We continue to work with
our agents to target classes of business and accounts compatible
with our underwriting appetite, which includes certain types of
religious institution risks, contracting risks, small business
risks and property risks. Despite the pricing pressures of the
marketplace, management maintains a strong focus on its policy
of disciplined underwriting and pricing standards, declining
business which it determines is inadequately priced for its
level of risk. In spite of these competitive market conditions,
ourGroup’s policy retention on renewal has been favorable
across most product lines.
In the fourth quarter of 2008, a new Business Owners Policy for
California risks was introduced. This product targets small to
medium sized businesses, which have been shown to be somewhat
less price sensitive than larger accounts. This product also
helps to balance FPIC’s business between property and
casualty exposures. Additionally, a new contracting product
which specializes in covering artisan contractors is being
developed for Arizona, California, Nevada and Oregon and is
targeted for introduction in early 2009. Artisan contractors
primarily provide repair and maintenance services, and this
segment tends to experience less severe market fluctuations
compared to the real estate construction industry.
Effective January 1, 2008, the Group increased its
reinsurance retention to $850,000 (from a maximum retention of
$750,000 in 2007) on the casualty, property and
workers’ compensation lines of business. Pollution coverage
written by FPIC is now fully retained with a standard sub-limit
of $150,000 (and up to $300,000 on an exception basis). Prior to
2008, FPIC reinsured 100% of its pollution coverage, which in
the twelve months ended December 31, 2007 represented
$1.8 million of ceded written premium. We also purchased an
additional $1.0 million of surety coverage (subject to a
10% retention), which resulted in an increased reinsurance
coverage to $4.5 million from $3.5 million per
principal and a maximum retention of $900,000 per principal as
compared to
the previous $800,000. The net effect of these changes in
reinsurance arrangements increased net premiums written for 2008.
Growth in Net Investment Income is discussed below.
(N/M means “not meaningful”)
In 2008 net investment income increased $0.9 million,
or 6.8%, to $13.9 million, as compared to
$13.1 million in 2007. Net investment income in 2007
benefited from the $720,000 non-recurring impact of the
retaliatory tax refund. The increase in net investment income in
2008 is the result of an increase in average cash and invested
assets. Average cash and invested assets totaled
$367 million for 2008 as compared to $333 million for
2007, representing an increase of $33 million. The increase
in invested assets is driven primarily by operating cash flow,
including the benefits of the 2008 and 2007 reinsurance
agreement changes, which result in less premium being ceded to
reinsurers.
In 2008 investment income on fixed income securities increased
$1.5 million, or 11.3%, to $14.9 million, as compared
to $13.4 million in 2007. This was driven by an increase in
the average investments held in fixed income securities, offset
by a decline in the yield on investments. Our tax equivalent
yield (yield adjusted for tax-benefit received on tax-exempt
securities) on fixed income securities declined to 5.06% in
2008, as compared to 5.22% in 2007.
Dividend income remained consistent at $351,000 in 2008 as
compared to $319,000 in 2007. Interest income on cash and cash
equivalents declined $1.0 million or 67.2% to
$0.5 million in 2008, as compared to $1.4 million in
2007, primarily as a result of the $720,000 of non-recurring
interest received on the retaliatory tax refund in 2007.
Investment expenses declined $0.3 million or 14.8% to
$1.8 million in 2008, from $2.1 million in 2007.
Net realized losses in 2008 were $7.1 million, as compared
to net realized gains of $24,000 in 2007. In 2008 net
realized losses of $7.1 million included write-downs of
securities determined to be other than-temporarily impaired of
$6.2 million, net gains on securities sales of
$0.6 million, and a loss on the mark-to-market valuation on
the interest rate swaps of $1.5 million. In 2007 net
realized gains of $24,000 included net gains on securities sales
of $0.9 million, a loss on the mark-to-market valuation on
the interest rate swaps of $0.8 million, and write-downs of
securities determined to be other than-temporarily impaired of
$0.1 million. Securities determined to be
other-than-temporarily impaired were written down to fair value
at the time of the write-down. See the discussion of other than
temporary impairments on investment securities in the Critical
Accounting Policies section. We have three ongoing interest rate
swap agreements to hedge against interest rate risk on our
floating rate trust preferred securities. The estimated fair
value of the interest rates swaps is obtained from the
third-party financial institution counterparties. We mark the
investments to market using these valuations and records the
change in the economic value of the interest rate swaps as a
realized gain or loss in the consolidated statement of earnings.
Fixed maturity investments represent 99.6% of invested assets,
and as of December 31, 2008, the fixed income portfolio
consists of 99.6% investment grade securities, with the
remaining 0.4% non-investment grade rated securities. The 0.4%
includes three corporate securities held with a combined market
value of $1.2 million, and one
asset-backed security held with a market value of
$0.2 million. The fixed income portfolio has an average
rating of Aa2/AA, an average effective maturity of
5.0 years, an average duration of 3.5 years with an
average tax equivalent book yield of 5.06%.
Among our portfolio holdings, the only subprime exposure
consists of asset-backed securities (ABS) within the home equity
subsector. The ABS home equity subsector totaled
$0.6 million (book value) on December 31, 2008,
representing 4.1% of the ABS holdings, 0.7% of the total
structured product holdings, and 0.2% of total fixed income
portfolio holdings. The subprime related exposure consists of
three individual securities, of which two are insured by a
monoline insurer against default of principal and interest.
However, since FGIC and AMBAC have been downgraded from their
previous AAA status, the two insured securities are now rated
according to the higher of the underlying collateral or the
monoline rating. One bond is rated Baa1/A while the other is
rated Baa3/BB. With regard to the remaining security without
monoline insurance, it is rated Aa2/AA by Moody’s and
S&P, respectively. See “Management’s Discussion
and Analysis of Financial Condition and Results of
Operations” under the subsection entitled
“Quantitative and Qualitative Information about Market
Risk.”
The estimated fair value and unrealized loss for securities in a
temporary unrealized loss position as of December 31, 2008
are as follows:
Fixed maturity investments with unrealized losses for less than
twelve months are primarily due to changes in the interest rate
environment and anomalies in pricing in the current difficult
market. At December 31, 2008 we had 11 fixed maturity
securities with unrealized losses for more than twelve months.
Of the 11 securities with unrealized losses for more than twelve
months, all of them have fair values of no less than 72% of book
value. We do not believe these declines are other than temporary
due to the credit quality of the holdings. We currently have the
ability and intent to hold these securities until recovery.
In the years ended December 31, 2008, 2007 and 2006, we
recorded a pre-tax charge to earnings of $6.2 million,
$0.1 million and $0.1 million, respectively, for
write-downs of other than temporarily impaired securities. See
the discussion of recent downgrades and other than temporary
impairments on investment securities in the “Critical
Accounting Policies” section.
There are 12 common stock securities that are in an unrealized
loss position at December 31, 2008. All of these securities
have been in an unrealized loss position for less than
6 months. There are 4 preferred stock securities that are
in an unrealized loss position at December 31, 2008. Three
preferred stock securities have been in an unrealized loss
position for less than 8 months. One preferred stock
security has been in an unrealized loss position for more than
twelve months. We do not believe these declines are other than
temporary as a result of reviewing the circumstances of each
such security in an unrealized loss position. We currently have
the ability and intent to hold these securities until recovery.
However, future write-downs may become necessary in light of
unprecedented market and liquidity disruptions.
The following table summarizes the period of time that equity
securities sold at a loss during 2008 had been in a continuous
unrealized loss position:
The equity securities sold at a loss had been expected to
appreciate in value, but due to unforeseen circumstances were
sold so that sale proceeds could be reinvested. Securities were
sold due to a desire to reduce exposure to certain issuers and
industries or in light of unforeseen economic conditions.
Results of our Commercial Lines segment were as follows:
In 2008 our commercial lines direct premiums written decreased
by $16.8 million or 10.5% to $143.3 million as
compared to direct premium written in 2007 of
$160.0 million. The decline in direct premiums written is
attributed to several factors, including a decline in
construction related activity and related audit premium in
California, increased competition on large accounts, and the
return of a number of competitors to the California contractor
market and the East Coast habitational market. Our California
contractors book reflects the decreased economic activity in the
California construction market. Since the insurance premiums for
these contractors generally reflect their level of economic
activity, the average premium per policy has fallen as the
insured’s business has contracted, resulting in lower
insurance exposures for these contractors. The retention levels
in this book remain attractive, and policy count is up
year-over-year, despite the decline in direct premiums written.
See additional discussion above in the “2008 vs. 2007
Revenue” discussion.
In 2008 our commercial lines net premiums earned increased by
$7.0 million or 5.6% to $132.4 million as compared to
net premiums earned in 2007 of $125.4 million. Net premiums
earned increased 5.6% despite a 8.6% decline in net premiums
written, with the decline in net premiums written caused
primarily by the 10.5% decline in direct premiums written,
offset by the positive impact on net premiums written of the
change in our reinsurance structure as described above.
Offsetting these factors was the reduction in audit premium
recorded in 2008, which is earned immediately upon booking.
In the commercial lines segment for 2008 we had underwriting
income of $4.2 million, a GAAP combined ratio of 96.8%, a
GAAP loss and loss adjustment expense ratio of 61.3% and a GAAP
underwriting expense ratio of 35.5%, compared to underwriting
income of $6.0 million, a GAAP combined ratio of 95.2%, a
GAAP loss and loss adjustment expense ratio of 60.8% and a GAAP
underwriting expense ratio of 34.4% in 2007. Our commercial
lines loss ratio for 2008 reflects a higher frequency and claim
severity than the similar period in 2007 for casualty and
property lines of business in our West Coast commercial lines
business. The performance of the commercial lines in 2007 was
impacted favorably by the non-recurring retaliatory tax refund.
Results of our Personal Lines segment were as follows:
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