Annual Report (Form 10-K), fiscal year 1994

ITEM 1. BUSINESS. ------- --------
GENERAL -------
EMC Insurance Group Inc. is an insurance holding company incorporated in Iowa in 1974. EMC Insurance Group Inc. is approximately 67 percent owned by Employers Mutual Casualty Company (Employers Mutual), a multiple-line property and casualty insurance company organized as an Iowa mutual insurance company in 1911 that is licensed in all 50 states and the District of Columbia. EMC Insurance Group Inc. and its subsidiaries are referred to herein as the "Company". Employers Mutual and all of its subsidiaries (including the Company), which collectively have assets totaling $1,289,722,903 and written premiums of $583,288,995, are referred to as the "EMC Insurance Companies".
The Company conducts its insurance business through four business segments as follows:
............................... : : : EMC INSURANCE GROUP INC. : :.............................: : Excess and Property and : Nonstandard Surplus Lines Casualty : Risk Automobile Insurance Insurance Reinsurance : Insurance Agency ................................:................................. : : : : : : : : EMCASCO Insurance EMC Farm and City EMC Company (EMCASCO) Reinsurance Insurance Underwriters, Illinois EMCASCO Company Company Ltd. Insurance Company (Illinois EMCASCO) Dakota Fire Insurance Company (Dakota Fire)
EMCASCO was formed in Iowa in 1958, Illinois EMCASCO was formed in Illinois in 1976 and Dakota Fire was formed in North Dakota in 1957 for the purpose of writing property and casualty insurance lines. These companies are licensed to write insurance in a total of 35 states and are participants in a pooling agreement with Employers Mutual. (See "Property and Casualty Insurance - Pooling Agreement").
The reinsurance subsidiary was formed in 1981 to assume reinsurance business of Employers Mutual. The company assumes 95 percent of Employers Mutual's assumed reinsurance business, exclusive of certain reinsurance contracts, and is licensed to do business in 11 states.
The nonstandard risk automobile insurance subsidiary was purchased in 1984. The company was formed in Iowa in 1962 to write nonstandard risk automobile insurance and is licensed in 5 states.
The excess and surplus lines insurance agency was acquired in 1985. The company was formed in Iowa in 1975 as a broker for excess and surplus lines insurance and acts as managing underwriter for such lines for several of the property and casualty pool members. (See "Property and Casualty Insurance - Pooling Agreement").
FINANCIAL INFORMATION ABOUT INDUSTRY SEGMENTS ---------------------------------------------
For information concerning the Company's revenues, operating income and identifiable assets attributable to each of its industry segments over the past three years, see note 9 of Notes to Consolidated Financial Statements under Item 8 of this Form 10-K.
PROPERTY AND CASUALTY INSURANCE -------------------------------
POOLING AGREEMENT
The three property and casualty insurance subsidiaries of the Company and two subsidiaries of Employers Mutual (Union Insurance Company of Providence and American Liberty Insurance Company) are parties to reinsurance pooling agreements with Employers Mutual (collectively the "pooling agreement"). Under the terms of the pooling agreement, each company cedes to Employers Mutual all of its insurance business and assumes from Employers Mutual an amount equal to its participation in the pool. All losses, settlement expenses and other underwriting and administrative expenses, excluding the voluntary reinsurance business assumed by Employers Mutual from unaffiliated insurance companies, are prorated among the parties on the basis of participation in the pool. The aggregate participation of the Company's property and casualty insurance subsidiaries is 22 percent. Operations of the pool give rise to intercompany balances with Employers Mutual, which are settled on a quarterly basis. The investment programs and income tax liabilities of the pool participants are not subject to the pooling agreement.
The purpose of the pooling agreement is to reduce the risk of an exposure insured by any of the pool participants by spreading it among all the companies. The pooling agreement produces a more uniform and stable underwriting result from year to year for all companies in the pool than might be experienced individually. In addition, each company benefits from the capacity of the entire pool, rather than being limited to policy exposures of a size commensurate with its own assets, and from the wide range of policy forms and lines of insurance written and the variety of rate filings and commission plans offered by each of the companies. A single set of reinsurance treaties is maintained for the protection of all six companies in the pool.
Prior to December 31, 1993, the parties to the pooling agreement recorded amounts assumed from the National Workers' Compensation Reinsurance Pool on a net basis. Under this approach, reserves for outstanding losses and unearned premiums were reported as liabilities under "Indebtedness to Related Party" in the Company's consolidated financial statements. Effective December 31, 1993, the parties to the pooling agreement began recording these amounts as outstanding losses and unearned premiums and restated all prior year consolidated financial statements for comparative purposes. There was no income effect from this reclassification. In connection with this gross-up of balances, amounts due from Employers Mutual increased $13,147,831 at December 31, 1993. Under the terms of the pooling agreement, these balances were settled in the first quarter of 1994.
PRINCIPAL PRODUCTS
The Company's property and casualty insurance subsidiaries and the other parties to the pooling agreement underwrite both commercial and personal lines of insurance. The following table sets forth the aggregate direct written premiums of all parties to the pooling agreement for the three years ended December 31, 1994. The pooling agreement is continuous but may be amended or terminated at the end of any calendar year as to any one or more parties.
Percent Percent Percent of of of Line of Business 1994 Total 1993 Total 1992 Total ---------------- -------- ----- -------- ----- -------- ----- (Dollars in thousands) Commercial Lines: Automobile ............ $ 91,674 17.0% $ 83,415 16.0% $ 77,102 14.9% Property .............. 81,358 15.1 72,743 13.9 71,856 13.9 Workers' compensation 133,621 24.7 134,529 25.8 141,245 27.2 Liability ............. 100,844 18.7 99,976 19.1 98,029 18.9 Other ................. 13,405 2.5 11,948 2.3 11,858 2.3 -------- ----- -------- ----- -------- ----- Total commercial lines 420,902 78.0 402,611 77.1 400,090 77.2 -------- ----- -------- ----- -------- ----- Personal Lines: Automobile ............ 80,694 14.9 83,068 15.9 82,346 15.9 Property .............. 38,107 7.1 36,515 7.0 35,785 6.9 Liability ............. - - - - 200 - Other ................. 56 - 56 - 57 - -------- ----- -------- ----- -------- ----- Total personal lines 118,857 22.0 119,639 22.9 118,388 22.8 -------- ----- -------- ----- -------- ----- Total ............ $539,759 100.0% $522,250 100.0% $518,478 100.0% ======== ===== ======== ===== ======== =====
MARKETING
Marketing of insurance by the parties to the pooling agreement is conducted through 18 offices located throughout the United States and approximately 2,350 independent agents. These offices maintain close contact with the local market conditions and are able to react rapidly to change. Each office employs underwriting, claims, marketing and risk improvement representatives, as well as field auditors and branch administrative technicians. The offices are supported by Employers Mutual technicians and specialists. Systems are in place to monitor the underwriting results of each office and to maintain guidelines and policies consistent with the underwriting and marketing environment in each region.
The following table sets forth the geographic distribution of the aggregate direct written premiums of all parties to the pooling agreement for the three years ended December 31, 1994.
1994 1993 1992 ---- ---- ---- Arizona ............................ 3.8% 3.7% 3.6% Colorado ........................... 3.3 2.8 2.7 Illinois ........................... 6.7 6.8 7.0 Iowa ............................... 23.0 26.2 26.7 Kansas ............................. 8.2 7.4 7.1 Michigan ........................... 3.8 3.1 2.8 Minnesota .......................... 5.3 5.3 5.3 Nebraska ........................... 8.0 7.5 7.6 North Carolina ..................... 3.8 3.3 3.3 Rhode Island ....................... 3.3 3.2 2.9 Texas .............................. 2.7 2.8 3.2 Wisconsin .......................... 5.7 6.7 7.0 Other * ............................ 22.4 21.2 20.8 ----- ----- ----- 100.0% 100.0% 100.0% ===== ===== =====
* Includes all other jurisdictions, none of which accounted for more than 3%.
COMPETITION
The property and casualty insurance business is highly competitive. The Company's property and casualty insurance subsidiaries and the other pool members compete in the United States insurance market with numerous insurers, many of which have greater financial resources. Competition in the types of insurance in which the property and casualty insurance subsidiaries are engaged is based on many factors, including the perceived overall financial strength of the insurer, premiums charged, contract terms and conditions, services offered, speed of claim payments, reputation and experience. In this competitive environment, insureds have tended to favor large, financially strong insurers and the Company faces the risk that insureds may become more selective and may seek larger and/or more highly rated insurers.
BEST'S RATING
A.M. Best rates insurance companies based on their relative financial strength and ability to meet their contractual obligations. The "A" (Excellent) rating assigned to the Company's property and casualty insurance subsidiaries and the other pool members is based on the pool members' 1993 operating results and financial condition as of December 31, 1993. Best's reevaluates its ratings from time to time (normally on an annual basis) and there can be no assurance that the Company's property and casualty insurance subsidiaries and the other pool members will maintain their current rating in the future. Management believes that a Best's rating of "A" (Excellent) or better is important to the Company's business since many insureds require that companies with which they insure be so rated. Best's publications indicate that these ratings are assigned to companies which Best's believes have achieved excellent overall performance and have a strong ability to meet their obligations over a long period of time. Best's ratings are based upon factors of concern to policyholders and insurance agents and are not necessarily directed toward the protection of investors.
REINSURANCE CEDED
The parties to the pooling agreement cede insurance in the ordinary course of business for the purpose of limiting their maximum loss exposure through diversification of their risks. The pool participants also purchase catastrophe reinsurance to cover multiple losses arising from a single event.
All major reinsurance treaties, with the exception of the pooling agreement and a boiler treaty, are on an "excess of loss" basis whereby the reinsurer agrees to reimburse the primary insurer for covered losses in excess of a predetermined amount, up to a stated limit. The boiler treaty provides for 100 percent reinsurance of the pool's direct boiler coverage written. Facultative reinsurance from approved domestic markets, which provides reinsurance on an individual risk basis and requires specific agreement of the reinsurer as to the limits of coverage provided, is purchased when coverage by an insured is required in excess of treaty capacity or where a high-risk type policy could expose the treaty reinsurance programs.
Retention levels are adjusted according to reinsurance market conditions and the surplus position of Employers Mutual. The intercompany pooling arrangement aids efficient buying of reinsurance since it allows for higher retention levels and correspondingly decreased dependence on the reinsurance marketplace.
A summary of the reinsurance treaties benefiting the parties to the pooling agreement follows:
Type of Coverage Retention Limits ---------------- --------- ------ Property per risk ........... $2,000,000 100 percent of $18,000,000 Property catastrophe ........ $9,000,000 95 percent of $51,000,000 Casualty .................... $2,000,000 100 percent of $44,000,000 Umbrella .................... $5,000,000 100 percent of $ 5,000,000 Fidelity .................... $ 500,000 100 percent of $ 3,500,000 Surety ...................... $ 500,000 100 percent of $ 5,300,000 Boiler ...................... $ 0 100 percent of $50,000,000
Although reinsurance does not discharge the original insurer from its primary liability to its policyholders, it is the practice of insurers for accounting purposes to treat reinsured risks as risks of the reinsurer.The primary insurer would only reassume liability in those situations where the reinsurer is unable to meet the obligations it assumed under the reinsurance agreements. The collectability of reinsurance is subject to the solvency of the reinsurers.
The major participants in the pool members' reinsurance programs are presented below. The percentages represent the reinsurers' share of the total reinsurance protection under all coverages. Each type of coverage is purchased in layers, and an individual reinsurer may participate in more than one coverage and at various layers within these coverages. The property per risk, property catastrophe and casualty reinsurance programs are handled by a reinsurance intermediary (broker). The reinsurance of those programs is syndicated to approximately 90 domestic and foreign reinsurers.
Percent of Total 1994 Property per risk, property Reinsurance Best's catastrophe and casualty coverages: Protection Rating ----------------------------------- ----------- ------ Underwriters at Lloyd's of London .................... 22.0% (1) Insurance Company of North America ................... 7.2 A- Prudential Reinsurance Company ....................... 6.2 A NAC Reinsurance Corporation .......................... 3.4 A Hartford Fire Insurance Company ...................... 3.1 A+ Hannover Ruckversicherung AG ......................... 3.0 (2) AXA Reinsurance Company .............................. 2.5 A
Umbrella coverage: ------------------ General Reinsurance Corporation ...................... 100.0 A++
Fidelity and surety coverages: ------------------------------ Allstate Insurance Company ........................... 42.0 A- Kemper Reinsurance Company ........................... 20.0 A- Signet Star Reinsurance Company ...................... 20.0 A Winterthur Reinsurance Corporation of America ........ 18.0 A
Boiler coverage: ---------------- Hartford Steam Boiler Inspection and Insurance Company 100.0 A+
(1) Not rated; however, the individual members of the Lloyd's organization are required to pledge their entire net worth toward the satisfaction of their liabilities. In response to reported losses of $3.8 billion, $4.2 billion, $4.9 billion and $1.5 billion (estimated) in 1989, 1990, 1991 and 1992, respectively, Lloyd's has developed a business plan to improve its profitability. The plan is described in detail in the "Rowland" report published by Lloyd's in April, 1993 and Lloyd's began implementation of the plan in 1994. For the 1993 underwriting year, Chatset (a publication that is considered a guide to syndicate run-offs) is predicting an overall profit of $1.2 billion for Lloyds.
In addition, standing behind the means of individual members is the Lloyd's Central Fund. This fund is considered by Lloyd's to be a safety net, whereby Lloyd's membership as a whole can be compelled to make up deficiencies caused by individual names defaulting. Currently, there are significant earmarkings against the Central Fund for these deficiencies. There is also a multi-billion dollar trust fund to secure Lloyd's obligations to United States policyholders which applies on a several, not joint basis, to each syndicate's obligations for U.S. business. As of January 31, 1995, the amount in the Lloyd's American Trust Fund is $10.9 billion.
(2) Not rated.
Premiums ceded by all parties to the pooling agreement and by the Company's property and casualty insurance subsidiaries for the year ended December 31, 1994 are presented below. Each type of reinsurance coverage is purchased in layers, and an individual reinsurer may participate in more than one coverage and at various layers within these coverages. Since each layer of each coverage is priced separately, with the lower layers being more expensive than the upper layers, a reinsurer's overall participation in a reinsurance program does not necessarily correspond to the amount of premiums it receives.
Premiums Ceded By ------------------------ Property All Pool and Casualty Reinsurer Members Subsidiaries --------- ----------- ------------ General Reinsurance Corporation ...................... $ 2,789,369 $ 613,662 Underwriters at Lloyd's of London .................... 1,845,726 406,060 Hartford Steam Boiler Inspection and Insurance Company 1,208,938 265,966 Hartford Fire Insurance Company ...................... 751,492 165,328 AXA Reinsurance Company .............................. 537,038 118,148 PMA Reinsurance Corporation .......................... 503,346 110,736 American Reinsurance Company ......................... 454,115 99,905 NAC Reinsurance Corporation .......................... 403,359 88,739 Prudential Reinsurance Company ....................... 346,385 76,205 Hannover Ruckversicherung AG ......................... 333,774 73,430 Other Reinsurers ..................................... 5,276,408 1,160,810 ----------- ------------ Total ............................................. $14,449,950 $ 3,178,989 =========== ============
The parties to the pooling agreement also cede reinsurance on both a voluntary and a mandatory basis to state and national organizations in connection with various workers' compensation and assigned risk programs and to private organizations established to handle large risks. Premiums ceded by all parties to the pooling agreement and by the Company's property and casualty insurance subsidiaries for the year ended December 31, 1994 are presented below.
Premiums Ceded By ------------------------ Property All Pool and Casualty Reinsurer Members Subsidiaries --------- ----------- ------------ Wisconsin Compensation Rating Bureau ................. $ 9,925,061 $ 2,183,514 National Workers' Compensation Reinsurance Pool ...... 9,313,774 2,049,030 Improved Risk Mutual ................................. 4,848,249 1,066,615 North Carolina Reinsurance Facility .................. 1,400,527 308,116 Other Reinsurers ..................................... 472,072 103,855 ----------- ------------ $25,959,683 $ 5,711,130 =========== ============
In formulating reinsurance programs, Employers Mutual is selective in its choice of reinsurers. Employers Mutual selects reinsurers on the basis of financial stability and long-term relationships, as well as price of the coverage. Reinsurers are generally required to have a Best's rating of "A-" or higher and policyholders' surplus of $50,000,000 ($100,000,000 for casualty reinsurance).
For information concerning amounts due the Company from reinsurers for losses and settlement expenses and prepaid reinsurance premiums and the effect of reinsurance on premiums written and earned, and losses and settlement expenses incurred, see "Property and Casualty Insurance Subsidiaries, Reinsurance Subsidiary and Nonstandard Risk Automobile Insurance Subsidiary - Reinsurance Ceded."
RELATIONSHIP BETWEEN NET PREMIUMS WRITTEN AND SURPLUS
The volume of insurance which a property and casualty insurance company writes under industry standards is a multiple of its surplus calculated in accordance with statutory accounting practices. Generally, a ratio of 3 to 1 or less is considered satisfactory. The ratios of the pool members for the past three years are as follows:
Year ended December 31, ------------------------------ 1994 1993 1992 ---- ---- ---- Employers Mutual .................. 1.28 1.33 1.32 EMCASCO ........................... 2.18 2.51 2.56 Illinois EMCASCO .................. 2.18 2.44 2.65 Dakota Fire ....................... 1.98 2.18 2.49 American Liberty .................. 1.26 1.38 1.38 Union ............................. .77 1.63 1.68
The decrease in Union's 1994 ratio is primarily due to a significant increase in surplus resulting from the demutualization of Union in the first quarter of 1994.
OUTSTANDING LOSSES AND SETTLEMENT EXPENSES
The property and casualty insurance subsidiaries' reserve information is included in the property and casualty loss reserve development for 1994. See "Property and Casualty Insurance Subsidiaries, Reinsurance Subsidiary and Nonstandard Risk Automobile Insurance Subsidiary - Outstanding Losses and Settlement Expenses."
REINSURANCE -----------
The reinsurance subsidiary is a property and casualty treaty reinsurer with a concentration in property lines. The reinsurance subsidiary began its operations in 1981 with a five percent quota share assumption of Employers Mutual's assumed reinsurance business. The quota share percentage has been gradually increased over the years and since 1988 the reinsurance subsidiary has assumed a 95 percent quota share of Employers Mutual's assumed reinsurance business, exclusive of certain reinsurance contracts. The reinsurance subsidiary receives 95 percent of all premiums and assumes 95 percent of all related losses and settlement expenses of this business. Since 1993, losses in excess of $1,000,000 per event are retained by Employers Mutual. The reinsurance subsidiary does not reinsure any of Employers Mutual's direct insurance business, nor any "involuntary" facility or pool business that Employers Mutual assumes pursuant to state law. In addition, the reinsurance subsidiary is not liable for credit risk in connection with the insolvency of any reinsurers of Employers Mutual.
MARKETING
Operations for the last two years reflect a shift from catastrophe excess of loss business to pro rata business. During 1995, more emphasis will be placed on writing excess of loss business in non-hurricane prone areas and on increasing participation on existing contracts that have favorable terms. Pro rata business will continue to be written, but the focus will be on properly structured regional accounts rather than large national accounts. This gradual movement towards excess of loss business is prompted by a deterioration of pro rata rates and a greater control over the pricing of excess of loss business.
COMPETITION
The reinsurance marketplace is very competitive. Employers Mutual competes in the global reinsurance market with numerous reinsurers, many of which have greater financial resources. In this competitive environment, reinsurance brokers have tended to favor large, financially strong reinsurers who are able to provide "mega" line capacity for all lines of business. The Company faces the risk that reinsurance brokers may become more selective and may seek larger and/or more highly rated reinsurers.
REINSURANCE CEDED
The reinsurance subsidiary has an aggregate excess of loss treaty with Employers Mutual which provides protection from a large accumulation of retentions resulting from multiple catastrophes in any one calendar year. The coverage provided is $2,000,000 excess of $2,500,000 aggregate losses retained, excess of $200,000 per event. Maximum recovery is limited to $4,000,000 per accident year. The reinsurance subsidiary recovered $0, $143,501 and $4,221,444 under this treaty and paid reinstatement premiums of $0, $208,470 and $744,561 in 1994, 1993 and 1992, respectively. Total premiums paid to Employers Mutual amounted to $557,842, $708,445 and $1,124,561 in 1994, 1993 and 1992, respectively.
Effective January 1, 1995, the aggregate excess of loss treaty was amended to increase the aggregate losses retained to $3,000,000 and to decrease the maximum recovery limit to $2,000,000 per accident year.
For information concerning amounts due the Company from reinsurers for losses and settlement expenses and prepaid reinsurance premiums and the effect of reinsurance on premiums written and earned and losses and settlement expenses incurred, see "Property and Casualty Insurance Subsidiaries, Reinsurance Subsidiary and Nonstandard Risk Automobile Insurance Subsidiary - Reinsurance Ceded."
OUTSTANDING LOSSES AND SETTLEMENT EXPENSES
The reinsurance subsidiary's reserve information is included in the property and casualty loss reserve development for 1994. See "Property and Casualty Insurance Subsidiaries, Reinsurance Subsidiary and Nonstandard Risk Automobile Insurance Subsidiary - Outstanding Losses and Settlement Expenses."
BEST'S RATING
The most recent Best's Property Casualty Key Rating Guide gives the reinsurance subsidiary a "B+" (Very Good) policyholders' rating. Best's ratings are based upon factors of concern to policyholders and insurance agents and are not necessarily directed toward the protection of investors.
NONSTANDARD RISK AUTOMOBILE INSURANCE -------------------------------------
The Company's nonstandard risk automobile insurance subsidiary specializes in insuring private passenger automobile risks that are found to be unacceptable in the normal automobile market.
MARKETING
The nonstandard risk automobile insurance subsidiary is licensed in a five state area that includes Iowa, Kansas, Nebraska, North Dakota and South Dakota. Personal lines automobile policies are solicited through the American Agency System and are written for two, three or six month terms. Limits of liability are offered equal to the state financial responsibility laws. Physical damage coverages are written at normal insurance deductibles. The nonstandard risk automobile insurance subsidiary expects to begin writing business in the state of Missouri in late 1995.
During 1994, the nonstandard risk automobile insurance subsidiary elected to emphasize profitability over premium volume and did not reduce rates in order to retain business. Production is expected to remain relatively flat in 1995 as the company will continue to emphasize profitability over market share. Profitable underwriting results in the future are likely to be more dependent upon successful niche marketing rather than full coverage programs.
COMPETITION
The nonstandard risk marketplace is very competitive. Policies are written for relatively short periods of time and insureds search for the best rates available. Recently, the larger standard insurance companies have begun to develop rate tiers that are geared toward retaining nonstandard risk customers, rather than passing them into the nonstandard market. This additional availability in the standard market has resulted in increased competition within the nonstandard market.
REINSURANCE CEDED
The nonstandard risk automobile insurance subsidiary has a reinsurance treaty on an excess of loss basis with Employers Mutual, which provides reinsurance for 100 percent of each loss in excess of $100,000, up to $1,000,000. Recoveries under this treaty totaled $71,567, $0 and $0 in 1994, 1993 and 1992, respectively. Premiums paid to Employers Mutual amounted to $49,659, $42,065 and $35,377 in 1994, 1993 and 1992, respectively.
For information concerning amounts due the Company from reinsurers for losses and settlement expenses and prepaid reinsurance premiums and the effect of reinsurance on premiums written and earned and losses and settlement expenses incurred, see "Property and Casualty Insurance Subsidiaries, Reinsurance Subsidiary and Nonstandard Risk Automobile Insurance Subsidiary - Reinsurance Ceded."
OUTSTANDING LOSSES AND SETTLEMENT EXPENSES
The nonstandard risk automobile insurance subsidiary's reserve information is included in the property and casualty loss reserve development for 1994. See "Property and Casualty Insurance Subsidiaries, Reinsurance Subsidiary and Nonstandard Risk Automobile Insurance Subsidiary - Outstanding Losses and Settlement Expenses."
BEST'S RATING
The most recent Best's Property Casualty Key Rating Guide gives the nonstandard risk automobile insurance subsidiary an "A" (Excellent) policyholders' rating. Best's ratings are based upon factors of concern to policyholders and insurance agents and are not necessarily directed toward the protection of investors.
PROPERTY AND CASUALTY INSURANCE SUBSIDIARIES, REINSURANCE SUBSIDIARY AND ------------------------------------------------------------------------ NONSTANDARD RISK AUTOMOBILE INSURANCE SUBSIDIARY ------------------------------------------------
SERVICES PROVIDED BY EMPLOYERS MUTUAL
Employers Mutual provides various services to all of it's subsidiaries. Such services include data processing, claims, financial, actuarial, auditing, marketing and underwriting. Costs of these services are charged to the subsidiaries outside the pooling agreement based upon a number of criteria, including usage and number of transactions. Costs not charged to these subsidiaries are charged to the pool and each pool participant shares in the total cost in proportion to its participation percentage.
STATUTORY COMBINED RATIOS
The following table sets forth the Company's insurance subsidiaries' statutory combined ratios and the property and casualty insurance industry averages for the five years ended December 31, 1994. The combined ratios below are the sum of the following: the loss ratio, calculated by dividing losses and settlement expenses by net premiums earned, and the expense ratio, calculated by dividing underwriting expenses by net premiums written and policyholder dividends by net premiums earned.
Generally, if the combined ratio is below 100 percent, a company has an underwriting profit; if it is above 100 percent, a company has an underwriting loss.
Year ended December 31, -------------------------------------- 1994 1993 1992 1991 1990 ------ ------ ------ ------ ------ Property and casualty insurance Loss ratio .................... 67.2% 72.6% 76.1% 76.8% 73.8% Expense ratio ................. 31.1 30.9 30.1 30.5 30.8 ------ ------ ------ ------ ------ Combined ratio .............. 98.3% 103.5% 106.2% 107.3% 104.6% ====== ====== ====== ====== ======
Reinsurance Loss ratio .................... 82.0% 77.7% 109.1% 82.9% 92.6% Expense ratio ................. 30.4 33.1 34.8 36.6 37.2 ------ ------ ------ ------ ------ Combined ratio .............. 112.4% 110.8% 143.9% 119.5% 129.8% ====== ====== ====== ====== ======
Nonstandard risk automobile insurance Loss ratio .................... 71.5% 94.3% 92.3% 72.4% 77.8% Expense ratio ................. 24.4 23.7 23.7 25.2 24.7 ------ ------ ------ ------ ------ Combined ratio .............. 95.9% 118.0% 116.0% 97.6% 102.5% ====== ====== ====== ====== ======
Total insurance operations Loss ratio .................... 70.9% 75.6% 83.4% 77.8% 78.0% Expense ratio ................. 30.4 30.7 30.5 31.4 31.5 ------ ------ ------ ------ ------ Combined ratio .............. 101.3% 106.3% 113.9% 109.2% 109.5% ====== ====== ====== ====== ====== Property and casualty insurance industry averages (1) Loss ratio .................... 82.0% 79.5% 88.1% 81.2% 82.3% Expense ratio ................. 27.4 27.4 27.6 27.7 27.3 ------ ------ ------ ------ ------ Combined ratio .............. 109.4% 106.9% 115.7% 108.9% 109.6% ====== ====== ====== ====== ======
(1) As reported by A.M. Best Company. The ratio for 1994 is an estimate; the actual combined ratio is not currently available.
REINSURANCE CEDED
The following table presents amounts due to the Company from reinsurers for losses and settlement expenses and prepaid reinsurance premiums as of December 31, 1994:
Amount Percent Best's Recoverable of Total Rating ----------- -------- ------ Wisconsin Compensation Rating Bureau .. $ 7,507,636 44.0% (1) National Workers' Compensation Reinsurance Pool .................... 2,558,657 15.0 (1) General Reinsurance Corporation ....... 968,459 5.7 A++ Improved Risk Mutual (IRM) ............ 780,179 4.6 (2) American Re-Insurance Company ......... 633,168 3.7 A+ Minnesota Workers' Compensation Reinsurance Association ............. 480,229 2.8 (3) North Carolina Reinsurance Facility ... 426,218 2.5 (4) Mutual Reinsurance Bureau (MRB)........ 406,627 2.4 (5) New England Reinsurance Corporation ... 396,829 2.3 (6) Hartford Fire Insurance Company ....... 338,510 2.0 A+ Other Reinsurers ...................... 2,559,569 15.0 ----------- -------- Total ........................... $17,056,081(7) 100.0% =========== ========
(1) Amounts recoverable reflect the property and casualty insurance subsidiaries' pool participation percentage of amounts ceded to these organizations by Employers Mutual in connection with its role as "service carrier". Under these arrangements, Employers Mutual writes business for these organizations on a direct basis and then cedes 100 percent of the business to these organizations. Credit risk associated with these amounts is minimal as all companies participating in these organizations are responsible for the liabilities of such organizations on a pro rata basis.
(2) The amount recoverable reflects the property and casualty insurance subsidiaries' pool participation percentage of amounts ceded to this underwriting association by the pool members. IRM was formed to underwrite property insurance for large commercial risks and is composed of Employers Mutual and 14 other nonaffiliated property and casualty insurance companies. Each of the 15 insurance companies cede insurance to IRM and assume back a percentage of this business. Participation ranges from 3.2 percent to a maximum of 10.0 percent (Employers Mutual has a 10.0 percent share of this business). Each member company benefits from the increased capacity, as well as risk improvement and other services provided by IRM. IRM is backed by the financial strength of the 15 member companies. All of the members of IRM were assigned an "A-" (Excellent) or better rating by the most recent Best's Property Casualty Key Ratings Guide.
(3) The amount recoverable reflects the property and casualty insurance subsidiaries' pool participation percentage of amounts ceded to this association by the pool members under a reinsurance contract that provides protection for workers' compensation losses in excess of $430,000 per occurrence. Credit risk associated with this amount is minimal as all companies writing direct workers' compensation business in the state of Minnesota are responsible for the liabilities of this association on a pro rata basis.
(4) The amount recoverable reflects the property and casualty insurance subsidiaries' pool participation percentage of amounts ceded to this organization by the pool members in conjunction with the state run assigned risk program ("state fund"). Under this program, all insurers writing direct business in the state of North Carolina are required by law to write insurance for risks that are not insurable in the normal marketplace. Business written under this program is ceded 100 percent to the state fund and each respective company assumes from the state fund its share of such business in proportion to its direct writings in the state. Credit risk associated with this amount is minimal as all companies writing direct business in the state are responsible for the liabilities of this organization on a pro rata basis.
(5) The amount recoverable reflects the property and casualty insurance subsidiaries' pool participation percentage of amounts ceded to this underwriting organization by Employers Mutual. MRB is composed of Employers Mutual and five other nonaffiliated mutual insurance companies. Each of the six members cede primarily property insurance to MRB and assume equal proportionate shares of this business. Each member benefits from the increased capacity provided by MRB. MRB is backed by the financial strength of the six member companies. All of the members of MRB were assigned an "A" (Excellent) or better rating by the most recent Best's Property Casualty Key Ratings Guide.
(6) Not rated.
(7) The total amount at December 31, 1994 represented $788,174 in paid losses and settlement expenses recoverable, $14,146,874 in unpaid losses and settlement expenses recoverable and $2,121,033 in unearned premiums recoverable.
The effect of reinsurance on premiums written and earned, and losses and settlement expenses incurred for the three years ended December 31, 1994 is presented below. Amounts for the years ended December 31, 1994 and 1993 reflect (1) the change in the property and casualty insurance subsidiaries' pooling agreement whereby effective January 1, 1993, the voluntary assumed reinsurance business written by Employers Mutual is no longer subject to cession to the pool members and (2) the amendment to the reinsurance subsidiary's quota share agreement whereby effective January 1, 1993 losses in excess of $1,000,000 per event are retained by Employers Mutual and the reinsurance subsidiary therefore no longer purchases catastrophe protection. (See notes 2 and 3 of Notes to Consolidated Financial Statements under Item 8 of this Form 10-K).
Year ended December 31, ---------------------------------------- 1994 1993 1992 ------------ ------------ ------------ Premiums written: Direct ......................... $143,444,388 $135,277,129 $138,829,576 Assumed from nonaffiliates ..... 5,843,091 6,636,942 16,467,613 Assumed from affiliates ........ 158,646,332 147,620,705 150,070,741 Ceded to nonaffiliates ......... (8,890,119) (10,701,482) (17,721,207) Ceded to affiliates ............ (132,100,537) (120,898,914) (129,826,840) ------------ ------------ ------------ Net premiums written ........ $166,943,155 $157,934,380 $157,819,883 ============ ============ ============
Premiums earned: Direct ......................... $140,012,247 $137,141,457 $142,391,771 Assumed from nonaffiliates ..... 5,988,228 6,758,364 14,980,642 Assumed from affiliates ........ 156,839,482 148,366,487 140,442,245 Ceded to nonaffiliates ......... (9,601,270) (11,507,217) (16,775,394) Ceded to affiliates ............ (128,409,308) (124,321,553) (133,628,977) ------------ ------------ ------------ Net premiums earned ......... $164,829,379 $156,437,538 $147,410,287 ============ ============ ============
Losses and settlement expenses incurred: Direct ......................... $113,680,306 $ 97,842,980 $112,579,261 Assumed from nonaffiliates ..... 2,774,689 6,575,099 17,415,319 Assumed from affiliates ........ 108,594,530 107,369,274 114,359,445 Ceded to nonaffiliates ......... (3,077,305) (5,845,414) (16,862,082) Ceded to affiliates ............ (105,028,166) (85,586,640) (105,404,110) ------------ ------------ ------------ Net losses and settlement expenses incurred ......... $116,944,054 $120,355,299 $122,087,833 ============ ============ ============
OUTSTANDING LOSSES AND SETTLEMENT EXPENSES
The Company maintains reserves for losses and settlement expenses with respect to both reported and unreported claims. The amount of reserves for reported claims is primarily based upon a case-by-case evaluation of the specific type of claim, knowledge of the circumstances surrounding each claim and the policy provisions relating to the type of loss. Reserves on assumed business are the amounts reported by the ceding company.
The amount of reserves for unreported claims is determined on the basis of statistical information for each line of insurance with respect to the probable number and nature of claims arising from occurrences which have not yet been reported. Established reserves are closely monitored and are frequently recomputed using a variety of formulas and statistical techniques for analyzing current actual claim cost, frequency data and other economic and social factors.
The Company does not discount reserves. Inflation is implicitly provided for in the reserving function through analysis of cost trends, reviews of historical reserving results and projections of future economic conditions. Large ($25,000 and over) incurred and reported gross reserves are reviewed regularly for adequacy. In addition, long-term and lifetime medical claims are periodically reviewed for cost trends and the applicable reserves are appropriately revised.
Loss reserves are estimates at a given time of what the insurer expects to pay on incurred losses, based on facts and circumstances then known. During the loss settlement period, which may be many years, additional facts regarding individual claims become known, and accordingly, it often becomes necessary to refine and adjust the estimates of liability on a claim.
Settlement expense reserves are intended to cover the ultimate cost of investigating claims and defending lawsuits arising from claims. These reserves are established each year based on previous years' experience to project the ultimate cost of settlement expenses. To the extent that adjustments are required to be made in the amount of outstanding loss reserves each year, settlement expense reserves are correspondingly revised.
Estimating reserves for asbestos and environmental related claims is very difficult due to the following uncertainties surrounding these types of claims: the legal definition of asbestos and environmental damage is still evolving, the assignment of responsibility varies widely by state, defense costs are often much greater than the claim costs and claims often emerge long after the policy has expired, making assignment of damages to the appropriate party and to the time period covered by a particular policy difficult. In establishing reserves for these types of claims, management monitors the relevant facts concerning each claim, the current status of the legal environment, the social and political conditions and the claim history and trends within the Company and the industry.
Despite the inherent uncertainties of estimating insurance company loss and settlement expense reserves, management believes that the Company's reserves are being calculated in accordance with sound actuarial practices and, based upon current information, that the Company's reserves for losses and settlement expenses at December 31, 1994 are adequate.
The following table sets forth a reconciliation of beginning and ending reserves for losses and settlement expenses of the property and casualty insurance subsidiaries, the reinsurance subsidiary and the nonstandard risk automobile insurance subsidiary. Amounts presented are on a net basis, with a reconciliation of beginning and ending reserves to the gross amounts presented in the consolidated financial statements in accordance with SFAS 113. (See note 1 of Notes to Consolidated Financial Statements under Item 8 of this Form 10-K.)
Year ended December 31, ---------------------------------------- 1994 1993 1992 ------------ ------------ ------------ Gross reserves for losses and settlement expenses, beginning of year .......................... $197,121,852 $215,388,865 $158,814,130
Ceded reserves for losses and settlement expenses, beginning of year .......................... 17,454,679 25,253,507 13,951,033 ------------ ------------ ------------ Net reserves for losses and settlement expenses, beginning of year .......................... 179,667,173 190,135,358 144,863,097 ------------ ------------ ------------ Incurred losses and settlement expenses: ---------------------- Provision for insured events of the current year ............ 123,343,829 119,896,526 116,615,951
(Decrease) increase in provision for insured events of prior years .......................... (6,399,775) 458,773 5,471,882 ------------ ------------ ------------ Total incurred losses and settlement expenses ........ $116,944,054 $120,355,299 $122,087,833 ------------ ------------ ------------
Year ended December 31, ---------------------------------------- Payments: 1994 1993 1992 --------- ------------ ------------ ------------ Losses and settlement expenses attributable to insured events of the current year ............ $ 48,771,573 $ 47,600,851 $ 46,436,360
Losses and settlement expenses attributable to insured events of prior years ................. 59,491,875 45,508,460 53,810,715
Payment related to the commutation of the reinsurance subsidiary's catastrophe and aggregate excess of loss reinsurance treaties ... (686,962) - -
Payment related to the change in the property and casualty insurance subsidiaries' pooling agreement ...................... - 4,373,629 (23,431,503)
Payment related to the commutation of two reinsurance contracts under the reinsurance subsidiary's quota share agreement ...................... - 21,904,001 -
Adjustment related to the gross-up of reserve amounts associated with the National Workers' Compensation Reinsurance Pool .. - 11,436,543 - ------------ ------------ ------------ Total payments .............. 107,576,486 130,823,484 76,815,572 ------------ ------------ ------------ Net reserves for losses and settlement expenses, end of year 189,034,741 179,667,173 190,135,358
Ceded reserves for losses and settlement expenses, end of year 14,146,874 17,454,679 25,253,507 ------------ ------------ ------------ Gross reserves for losses and settlement expenses, end of year $203,181,615 $197,121,852 $215,388,865 ============ ============ ============
The following table shows the calendar year development of the unpaid loss and settlement expense reserves of the property and casualty insurance subsidiaries, the reinsurance subsidiary and the nonstandard risk automobile insurance subsidiary. Amounts presented are on a net basis with (i) a reconciliation of the net loss and settlement expense reserves at the end of 1992, 1993 and 1994 to the gross amounts presented in the consolidated financial statements in accordance with SFAS 113 and (ii) disclosure of the gross re-estimated loss and settlement expense reserves as of the end of 1992, 1993 and 1994 and the related re-estimated reinsurance receivables.
Reflected in this table is (1) the increase in the reinsurance subsidiary's quota share assumption of Employers Mutual's assumed reinsurance business from 75 percent in 1987 to 95 percent in 1988, (2) the increase in the property and casualty insurance subsidiaries' collective participation in the pool from 17 percent to 22 percent in 1992, (3) the change in the pooling agreement whereby effective January 1, 1993 the voluntary reinsurance business written by Employers Mutual is no longer subject to cession to the pool members, (4) the commutation of two reinsurance contracts under the reinsurance subsidiary's quota share agreement in 1993, (5) the gross-up of reserve amounts associated with the National Workers' Compensation Reinsurance Pool at December 31, 1993 and (6) the reinsurance subsidiary's commutation of all outstanding reinsurance balances ceded to Employers Mutual under catastrophe and aggregate excess of loss reinsurance treaties related to accident years 1991 through 1993 in 1994.
In evaluating the table, it should be noted that each cumulative redundancy (deficiency) amount includes the effects of all changes in reserves for prior periods. Conditions and trends that have affected development of the liability in the past, such as the time lag in the reporting of assumed reinsurance business and the high rate of inflation associated with medical services and supplies, may not necessarily occur in the future. Accordingly, it may not be appropriate to project future development of reserves based on this table.
Underwriting results of the Company are significantly influenced by estimates of loss and settlement expense reserves. Changes in reserve estimates are reflected in operating results in the year such changes are recorded. During 1992, the property and casualty insurance subsidiaries and the nonstandard risk automobile insurance subsidiary strengthened prior year reserves on certain lines of business and the reinsurance subsidiary experienced a time lag in the reporting of assumed reinsurance business. During 1993, the property and casualty insurance companies continued to strengthen reserves on certain lines of business while the reinsurance subsidiary experienced adverse development on losses associated with Hurricane Andrew. These reserve increases in 1992 and 1993 were partially offset by reserve decreases on other lines of business, resulting in a net increase in the provision for insured events of prior years of $5,471,882 in 1992 and $458,773 in 1993. During 1994, the reinsurance subsidiary experienced adverse development on certain contracts. These reserve increases were offset by significant reserve decreases in the property and casualty insurance subsidiaries and the nonstandard risk automobile insurance subsidiary. As a result, the provision for insured events of prior years decreased $6,399,775. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Results of Operations" under Item 7 of this Form 10-K.
Environmental Claims
The Company's environmental claims activity is predominately from hazardous waste and pollution-related claims. The parties to the pooling agreement have not written primary coverage for the major oil or chemical companies; the greatest exposure arises out of commercial general liability and umbrella policies issued to municipalities during the 1970s which allegedly cover contamination emanating from closed landfills. The remaining exposure is for claims from small regional operations or local businesses involved with disposing wastes at dump sites or having pollution on their own property due to hazardous material use or leaking underground storage tanks. These insureds include small manufacturing operations, tool makers, automobile dealerships, contractors, gasoline stations and real estate developers. Claims related to misdeliveries or minor spills of petroleum products covered under properly endorsed commercial auto policies are not considered environmental claims since coverage is normally not disputed, damages are readily determinable and settlement normally occurs over a short period of time.
The Company's reinsurance subsidiary assumes reinsurance business that has environmental exposures. At December 31, 1994, reserves for reported claims totaled $950. The reinsurance subsidiary's environmental exposures declined substantially in 1993 due to the commutation of a reinsurance contract with Employers Mutual. Outstanding losses and settlement expenses related to the commuted contract totaled $319,211 in 1992. Losses and settlement expenses incurred related to the commuted contract totaled $197,859 and $161,693 in 1993 and 1992, respectively.
The following table presents selected data on environmental losses and settlement expenses incurred and reserves outstanding for the Company. The amounts for 1993 and 1992 have been restated to exclude claims associated with misdeliveries or minor spills of petroleum products. As a result of this restatement, incurred losses and settlement expenses decreased $189,192 and $349,122, loss and settlement expense reserves decreased $426,981 and $389,806 and the number of outstanding claims decreased 21 and 26 for the years 1993 and 1992, respectively.
Year Ended December 31, ------------------------------- 1994 1993 1992 --------- --------- --------- Total losses incurred ....................... $ (31,616) $ 292,440 $ 199,992 Total settlement expenses incurred .......... 36,378 88,847 58,383 --------- --------- --------- Total losses and settlement expenses incurred ................................ $ 4,762 $ 381,287 $ 258,375 ========= ========= =========
Loss reserves ............................... $ 257,038 $ 316,341 $ 579,770 Settlement expense reserves ................. 164,626 168,615 101,524 --------- --------- --------- Total loss and settlement expense reserves $ 421,664 $ 484,956 $ 681,294 ========= ========= ========= Number of outstanding claims ................ 46 42 48 ========= ========= =========
The negative incurred loss amount in 1994 reflects the settlement of several claims for less than the reserves carried and a reduction in the amount of reserves carried for several other claims.
The Company has one policyholder which has filed claims at three separate sites in connection with the transportation of hazardous waste to landfills. Another policyholder has filed claims at two separate sites related to the generation of waste disposed of at hazardous waste facilities. Included in the above table at December 31, 1994 are four pollution sites which involve multiple policyholders as follows:
Number Pollution site of claims -------------- --------- Closed landfill ................... 6 Closed landfill ................... 3 Closed landfill ................... 2 Transformer reclamation facility .. 2
Coverage is being disputed in 44 of the 45 claims which were outstanding at December 31, 1994. The coverage disputes relate to claims involving the removal of underground storage tanks or the clean up of (i) underground storage tank sites, (ii) landfills based on ownership of the landfill or the generation of waste disposed of at landfills or (iii) insured property.
Asbestos Claims --------------- The Company's asbestos claim activity primarily relates to bodily injury claims where an insured has been named as one of multiple defendants covering exposure over many years.
The Company's reinsurance subsidiary assumes reinsurance business that has asbestos related exposures. At December 31, 1994, reserves for reported claims totaled $79,666. The reinsurance subsidiary's asbestos related exposures declined substantially in 1993 due to the commutation of a reinsurance contract with Employers Mutual. Outstanding losses and settlement expenses related to the commuted contract totaled $904,834 in 1992. Losses and settlement expenses incurred related to the commuted contract totaled $226,470 and $330,653 in 1993 and 1992, respectively.
The following table presents selected data on asbestos related losses and settlement expenses incurred and reserves outstanding for the Company:
Year Ended December 31, ------------------------------- 1994 1993 1992 ---------- ---------- ---------- Total losses incurred ....................... $ 210,776 $ 198,267 $ 347,764 Total settlement expenses incurred .......... 59,750 (3,299) 7,995 ---------- ---------- ---------- Total losses and settlement expenses incurred ................................ $ 270,526 $ 194,968 $ 355,759 ========== ========== ==========
Loss reserves ............................... $ 255,799 $ 49,161 $ 982,197 Settlement expense reserves ................. 70,286 16,616 20,966
---------- ---------- ---------- Total loss and settlement expense reserves $ 326,085 $ 65,777 $1,003,163 ========== ========== ==========
Number of outstanding claims ................ 70 39 44 ========== ========== ==========
The incurred and reserve amounts for 1994 reflect a workers' compensation claim involving an employee of an insured who alleges exposure to asbestos. The insured asserts that the employee was not exposed to asbestos while in their employment. While the Company has established a loss reserve for this claim, management does not anticipate a workers' compensation award being upheld for the employee.
The increase in the number of outstanding claims in 1994 is primarily due to an insured being named as one of serval defendants in a case involving twenty claimants who were allegedly exposed to asbestos. The Company's initial investigation failed to find a link between the claimants and our insured. Management does not expect to have a large exposure and has established nominal reserve amounts related to these claims.
Based upon current facts, management believes the reserves established for environmental and asbestos related claims at December 31, 1994 are adequate. Although future changes in the legal and political environment may result in adjustments to these reserves, management believes any adjustments will not have a material impact on the financial condition or operations of the Company.
EXCESS AND SURPLUS LINES INSURANCE AGENCY -----------------------------------------
The excess and surplus lines insurance agency was acquired by the Company in 1985. Incorporated in 1974, the agency provides access to the excess and surplus lines markets through independent agents and managing general agents. The agency also functions as managing underwriter for such lines for several of the pool members and represents several major excess and surplus lines companies, including Lloyd's of London. Lines of insurance handled range from relatively straight forward property and casualty insurance to the more exotic hole-in-one, kidnap and ransom, ocean marine, aircraft and professional liability lines. Income is derived from fees and commissions and not from underwriting the risk.
INVESTMENTS -----------
Effective December 31, 1993, the Company adopted Statement of Financial Accounting Standards No. 115 (SFAS 115) "Accounting for Certain Investments in Debt and Equity Securities." SFAS 115 requires that investments in all debt securities and those equity securities with readily determinable market values be classified into one of three categories: held-to-maturity, trading or available-for-sale. Classification of investments is based upon management's current intent. Debt securities which management has a positive intent and ability to hold until maturity are classified as securities held-to-maturity and are carried at amortized cost. Unrealized holding gains and losses on securities held-to-maturity are not reflected in the consolidated financial statements. Debt and equity securities that are held for current resale are classified as trading securities and are carried at market value, with unrealized holding gains and losses included in earnings. All other debt and equity securities not included in the above two categories are classified as securities available-for-sale and are carried at market value, with unrealized holding gains and losses reported as a separate component of stockholders' equity, net of tax. Adoption of this statement had no effect on the income of the Company. Unrealized holding (losses) gains on securities available-for- sale had the effect of (decreasing) increasing stockholders' equity by ($1,316,596) and $2,048,651 at December 31, 1994 and 1993, respectively, net of income taxes of $0 and $1,055,365. At December 31, 1994 and 1993, the Company had no investments classified as trading securities.
Prior to December 31, 1993, investments in fixed maturities were carried at amortized cost and equity securities were carried at market value. Changes in the unrealized holding gains and losses resulting from the revaluation of equity securities were reported as direct increases and decreases in stockholders' equity. Unrealized holding gains and losses on fixed maturities were not recognized in the consolidated financial statements.
The assets of the property and casualty insurance subsidiaries, the reinsurance subsidiary and the nonstandard risk automobile insurance subsidiary are primarily invested in government bonds. At December 31, 1994, approximately 82 percent of the Company's fixed maturity bonds were invested in government or government agency issued securities. Investments in bonds categorized as held-to-maturity are purchased with the intent of being held to maturity. A variety of maturities are maintained in the Company's portfolio to assure adequate liquidity. The maturity structure of bond investments is also established by the relative attractiveness of yields on short, intermediate, and long-term bonds. The Company does not invest in any high-yield debt investments (commonly referred to as junk bonds).
The Company intends to increase its investment in equity securities during 1995. Approximately $13,500,000 of short-term funds will be reinvested in equity securities classified as available-for-sale during the first six months of 1995. The overall liquidity position of the Company will not be affected by this change.
Investments of the Company's insurance subsidiaries are subject to the insurance laws of the state of their incorporation. These laws prescribe the kind, quality and concentration of investments which may be made by insurance companies. In general, these laws permit investments, within specified limits and subject to certain qualifications, in federal, state and municipal obligations, corporate bonds, preferred and common stocks and real estate mortgages. The Company believes it is in compliance with these laws. Failure to comply could result in administrative supervision.
The National Association of Insurance Commissioners (NAIC) is in the process of developing model legislation to govern insurance company investments. An exposure draft was released in August of 1994 and a model law may be adopted by the NAIC in 1995. This model law is not expected to have a material impact on the operations of the Company's insurance subsidiaries.
The investments of the Company are supervised by an investment committee of the Board of Directors of the Company, which includes one individual who is an officer of the Company. The bond portfolios for each of the subsidiaries are managed by an internal staff which is composed of employees of Employers Mutual.
Investment expenses are based on actual expenses incurred by each of the Company's subsidiaries plus an allocation of other investment expenses incurred by Employers Mutual, which is based on a weighted average of total assets and investment transactions of each subsidiary.
The following table shows the composition of the Company's investment portfolio (at amortized cost), by type of security, as of December 31, 1994 and 1993. In the Company's consolidated financial statements, securities held-to-maturity are carried at amortized cost; securities available-for-sale are carried at market value.
Year ended December 31, -------------------------------------------- 1994 1993 --------------------- --------------------- Amortized Amortized Cost Percent Cost Percent ------------ ------- ------------ ------- Securities held-to-maturity: Fixed maturity securities: United States government agencies and authorities .. $102,480,740 30.4% $109,895,914 36.4% States and political subdivisions .............. 78,423,605 23.2 18,374,003 6.1 Foreign governments ......... 583,309 .2 587,060 .2 Public utilities ............ 8,622,154 2.5 8,813,202 2.9 Corporate securities ........ 13,052,550 3.9 17,050,988 5.7 Mortgage-backed securities .. 40,487,362 12.0 36,289,456 12.0 ------------ ------- ------------ ------- Total fixed maturity securities .............. 243,649,720 72.2 191,010,623 63.3 ------------ ------- ------------ ------- Securities available-for-sale: Fixed maturity securities: U.S. Treasury securities .... 15,835,019 4.7 26,803,980 8.9 States and political subdivisions .............. 55,274,052 16.4 58,431,008 19.4 Foreign governments ......... 1,994,980 .6 - - Corporate securities ........ 4,250,000 1.3 7,496,245 2.5 Other debt securities ....... 454,941 .1 486,941 .2 ------------ ------- ------------ ------- Total fixed maturity securities .............. 77,808,992 23.1 93,218,174 31.0 ------------ ------- ------------ ------- Equity securities ............. - - 505,000 .2 ------------ ------- ------------ ------- Short-term investments ........ 16,029,426 4.7 16,729,390 5.5 ------------ ------- ------------ ------- Total investments ........ $337,488,138 100.0% $301,463,187 100.0% ============ ======= ============ =======
Fixed maturity securities held by the Company generally have an investment quality rating of "A" or better by independent rating agencies. The following table shows the composition of the Company's fixed maturity securities, by rating, as of December 31, 1994.
Securities Securities held-to-maturity available-for-sale (at amortized cost) (at market value) --------------------- --------------------- Amount Percent Amount Percent ------------ ------- ------------ ------- Rating(1) Aaa ..................... $177,634,659 72.9% $ 37,805,573 49.4% Aa ...................... 29,632,708 12.2 26,852,122 35.1 A ....................... 32,412,444 13.3 10,459,216 13.7 Baa ..................... 3,471,265 1.4 1,375,485 1.8 Ba ...................... 498,644 .2 - - ------------ ------- ------------ ------- Total fixed maturities $243,649,720 100.0% $ 76,492,396 100.0% ============ ======= ============ =======
(1) Ratings for preferred stocks and fixed maturity securities with initial maturities greater than one year are assigned by Moody's Investor's Services, Inc. Moody's rating process seeks to evaluate the quality of a security by examining the factors that affect returns to investors. Moody's ratings are based on quantitative and qualitative factors, as well as the economic, social and political environment in which the issuing entity exists. The quantitative factors include debt coverage, sales and income growth, cash flows and liquidity ratios. Qualitative factors include management quality, access to capital markets and the quality of earnings and balance sheet items. Ratings for securities with initial maturities less than one year are based on an evaluation of the underlying assets or the credit rating of the issuer's parent company.
The amortized cost and estimated market value of fixed maturity securities at December 31, 1994, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
Estimated Amortized Market Cost Value ------------ ------------ Securities held-to-maturity: Due in one year or less ................... $ 11,767,723 $ 11,920,042 Due after one year through five years ..... 83,119,839 82,556,120 Due after five years through ten years .... 79,969,324 77,390,645 Due after ten years ....................... 28,305,472 27,544,307 Mortgage-backed securities ................ 40,487,362 39,310,374 ------------ ------------ Totals .................................. $243,649,720 $238,721,488 ============ ============
Securities available-for-sale: Due in one year or less ................... $ 20,884,351 $ 20,896,089 Due after one year through five years ..... 16,762,627 16,297,903 Due after five years through ten years .... 25,213,287 25,595,670 Due after ten years ....................... 14,948,727 13,702,734 ------------ ------------ Totals .................................. $ 77,808,992 $ 76,492,396 ============ ============
The mortgage-backed securities shown in the above table include $23,034,688 of securities issued by government corporations and agencies and $17,452,674 of collateralized mortgage obligations (CMOs). CMOs are securities backed by mortgages on real estate which come due at various times. The Company has attempted to minimize the prepayment risks associated with mortgage-backed securities by not investing in "principal only" and "interest only" CMOs. The CMOs that the Company has invested in are designed to reduce the risk of prepayment by providing predictable principal payment schedules within a designated range of prepayments. Investment yields may vary from those anticipated due to changes in prepayment patterns of the underlying collateral.
Investment results of the Company for the periods indicated are shown in the following table:
Year Ended December 31, ---------------------------------------- 1994 1993 1992 ------------ ------------ ------------ Average invested assets (1) ........ $319,475,663 $306,387,058 $288,433,650 Investment income (2) .............. 20,929,680 20,779,951 21,539,597 Average yield ...................... 6.55% 6.78% 7.47% Realized investment gains .......... $ 519,567 $ 684,445 $ 384,283
(1) Average of the aggregate invested amounts (amortized cost) at the beginning and end of the year.
(2) Investment income is net of investment expenses and does not include realized gains or provision for income taxes.
EMPLOYEES --------- EMC Insurance Group Inc. has no employees of its own, although approximately 12 employees of Employers Mutual perform administrative duties on a part-time basis. Otherwise, the Company's business activities are conducted by employees of Employers Mutual, the nonstandard risk automobile subsidiary, and one of the property and casualty insurance subsidiaries, which have 1,492 (plus 32 part-time), 14 (plus 1 part-time), and 60 employees, respectively. The property and casualty insurance subsidiaries share the costs associated with the pooling agreement in accordance with their pool participation percentages. See "Property and Casualty Insurance - Pooling Agreement."
REGULATION ----------
The Company's insurance subsidiaries are subject to extensive regulation and supervision by their home states, as well as those in which they do business. The purpose of such regulation and supervision is primarily to provide safeguards for policyholders rather than to protect the interests of stockholders. The insurance laws of the various states establish regulatory agencies with broad administrative powers, including the power to grant or revoke operating licenses and to regulate trade practices, investments, premium rates, deposits of securities, the form and content of financial statements and insurance policies, accounting practices and the maintenance of specified reserves and capital for the protection of policyholders.
Premium rate regulation varies greatly among jurisdictions and lines of insurance. In most states in which the Company's subsidiaries write insurance, premium rates for their lines of insurance are subject to either prior approval or limited review upon implementation. States require rates for property and casualty insurance that are adequate, not excessive, and not unfairly discriminatory.
The Company's insurance subsidiaries are required to file detailed annual reports with the appropriate regulatory agency in each state where they do business based on applicable statutory regulations, which differ from generally accepted accounting principles. Their businesses and accounts are subject to examination by such agencies at any time. Since EMC Insurance Group Inc. and Employers Mutual are domiciled in Iowa, the State of Iowa exercises principal regulatory supervision, and Iowa law requires periodic examination. The Company's insurance subsidiaries are subject to examination by state insurance departments on a periodic basis as applicable law requires.
State laws governing insurance holding companies also impose standards on certain transactions with related companies, which include, among other requirements, that all transactions be fair and reasonable and that an insurer's surplus as regards policyholders be reasonable and adequate in relation to its liabilities. Under Iowa law, dividends or distributions made by registered insurers are restricted in amount and may be subject to approval from the Iowa Commissioner of Insurance. "Extraordinary" dividends or distributions are subject to prior approval and are defined as dividends or distributions which exceed the greater of 10 percent of statutory surplus as regards policyholders as of the preceding December 31, or net income of the preceding calendar year on a statutory basis. Both Illinois and North Dakota impose restrictions which are similar to those of Iowa on the payment of dividends and distributions. At December 31, 1994, $15,513,214 was available for distribution in 1995 to EMC Insurance Group Inc. without prior approval. See note 7 of Notes to Consolidated Financial Statements under Item 8 of this Form 10-K.
Under the insurance laws of all states in which the Company's insurance subsidiaries and Employers Mutual operate, insurers can be assessed up to prescribed limits for policyholder losses occasioned by the insolvency or liquidation of other insurance companies. Under these laws, the extent of any future assessments against the Company is uncertain. Most laws do provide, however, that an assessment may be excused or deferred if it would threaten a solvent insurer's financial strength. Such assessments totaled $128,576, $86,200 and $132,996 in 1994, 1993 and 1992, respectively.
The NAIC adopted certain risk-based capital standards in 1994 for property and casualty insurance companies. Risk-based capital requirements attempt to measure minimum statutory capital needs based upon the risks in a company's mix of products and investment portfolio. The formula has been designed to help state regulators assess capital adequacy of insurance companies and identify property/casualty insurers that are in (or are perceived as approaching) financial difficulty by establishing minimum capital needs based upon the risks applicable to the operations of the individual insurer. The formula takes into consideration industry performance and individual insurer financial characteristics by examining a number of financial criteria to test its perceived levels of risk against assets available to bear such risks.
The model act adopted by the NAIC provides a minimum level of capital at which a State Commissioner of Insurance may act to place an insurer under certain restraints or in the worst case, to place an insurer under his or her control. These risk-based capital rules are a quantitative measurement technique which purport to quantify the minimum amount of capital necessary to match the degree of financial risk. It is a method for specifying how much minimum capital an insurer must have, based on the risks it has assumed, to assure that it maintains an acceptably low probability of financial impairment.
The risk-based capital requirements measure three major areas of risk facing property and casualty insurers: asset risk, credit risk and underwriting risk. Companies having less statutory surplus than required by the risk-based capital requirements are subject to varying degrees of regulatory scrutiny and intervention, depending on the severity of the inadequacy. The Company's insurance subsidiaries' ratio of total adjusted capital to risk-based capital at December 31, 1994 is well in excess of the minimum level required.
ITEM 2.



ITEM 2. PROPERTIES. ------- ----------- Lease costs of the Company's two office facilities in West Des Moines, Iowa total approximately $73,000 and $31,000 annually. These leases expire March 31, 1998 and November 30, 1995, respectively.
Lease costs of the Company's office facilities in Oak Brook, Illinois, and Bismarck, North Dakota, which total approximately $220,000 and $126,000 annually, are included as expenses under the pooling agreement. See "Property and Casualty Insurance - Pooling Agreement" under Item 1 of this Form 10-K.
Expenses of office facilities owned by Employers Mutual are borne by the parties to the pooling agreement, less the rent received from the space used and paid for by non-insurance subsidiaries and outside tenants. Expenses totaling $1,714,082, $1,784,868 and $1,699,591 for the three years ended December 31, 1994, 1993 and 1992, respectively, were charged to the pool in connection with the rental of 229,770 and 63,450 square feet located in Des Moines and Ames, Iowa.
ITEM 3.

ITEM 3. LEGAL PROCEEDINGS. ------- ------------------
The Company and Employers Mutual and its other subsidiaries are parties to numerous lawsuits arising in the normal course of the insurance business. The Company believes that the resolution of these lawsuits will not have a material adverse effect on its financial condition or its results of operations. The companies involved have reserves which are believed adequate to cover any potential liabilities arising out of all such pending or threatened proceedings.
ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. ------- ----------------------------------------------------
None.
PART II -------
ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED ------- ------------------------------------------------- STOCKHOLDER MATTERS. --------------------
The Company's common stock is traded on the NASDAQ National Market System under the symbol EMCI.
The following table shows the range of high and low bid quotations and dividends paid for each quarter within the two most recent years.
1994 1993 ---------------------------- ---------------------------- High Low Dividends High Low Dividends ------- ------- --------- ------- ------- ---------
1st Quarter $ 9 3/4 $ 8 1/2 $.13 $10 3/4 $ 8 $.13 2nd Quarter 10 8 1/2 .13 11 1/4 9 1/2 .13 3rd Quarter 9 1/2 8 1/2 .13 10 1/4 9 1/4 .13 4th Quarter 10 3/4 8 3/4 .13 10 1/4 8 3/4 .13 At December 31 9 1/2 9 1/2
On March 6, 1995, there were approximately 791 holders of record of the Company's common stock.
There are certain regulatory restrictions relating to the payment of dividends by the Company's insurance subsidiaries (see note 7 of Notes to Consolidated Financial Statements under Item 8 of this Form 10-K). It is the present intention of the Company's Board of Directors to declare quarterly cash dividends.
A dividend reinvestment and common stock purchase plan provides stockholders with the option of receiving additional shares of common stock instead of cash dividends. Participants may also purchase additional shares of common stock without incurring broker commissions by making optional cash contributions to the Plan. See note 14(c) of Notes to Consolidated Financial Statements under Item 8 of this Form 10-K. During 1994 and 1993, Employers Mutual elected to receive 50 percent of its dividends in common stock under this plan.
ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA. ------- ------------------------ Year ended December 31, -------------------------------------------- 1994 1993 1992 1991 1990 -------- -------- -------- -------- -------- (In thousands, except per share amounts)
Insurance premiums earned ...... $164,829 $156,438 $147,410 $113,419 $101,323 Investment income, net ......... 20,930 20,780 21,540 20,202 19,884 Realized investment gains ...... 520 684 384 65 48 Other income ................... 434 259 - - - -------- -------- -------- -------- -------- Total revenues ............ 186,713 178,161 169,334 133,686 121,255
Losses and expenses ............ 168,036 169,142 168,359 123,254 110,415 -------- -------- -------- -------- -------- Income before income taxes ..... 18,677 9,019 975 10,432 10,840
Income taxes ................... 5,171 1,885 759 3,124 2,894 -------- -------- -------- -------- -------- Income from continuing operations ................... 13,506 7,134 216 7,308 7,946
Income from discontinued operations ................... - - - 1,853 319
Income from accounting changes - 2,621 - - - -------- -------- -------- -------- -------- Net income ............... $ 13,506 $ 9,755 $ 216 $ 9,161 $ 8,265 ======== ======== ======== ======== ========
Earnings per common share: Income from continuing operations ................. $ 1.29 $ .70 $ .02 $ .73 $ .80
Income from discontinued operations ................. - - - .18 .03
Income from accounting changes .................... - .26 - - - -------- -------- -------- -------- -------- Total .................... $ 1.29 $ .96 $ .02 $ .91 $ .83 ======== ======== ======== ======== ========
Premiums earned by segment: Property and casualty ........ $115,412 $109,585 $109,139 $ 78,413 $ 70,597 Reinsurance .................. 37,256 33,324 26,615 25,009 20,696 Nonstandard risk automobile .. 12,161 13,529 11,656 9,997 10,030 -------- -------- -------- -------- -------- Total .................... $164,829 $156,438 $147,410 $113,419 $101,323 ======== ======== ======== ======== ========
Total assets ................... $387,370 $368,936 $372,807 $311,001 $296,126 ======== ======== ======== ======== ========
Stockholders' equity ........... $116,727 $109,634 $100,911 $105,144 $100,615 ======== ======== ======== ======== ========
Average return on equity ....... 11.9% 9.3% .2% 8.9% 8.4% ======== ======== ======== ======== ========
Book value per share ........... $ 11.03 $ 10.63 $ 9.98 $ 10.47 $ 10.04 ======== ======== ======== ======== ========
Dividends paid per share ....... $ .52 $ .52 $ .52 $ .52 $ .52 ======== ======== ======== ======== ========
ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL ------- ------------------------------------------------- CONDITION AND RESULTS OF OPERATIONS. ------------------------------------
OVERVIEW
EMC Insurance Group Inc. (the "Company"), an approximately 67 percent owned subsidiary of Employers Mutual Casualty Company (Employers Mutual), is an insurance holding company with operations in property and casualty insurance, reinsurance, nonstandard risk automobile insurance and excess and surplus lines insurance management. Property and casualty insurance is the most significant segment, representing 70.0 percent of consolidated premium income.
The three property and casualty insurance subsidiaries of the Company and two subsidiaries of Employers Mutual are parties to reinsurance pooling agreements with Employers Mutual (collectively the "pooling agreement"). Under the terms of the pooling agreement, each company cedes to Employers Mutual all of its insurance business and assumes from Employers Mutual an amount equal to its participation in the pool. All losses, settlement expenses and other underwriting and administrative expenses, excluding the voluntary reinsurance business assumed by Employers Mutual from unaffiliated insurance companies, are prorated among the parties on the basis of participation in the pool. The aggregate participation of the Company's property and casualty insurance subsidiaries is 22 percent. Operations of the pool give rise to intercompany balances with Employers Mutual, which are settled on a quarterly basis. The investment programs and income tax liabilities of the pool participants are not subject to the pooling agreement.
The purpose of the pooling agreement is to reduce the risk of an exposure insured by any of the pool participants by spreading it among all the companies. The pooling agreement produces a more uniform and stable underwriting result from year to year for all companies in the pool than might be experienced individually. In addition, each company benefits from the capacity of the entire pool, rather than being limited to policy exposures of a size commensurate with its own assets, and from the wide range of policy forms and lines of insurance written and the variety of rate filings and commission plans offered by each of the companies. A single set of reinsurance treaties is maintained for the protection of all six companies in the pool.
The Company's reinsurance subsidiary assumes a 95 percent quota share portion of Employers Mutual's assumed reinsurance business, exclusive of certain reinsurance contracts. The reinsurance subsidiary receives 95 percent of all premiums and assumes 95 percent of all related losses and settlement expenses of this business. Since 1993, losses in excess of $1,000,000 per event are retained by Employers Mutual. The reinsurance subsidiary does not reinsure any of Employers Mutual's direct insurance business, nor any "involuntary" facility or pool business that Employers Mutual assumes pursuant to state law. In addition, the reinsurance subsidiary is not liable for credit risk in connection with the insolvency of any reinsurers of Employers Mutual.
The Company's nonstandard risk automobile insurance subsidiary specializes in insuring private passenger automobile risks that are found to be unacceptable in the normal automobile market.
The excess and surplus lines insurance agency provides insurance companies with access to the excess and surplus lines markets and also functions as managing underwriter for such lines for Employers Mutual and several of the pool members.
RESULTS OF OPERATIONS
Operating results for the three years ended December 31, 1994 are as follows:
($ in thousands) 1994 1993 1992 -------- -------- -------- Premiums earned .......................... $164,829 $156,438 $147,410 Losses and settlement expenses ........... 116,944 120,355 122,088 Other expenses ........................... 51,092 48,787 46,271 -------- -------- -------- Underwriting loss ........................ (3,207) (12,704) (20,949) Net investment income .................... 20,930 20,780 21,540 Realized investment gains ................ 520 684 384 Other income ............................. 434 259 - -------- -------- -------- Operating income before income taxes ..... $ 18,677 $ 9,019 $ 975 ======== ======== ======== Incurred losses and settlement expenses: Insured events of the current year ..... $123,344 $119,896 $116,616 (Decrease) increase in provision for insured events of prior years ........ (6,400) 459 5,472 -------- -------- -------- Total losses and settlement expenses .. $116,944 $120,355 $122,088 ======== ======== ======== Catastrophe losses ....................... $ 5,487 $ 8,513 $ 16,569 ======== ======== ========
Operating results before income taxes have improved significantly over the last three years. This improvement reflects a decrease in catastrophe losses and a decline in the loss and settlement expense provision for insured events of prior years. In 1994, all segments showed improved operating results, with the property and casualty insurance subsidiaries and the nonstandard risk automobile insurance subsidiary posting significant increases over 1993. Operating results for 1993 reflect greatly improved underwriting results in the property and casualty insurance subsidiaries and the reinsurance subsidiary. Operating results for 1992 were severely impacted by catastrophe losses associated with Hurricanes Andrew and Iniki.
Premiums earned have increased steadily over the last three years despite the competitive market conditions. For the year 1994, production increases in the property and casualty insurance subsidiaries and the reinsurance subsidiary were partially offset by a production decrease in the nonstandard risk automobile insurance subsidiary. For the year 1993, production increased for the reinsurance subsidiary and the nonstandard risk automobile insurance subsidiary, while the property and casualty insurance subsidiaries remained relatively flat.
Losses and settlement expenses have decreased over the last three years, reflecting a decline in catastrophe losses and the provision for insured events of prior years. During 1992, the property and casualty insurance subsidiaries and the nonstandard risk automobile insurance subsidiary strengthened prior year reserves on certain lines of business and the reinsurance subsidiary experienced a time lag in the reporting of assumed reinsurance business. During 1993, the property and casualty insurance subsidiaries continued to strengthen reserves on certain lines of business, while the reinsurance subsidiary experienced adverse development on losses associated with Hurricane Andrew. These reserve increases in 1992 and 1993 were partially offset by reserve decreases on other lines of business, resulting in a net increase in the Company's estimate of prior year reserves of $5,472,000 in 1992 and $459,000 in 1993. During 1994, the reinsurance subsidiary experienced adverse development on certain contracts. These reserve increases were offset by significant reserve decreases in the property and casualty insurance subsidiaries and the nonstandard risk automobile insurance subsidiary. As a result, the net decrease in the Company's prior year reserves in 1994 amounted to $6,400,000. In addition to the substantial amount of catastrophe losses incurred in 1992 and 1993, results for these years also reflect losses associated with two reinsurance contracts under the reinsurance subsidiary's quota share agreement that were commuted in 1993.
Investment income increased in 1994 after experiencing a decrease in 1993. The decrease in 1993 is primarily due to a decline in invested assets resulting from the transfer of $24,853,000 to Employers Mutual in connection with the change in the property and casualty insurance subsidiaries' pooling agreement relating to the voluntary assumed reinsurance business and the commutation of two reinsurance contracts under the reinsurance subsidiary's quota share agreement.
Realized gains on investments are primarily the result of calls and prepayments on fixed maturity securities.
Other income amounts represent the amortization of deferred income related to reserve discounting on the commutation of one of the reinsurance subsidiary's reinsurance contracts under the quota share agreement in 1993.
Effective January 1, 1994, the Company adopted Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits." Adoption of this statement had no effect on the operations of the Company.
Effective December 31, 1994, the Company adopted Statement of Financial Accounting Standards No. 119, "Disclosure about Derivative Financial Instruments and Fair Value of Financial Instruments." Adoption of this statement had no effect on current disclosures as the Company did not hold or issue any derivative financial instruments at December 31, 1994.
In 1993, the Company adopted four new accounting standards and implemented an accounting change. The net impact of these items was an increase in net income of $2,621,000 ($.26 per share). Following is a brief explanation of each item:
* Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 106 (SFAS 106), "Employers' Accounting for Postretirement Benefits Other Than Pensions." The Company adopted SFAS 106 by recognizing the transition obligation as a cumulative effect adjustment to income. The Company's transition obligation amounted to $2,166,000 ($.21 per share), net of income tax benefits of $1,116,000.
* Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 109 (SFAS 109), "Accounting for Income Taxes." The Company adopted SFAS 109 as a cumulative effect adjustment to income. The Company recognized a benefit of $5,595,000 ($.55 per share), net of a valuation allowance of $1,000,000.
* Effective January 1, 1993, the property and casualty insurance subsidiaries changed their method of calculating unearned premiums from the monthly pro rata method to the daily method. The property and casualty insurance subsidiaries changed their accounting method because of management's belief that the new method provides for a more accurate matching of revenues and expenses over the terms of the underlying insurance policies. This change resulted in a cumulative increase in unearned premiums of $1,110,000 and a decrease in income of $808,000 ($.08 per share), net of income tax benefits of $302,000.
* Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 113 (SFAS 113), "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts." SFAS 113 requires a gross (rather than net) balance sheet presentation for ceded reinsurance amounts and addresses the recognition of gain or loss resulting from reinsurance transactions and appropriate financial statement disclosure of reinsurance activities. Adoption of this statement had no effect on the income of the Company.
* Effective December 31, 1993, the Company adopted Statement of Financial Accounting Standards No. 115 (SFAS 115), "Accounting for Certain Investments in Debt and Equity Securities." SFAS 115 provides that investments in all debt securities and those equity securities with readily determinable market values are to be classified in one of three categories: held-to-maturity, trading or available-for-sale. Classification of investments is based upon management's current intent. Debt securities which management has a positive intent and ability to hold to maturity are classified as "securities held-to-maturity" and are carried at amortized cost. Unrealized holding gains and losses on securities held-to-maturity are not reflected in the consolidated financial statements. Debt and equity securities that are held for current resale are classified as "trading securities" and are reported at market value, with unrealized holding gains and losses included in earnings. All other debt and equity securities are classified as "securities available-for-sale" and are carried at market value, with unrealized holding gains and losses excluded from earnings and reported as a separate component of stockholders' equity, net of tax. Adoption of this statement had no effect on the income of the Company. Unrealized holding (losses) gains on securities available-for- sale had the effect of (decreasing) increasing stockholders' equity by ($1,317,000) and $2,048,000 at December 31, 1994 and 1993, respectively, net of income taxes of $0 and $1,055,000. At December 31, 1994 and 1993, the Company did not have any investments categorized as trading securities.
SEGMENT RESULTS
Property and Casualty Insurance
Following is an overview of recent changes that have affected the operations of the property and casualty insurance subsidiaries.
Effective January 1, 1992, the aggregate participation of the property and casualty insurance subsidiaries was increased to 22 percent from 17 percent. In connection with this change in pool participation, the Company's liabilities increased $31,428,000 and invested assets increased $29,402,000. The Company reimbursed Employers Mutual $2,026,000 for commissions incurred to generate this business.
As previously noted, Employers Mutual voluntarily assumes reinsurance business from nonaffiliated insurance companies and cedes 95 percent of this business to the Company's reinsurance subsidiary, exclusive of certain reinsurance contracts. Prior to 1993, amounts not ceded to the reinsurance subsidiary were retained by Employers Mutual and were subject to cession to the pool members. Effective January 1, 1993, the pooling agreement was amended so that the voluntary assumed reinsurance business written by Employers Mutual is no longer subject to cession to the pool members. As a result, amounts assumed by the Company from nonaffiliates have declined from the amounts assumed in 1992. In connection with this change in the pooling agreement, the Company's liabilities decreased $4,470,000 and invested assets decreased $4,427,000. Employers Mutual reimbursed the Company $43,000 for commissions incurred to generate this business.
Prior to December 31, 1993, the parties to the pooling agreement recorded amounts assumed from the National Workers' Compensation Reinsurance Pool on a net basis. Under this approach, reserves for outstanding losses and unearned premiums were reported as liabilities under "Indebtedness to Related Party" in the Company's consolidated financial statements. Effective December 31, 1993, the parties to the pooling agreement began recording these amounts as outstanding losses and unearned premiums and restated all prior year consolidated financial statements for comparative purposes. There was no income effect from this reclassification. In connection with this gross-up of balances, amounts due from Employers Mutual increased $13,148,000 at December 31, 1993. Under the terms of the pooling agreement, these balances were settled in the first quarter of 1994.
Operating results for the three years ended December 31, 1994 are as follows:
($ in thousands) 1994 1993 1992 -------- -------- -------- Premiums earned .......................... $115,412 $109,585 $109,139 Losses and settlement expenses ........... 77,872 79,777 82,314 Other expenses ........................... 36,606 33,621 33,994 -------- -------- -------- Underwriting gain (loss) ................. 934 (3,813) (7,169) Net investment income .................... 14,080 13,243 13,048 Realized investment gains ................ 334 405 285 -------- -------- -------- Operating income before income taxes ..... $ 15,348 $ 9,835 $ 6,164 ======== ======== ======== Incurred losses and settlement expenses: Insured events of the current year ..... $ 84,204 $ 81,355 $ 80,900 (Decrease) increase in provision for insured events of prior years ........ (6,332) (1,578) 1,414 -------- -------- -------- Total losses and settlement expenses .. $ 77,872 $ 79,777 $ 82,314 ======== ======== ======== Catastrophe losses ....................... $ 4,063 $ 3,372 $ 4,631 ======== ======== ========
Production increases for the last three years have been hindered by rate competition and the continued shift of large commercial insureds to alternative risk mechanisms. In response to these difficult market conditions, the property and casualty insurance subsidiaries have implemented new marketing programs that emphasize property insurance. In addition to increasing the amount of property insurance written, these programs have also helped to highlight the subsidiaries' other products. Premium rate adequacy varied greatly by line of business in 1994, but overall rate adequacy improved. This improvement reflects many factors, including careful underwriting, significant reform measures implemented by several states to control the administrative costs of workers' compensation claims and internal cost management programs. During 1994, 11 states implemented rate reductions for the workers' compensation line of business ranging from .3 percent to 16.0 percent while 14 states implemented rate increases ranging from .1 percent to 12.6 percent. These rate changes did not have a material impact on 1994 production as they were implemented at various times throughout the year and they largely offset each other.
Underwriting results have improved significantly over the last three years, primarily due to improved results in the workers' compensation line of business. Reform measures implemented by several states to control administrative costs related to workers' compensation insurance have been a major factor in this improvement. By monitoring this reform on a state by state basis and writing more business in states that show a potential for profit, management has been able to achieve improved results. Underwriting results for 1994 reflect a net decline of $6,332,000 in the estimate of prior year loss reserves. This decline reflects savings associated with the reform measures noted above. Underwriting results for 1993 and 1992 were negatively impacted by reserve strengthening in the workers' compensation line of business related to greater than expected increases in the price and usage of drugs, medical durables and medical services. Results for 1992 also reflect $1,427,000 of underwriting losses associated with the voluntary assumed reinsurance business written by Employers Mutual that effective January 1, 1993 is no longer subject to cession to the pool members.
Investment income increased in each of the last three years. The large increase in 1994 reflects interest income earned on $13,148,000 received from Employers Mutual in connection with the gross-up of reserve amounts associated with the National Workers' Compensation Reinsurance Pool in 1993.
Reinsurance
Following is an overview of recent changes that have affected the operations of the reinsurance subsidiary.
Effective January 1, 1993, the quota share agreement was amended so that losses in excess of $1,000,000 per event are retained by Employers Mutual. The reinsurance subsidiary pays an annual override commission to Employers Mutual for this additional protection, which totaled $2,095,000 in 1994 and $1,809,000 in 1993. The reinsurance subsidiary also pays for 95 percent of the outside reinsurance protection Employers Mutual purchases to protect itself from catastrophic losses on the assumed reinsurance business. This cost is recorded as a reduction to the premiums received by the reinsurance subsidiary and amounted to $2,563,000 and $2,867,000 in 1994 and 1993, respectively. Employers Mutual retained losses and settlement expenses totaling $7,020,000 in 1994 and $615,000 in 1993 under this agreement. In conjunction with this amendment to the quota share agreement, the reinsurance subsidiary terminated its catastrophe reinsurance contracts with Employers Mutual and other nonaffiliated reinsurers. Effective January 1, 1993, the reinsurance subsidiary no longer cedes reinsurance to nonaffiliated reinsurers and only cedes reinsurance to Employers Mutual under an aggregate "excess of loss" treaty.
Effective June 30, 1993, Employers Mutual commuted the portion of the quota share agreement that pertained to a casualty pool that is in a run-off position. In connection with this change in the quota share agreement, the Company's liabilities decreased $19,783,000 and invested assets decreased $17,806,000. The reserve discount amount of $1,977,000 was recorded as deferred income and is being amortized into operations over the estimated settlement period of the reserves, which is ten years. The amount recognized as income totaled $434,000 in 1994 and $259,000 in 1993.
Effective October 31, 1993, Employers Mutual commuted the portion of the quota share agreement that pertained to a voluntary pool that handled large "highly protected" risks. In connection with this change in the quota share agreement, the Company's liabilities decreased $3,827,000 and invested assets decreased $2,620,000. Employers Mutual reimbursed the Company $1,207,000 for commissions incurred to generate this business. No reserve discount was calculated as this business involved short-tail property coverage.
During 1994, the reinsurance subsidiary commuted all outstanding reinsurance balances ceded to Employers Mutual under catastrophe and aggregate excess of loss reinsurance treaties related to accident years 1991 through 1993. In connection with these commutations, the Company's assets and liabilities increased $687,000. There was no income effect from these commutations.
The reinsurance subsidiary has an aggregate excess of loss treaty with Employers Mutual which provides protection from a large accumulation of retentions resulting from multiple catastrophes in any one year. The coverage provided is $2,000,000, excess of $2,500,000 aggregate loss retained, excess of $200,000 per event. Maximum recovery is limited to $4,000,000 per accident year. The reinsurance subsidiary recovered $0, $144,000 and $4,221,000 under this treaty and paid reinstatement premiums of $0, $280,000 and $745,000 in 1994, 1993 and 1992, respectively. Total premiums paid to Employers Mutual amounted to $558,000, $708,000 and $1,125,000 in 1994, 1993 and 1992, respectively.
Operating results for the three years ended December 31, 1994 are as follows:
($ in thousands) 1994 1993 1992 -------- -------- -------- Premiums earned ............................ $ 37,256 $ 33,324 $ 26,615 Losses and settlement expenses ............. 30,565 27,872 29,047 Other expenses ............................. 11,408 11,492 9,472 -------- -------- -------- Underwriting loss .......................... (4,717) (6,040) (11,904) Net investment income ...................... 5,354 6,090 6,763 Realized investment gains .................. 116 201 52 Other income ............................... 434 259 - -------- -------- -------- Operating income (loss) before income taxes $ 1,187 $ 510 $ (5,089) ======== ======== ======== Incurred losses and settlement expenses: Insured events of the current year ....... $ 29,270 $ 25,359 $ 25,608 Increase in provision for insured events of prior years .................. 1,295 2,513 3,439 -------- -------- -------- Total losses and settlement expenses .... $ 30,565 $ 27,872 $ 29,047 ======== ======== ======== Catastrophe losses ......................... $ 1,424 $ 5,141 $ 11,609 ======== ======== ========
Premiums earned have increased steadily over the last three years. Under the terms of the amended quota share agreement with Employers Mutual, the amounts for 1994 and 1993 reflect a reduction of $2,836,000 and $2,439,000, respectively, related to the reinsurance subsidiary's payment of 95 percent of the cost of the reinsurance protection purchased by Employers Mutual to protect itself from catastrophic losses. Prior to 1993, the reinsurance subsidiary purchased its own catastrophe protection. Premiums earned for 1992 reflect $6,481,000 in premiums ceded (including $3,149,000 of reinstatement premiums) to Employers Mutual and other nonaffiliated reinsurers for this catastrophe protection. Operations for 1994 and 1993 reflect a shift from catastrophe "excess of loss" business to "pro rata" business. Premiums earned for 1994 reflect an increased participation in a voluntary pool and additional premium volume on new and existing pro rata contracts. Rates for pro rata business deteriorated somewhat during 1994 due to competitive market conditions at the primary company level.
Underwriting results have improved significantly over the last three years, primarily due to a decline in catastrophe losses. The large decrease in catastrophe losses in 1994 was partially offset by an increase in crop hail losses and a deterioration of results in the pro rata business. Incurred losses for the last three years reflect adverse development on prior year losses. The large amount in 1992 is primarily due to a time lag in the reporting of assumed reinsurance business. This time lag did not have a material effect on the underwriting results of the reinsurance subsidiary since the premium income associated with this business was recorded at the same time as the losses. The adverse development experienced in 1993 primarily relates to losses associated with Hurricane Andrew. Results for 1993 and 1992 reflect $1,678,000 and $2,246,000, respectively, of underwriting losses associated with two reinsurance contracts that were commuted in 1993.
Expenses for 1994 and 1993 include $2,095,000 and $1,809,000, respectively, of commissions paid to Employers Mutual in connection with the $1,000,000 cap on catastrophe losses under the amended quota share agreement.
The large decline in investment income in 1994 and 1993 is primarily attributable to the transfer of $20,426,000 to Employers Mutual during 1993 in connection with the commutation of two reinsurance contracts. This decline in investment income was partially offset by the recognition of deferred income totaling $434,000 in 1994 and $259,000 in 1993 related to reserve discounting on one of the commuted contracts.
Due to poor underwriting results achieved over the last several years, four large national pro rata contracts with approximately $3,500,000 of earned premium were cancelled effective December 31, 1994. As a result of these cancellations, earned premiums for 1995 are expected to remain relatively flat. During 1995, more emphasis will be placed upon writing excess of loss business in non-hurricane prone areas and increasing participation on existing contracts that have favorable terms. Pro rata business will continue to be written, but the focus will be on properly structured regional accounts rather than large national accounts. This gradual movement towards excess of loss business is prompted by the continued deterioration of pro rata rates and a greater control over the pricing of excess of loss business.
Nonstandard Risk Automobile Insurance
Operating results for the three years ended December 31, 1994 are as follows:
($ in thousands) 1994 1993 1992 -------- -------- -------- Premiums earned ............................ $ 12,161 $ 13,529 $ 11,656 Losses and settlement expenses ............. 8,507 12,706 10,727 Other expenses ............................. 3,160 3,366 2,922 -------- -------- -------- Underwriting gain (loss) ................... 494 (2,543) (1,993) Net investment income ...................... 1,152 1,166 1,179 Realized investment gains .................. 75 109 47 -------- -------- -------- Operating income (loss) before income taxes $ 1,721 $ (1,268) $ (767) ======== ======== ======== Incurred losses and settlement expenses: Insured events of the current year ....... $ 9,870 $ 13,182 $ 10,108 (Decrease) increase in provision for insured events of prior years .......... (1,363) (476) 619 -------- -------- -------- Total losses and settlement expenses .... $ 8,507 $ 12,706 $ 10,727 ======== ======== ======== Catastrophe losses ......................... $ - $ - $ 329 ======== ======== ========
The nonstandard risk marketplace is very competitive. Policies are written for relatively short periods of time and insureds continually search for the most attractive rates. In response to favorable results achieved in prior years, the company began increasing market share in 1992 by offering more competitive rates. The company experienced adverse selection in this new business as the standard market began to accept more of the marginal risks during this same time period. As a result, losses associated with this new business exceeded the premiums received.
Premiums earned declined in 1994 as the company elected to emphasize profitability over premium volume and did not reduce rates in order to retain business. Recently, the larger standard companies have begun to develop rate tiers that are geared toward retaining nonstandard risk customers, rather than passing them into the nonstandard market. This additional availability in the standard market has resulted in increased competition in the nonstandard market. Production for 1995 is expected to remain relatively flat as the company will continue to emphasize profitability over market share. The company expects to begin writing business in the state of Missouri in late 1995 which should help to offset any production decreases experienced in existing markets.
Underwriting results for 1994 reflect improved loss experience, favorable development on prior year loss reserves and rate increases that were implemented in all states during the later part of 1993 and the first part of 1994. Results for 1992 and 1993 were negatively impacted by increased loss frequency and severity associated with a new book of business and a strengthening of loss and settlement expense reserves. During 1992, this reserve strengthening was primarily directed toward prior year claims. During 1993, the reserve strengthening was primarily directed toward current year claims in response to increased loss frequency and severity on the new book of business. Profitable underwriting results in the future are likely to be more dependent upon successful niche marketing, rather than full coverage programs. The company is prepared to meet the needs of its consumers by offering selected coverages at prices deemed adequate for the risks insured.
Investment income has declined slightly over the last three years. This decline is due to reduced interest rates available for current investments.
Excess and Surplus Lines Insurance Management Agency
Operating income before income taxes increased to $505,000 in 1994 from $103,000 in 1993 and $496,000 in 1992. The improvement in 1994 is the result of a new management plan put into effect which places more emphasis on writing excess and surplus lines business through Employers Mutual's agency force. Operating results for 1993 and 1992 were negatively impacted by the termination of business with a large agency that had previously represented over 50 percent of this segment's volume.
Parent Company
Operating loss before income taxes decreased to $84,000 in 1994 from $161,000 in 1993 and a profit of $171,000 in 1992. The improvement in 1994 reflects a decline in operating expenses and an increase in investment income. The large decline in 1993 reflects a substantial reduction in investment income. Invested assets decreased in 1993 due to a capital contribution made to the reinsurance subsidiary in 1992 and a reduction in the amount of dividends received from the insurance company subsidiaries.
LOSS AND SETTLEMENT EXPENSE RESERVES
Loss and settlement expense reserves are the Company's largest liability. Management continually reviews these reserves using a variety of statistical and actuarial techniques to analyze claim costs, frequency and severity data, and social and economic factors. Significant periods of time may elapse between the occurrence of an insured loss, the reporting of the loss and the settlement of the loss. During the loss settlement period, additional facts regarding individual claims become known, and accordingly, it often becomes necessary to refine and adjust the estimates of liability on a claim. Changes in reserve estimates are reflected in operating results in the year such changes are recorded.
Estimating asbestos and environmental related reserves is very difficult due to the following uncertainties surrounding these types of claims: the legal definition of asbestos and environmental damage is still evolving, the assignment of responsibility varies widely by state, defense costs are often much greater than the claim costs and claims often emerge long after the policy has expired, making assignment of damages to the appropriate party and to the time period covered by a particular policy difficult. In establishing reserves for these types of claims, management monitors the relevant facts concerning each claim, the current status of the legal environment, the social and political conditions and the claim history and trends within the Company and the industry.
Over the last several years, the Company's financial results have not been materially affected by losses associated with environmental and asbestos claims. The Company's environmental claims activity is predominately from hazardous waste and pollution-related claims. The parties to the pooling agreement have not written primary coverage for the major oil or chemical companies; the greatest exposure arises out of commercial general liability and umbrella policies issued to municipalities during the 1970s which allegedly cover contamination emanating from closed landfills. The remaining exposure is for claims from small regional operations or local businesses involved with disposing wastes at dump sites or having pollution on their own property due to hazardous material use or leaking underground storage tanks. These insureds include small manufacturing operations, tool makers, automobile dealerships, contractors, gasoline stations and real estate developers.
The Company's asbestos claims activity is predominately from insureds that have been named as one of multiple defendants covering exposure over many years. The Company has not found any evidence of injury as a result of exposure to the Company's insured's products during the policy periods.
During 1994, Congress debated potential reforms to the "Superfund" law which included a new tax on commercial lines insurance companies. This tax would have been used to fund clean-up costs and settle lawsuits between potentially responsible parties and their insurers. This legislation was not successful in 1994 and it is currently unknown whether similar legislation will be introduced in 1995.
LIQUIDITY AND INVESTMENTS
The Company maintains a portion of the investment portfolio in relatively short-term and highly liquid investments to ensure the availability of funds to meet claims and expenses. The remainder of the investment portfolio is invested in securities with maturities that approximate the anticipated liabilities of the insurance issued. Net unrealized holding losses on fixed maturity securities available-for-sale totaled $1,317,000 at December 31, 1994. This compares to net unrealized holding gains of $3,134,000 at December 31, 1993. The decrease in the market value of these investments is primarily due to higher interest rates imposed by the Federal Reserve Board during 1994, which caused bond values to decline. Further declines in the market value of these investments may occur if the Federal Reserve Board again raises interest rates. Since the Company does not actively trade in the bond market, such fluctuations in the market value of these investments are not expected to have a material impact on the operations of the Company, as forced liquidations of investments are not anticipated. The Company closely monitors the bond market and makes appropriate adjustments in investment policy as changing conditions warrant. A valuation allowance related to the tax benefits associated with these unrealized holding losses was established in 1994 due to the uncertainty concerning the future realization of these tax benefits.
The majority of the Company's assets are invested in fixed maturities. These investments provide a substantial amount of income which offsets underwriting losses and contributes to net earnings. As these investments mature the proceeds will be reinvested at current rates, which may be higher or lower than those now being earned; therefore, more or less investment income may be available to contribute to net earnings depending on the interest rate level.
The Company intends to increase its investment in equity securities during 1995. Approximately $13,500,000 of short-term funds will be reinvested in equity securities classified as available-for-sale during the first six months of 1995. The overall liquidity position of the Company will not be affected by this change.
The major ongoing sources of the Company's liquidity are insurance premium income, investment income and cash provided from maturing or liquidated investments. The principal outflows of cash are payments of claims, commissions, premium taxes, operating expenses, income taxes, dividends and investment purchases.
During 1994, the Company generated positive cash flows from operations of $39,006,000, which included $13,148,000 related to the gross-up of reserve amounts associated with the National Workers' Compensation Reinsurance Pool, as previously noted. This compares to a negative operating cash flow of $8,794,000 in 1993, which included $24,853,000 paid to Employers Mutual in connection with the change in the property and casualty insurance subsidiaries' pooling agreement relating to the voluntary assumed reinsurance business and the commutation of two reinsurance contracts under the reinsurance subsidiary's quota share agreement. Operating cash flows of $50,826,000 in 1992 included $29,402,000 received from Employers Mutual in connection with the increase in the property and casualty insurance subsidiaries' pool participation.
The Company contributed $10,000,000 of the proceeds received from the sale of the life subsidiary to increase the surplus of the property and casualty insurance subsidiaries in 1992 in connection with the increase in pool participation. The Company contributed $3,000,000 to the surplus of the reinsurance subsidiary in 1992 in order to retain its status as an authorized reinsurance company in several states.
CAPITAL RESOURCES
As of December 31, 1994, the Company had no material commitments for capital expenditures.
Insurance company operations require capital to support premium writings. The Company believes that its insurance company subsidiaries have sufficient capital to support their expected near-term writings. The Company's insurance agency operations do not require a large amount of capital.
A major source of cash flows for the holding company is dividend payments from its subsidiaries. State insurance regulations restrict the maximum amount of dividends insurance companies can pay without prior regulatory approval. See note 7 of Notes to Consolidated Financial Statements for additional information regarding dividend restrictions. The Company collected $3,068,000, $860,000 and $3,288,000 of dividends from its insurance subsidiaries in 1994, 1993 and 1992, respectively. The Company paid cash dividends to stockholders totaling $3,511,000, $3,443,000 and $5,104,000 in 1994, 1993 and 1992, respectively. The decrease from 1992 is due to the fact that Employers Mutual received 50 percent of its dividends in common stock under the Company's dividend reinvestment and common stock purchase plan in 1994 and 1993.
IMPACT OF INFLATION
Inflation has a widespread effect on the Company's results of operations, primarily through increased losses and settlement expenses. The Company considers inflation, including social inflation which reflects an increasingly litigious society and increasing jury awards, when setting reserve amounts. Premiums are also affected by inflation, although they are often restricted or delayed by competition and the regulatory rate-setting environment.
DEVELOPMENTS IN INSURANCE REGULATION
The National Association of Insurance Commissioners (NAIC) adopted certain risk-based capital standards in 1994 for property and casualty insurance companies. Risk-based capital requirements attempt to measure minimum statutory capital needs based upon the risks in a company's mix of products and investment portfolio. The formula has been designed to help state regulators assess capital adequacy of insurance companies and identify property/casualty insurers that are in (or are perceived as approaching) financial difficulty by establishing minimum capital needs based upon the risks applicable to the operations of the individual insurer. The formula takes into consideration industry performance and individual insurer financial characteristics by examining a number of financial criteria to test its perceived levels of risk against assets available to bear such risks. The model act adopted by the NAIC provides a minimum level of capital at which a State Commissioner of Insurance may act to place an insurer under certain restraints or in the worst case, to place an insurer under his or her control. These risk-based capital rules are a quantitative measurement technique which purport to quantify the minimum amount of capital necessary to match the degree of financial risk. It is a method for specifying how much minimum capital an insurer must have, based on the risks it has assumed, to assure that it maintains an acceptably low probability of financial impairment.
The risk-based capital requirements measure three major areas of risk facing property and casualty insurers: asset risk, credit risk and underwriting risk. Companies having less statutory surplus than required by the risk-based capital requirements are subject to varying degrees of regulatory scrutiny and intervention, depending on the severity of the inadequacy. The Company's insurance subsidiaries' ratio of total adjusted capital to risk-based capital at December 31, 1994 is well in excess of the minimum level required.
The NAIC is in the process of developing model legislation to govern insurance company investments. An exposure draft was released in August of 1994 and a model law may be adopted by the NAIC in 1995. This model law is not expected to have a material impact on the operations of the Company's insurance subsidiaries.
ITEM 8.


ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. ------- --------------------------------------------
Management's Responsibility for Financial Reporting
The consolidated financial statements contained in this annual report were prepared by management in conformity with generally accepted accounting principles. In preparing these financial statements, reasonable estimates and judgments have been made when necessary.
Management is responsible for establishing and maintaining a system of internal control, designed to provide reasonable assurance as to the integrity and reliability of the financial records. The concept of reasonable assurance recognizes that there are inherent limitations in any control system and that the cost of maintaining a control system should not exceed the expected benefits to be derived therefrom. Management believes its system of internal control effectively meets its objective of reliable financial reporting.
The Audit Committee of the Board of Directors, composed solely of outside directors, met during the year with management and the independent accountants to review and discuss audit findings and other financial and accounting matters. The independent accountants have free access to the Audit Committee, with and without management present, to discuss the results of their audit work.
The consolidated financial statements are examined by KPMG Peat Marwick LLP, independent certified public accountants. Their report appears elsewhere in this annual report.
/s/ E. H. Creese ------------------------------------ E. H. Creese, C.P.A. Senior Vice President, Treasurer and Chief Financial Officer
Independent Auditor's Report
The Board of Directors and Stockholders EMC Insurance Group Inc.:
We have audited the accompanying consolidated balance sheets of EMC Insurance Group Inc. and Subsidiaries as of December 31, 1994 and 1993, and the related consolidated statements of income, stockholders' equity and cash flows for each of the years in the three-year period ended December 31, 1994. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of EMC Insurance Group Inc. and Subsidiaries as of December 31, 1994 and 1993, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1994, in conformity with generally accepted accounting principles.
As discussed in notes 1, 10, 11 and 13 to the consolidated financial statements, the Company changed its method of computing unearned premiums in 1993 and implemented the provisions of the Financial Accounting Standards Board's Statements No. 106, "Employers Accounting for Postretirement Benefits Other Than Pensions", No. 109, "Accounting for Income Taxes" and No. 115, "Accounting for Certain Investments in Debt and Equity Securities".
/s/ KPMG Peat Marwick LLP
Des Moines, Iowa February 20, 1995
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
Consolidated Balance Sheets
December 31, -------------------------- 1994 1993 ------------ ------------ ASSETS
Investments (note 10): Fixed maturities: Securities held-to-maturity, at amortized cost (market value $238,721,488 and $206,305,597) $243,649,720 $191,010,623 Securities available-for-sale, at market value (amortized cost $77,808,992 and $93,218,174) 76,492,396 96,352,190 Equity securities available-for-sale, at market value (cost $0 and $505,000) .................. - 475,000 Short-term investments, at cost ................. 16,029,426 16,729,390 ------------ ------------ Total investments .......................... 336,171,542 304,567,203
Cash .............................................. 1,258,221 675,203 Indebtedness of related party (note 4) ............ - 12,291,512 Accrued investment income ......................... 5,560,633 4,835,451 Accounts receivable ............................... 1,280,550 415,215 Deferred policy acquisition costs ................. 8,393,635 7,698,864 Deferred income taxes (note 11) ................... 14,190,499 13,040,693 Intangible assets, including goodwill, at cost less accumulated amortization of $1,674,643 and $1,540,130 .................................. 1,883,177 2,017,690 Reinsurance receivables (note 3) .................. 14,935,048 18,477,406 Prepaid reinsurance premiums (note 3) ............. 2,121,033 2,832,184 Other assets ...................................... 1,575,540 2,084,102 ------------ ------------ Total assets ............................... $387,369,878 $368,935,523 ============ ============
See accompanying Notes to Consolidated Financial Statements.
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
Consolidated Balance Sheets
December 31, -------------------------- 1994 1993 ------------ ------------ LIABILITIES
Losses and settlement expenses (notes 2,3,5 and 6) $203,181,615 $197,121,852 Unearned premiums (notes 2 and 3) ................. 47,672,570 45,941,056 Other policyholders' funds ........................ 3,102,609 2,854,793 Indebtedness to related party (note 4) ............ 937,356 - Income taxes payable .............................. 1,736,000 550,000 Postretirement benefits (note 13).................. 4,086,674 3,537,449 Deferred income (note 2) .......................... 1,283,662 1,717,641 Other liabilities ................................. 8,642,703 7,578,963 ------------ ------------ Total liabilities .......................... 270,643,189 259,301,754 ------------ ------------
STOCKHOLDERS' EQUITY (notes 7,8,10,14 and 15)
Common stock, $1 par value, authorized 20,000,000 shares; issued and outstanding, 10,587,629 shares in 1994 and 10,325,329 shares in 1993 ........... 10,587,629 10,325,329 Additional paid-in capital ........................ 57,162,911 55,021,926 Unrealized holding (losses) gains on fixed maturity securities available-for-sale, net of tax ...................................... (1,316,596) 2,068,451 Unrealized holding losses on equity securities available-for-sale, net of tax .................. - (19,800) Retained earnings ................................. 50,402,812 42,319,249 Treasury stock, at cost (10,931 shares in 1994 and 8,090 shares in 1993) ....................... (110,067) (81,386) ------------ ------------ Total stockholders' equity ................. 116,726,689 109,633,769 ------------ ------------ Contingent liabilities (notes 3,11 and 17)
Total liabilities and stockholders' equity $387,369,878 $368,935,523 ============ ============
See accompanying Notes to Consolidated Financial Statements.
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
Consolidated Statements of Income
Year ended December 31, ---------------------------------------- 1994 1993 1992 ------------ ------------ ------------ REVENUES: Premiums earned (notes 2 and 3) ... $164,829,379 $156,437,538 $147,410,287 Investment income, net (note 10) .. 20,929,680 20,779,951 21,539,597 Realized investment gains (note 10) 519,567 684,445 384,283 Other income (note 2) ............. 433,979 259,217 - ------------ ------------ ------------ 186,712,605 178,161,151 169,334,167 ------------ ------------ ------------ LOSSES AND EXPENSES: Losses and settlement expenses (notes 2,3 and 5) ...... 116,944,054 120,355,299 122,087,833 Dividends to policyholders ........ 3,103,788 2,494,284 3,382,736 Amortization of deferred policy acquisition costs ........ 31,701,789 30,717,175 29,291,362 Other underwriting expenses ....... 16,286,206 15,575,257 13,597,179 ------------ ------------ ------------ 168,035,837 169,142,015 168,359,110 ------------ ------------ ------------ Income before income taxes and cumulative effect of changes in accounting principles ....... 18,676,768 9,019,136 975,057 ------------ ------------ ------------ INCOME TAXES (note 11): Current ........................... 5,265,482 1,903,128 2,260,795 Deferred .......................... (94,441) (18,027) (1,501,430) ------------ ------------ ------------ 5,171,041 1,885,101 759,365 ------------ ------------ ------------ Income before cumulative effect of changes in accounting principles 13,505,727 7,134,035 215,692
CUMULATIVE EFFECT OF CHANGES IN ACCOUNTING PRINCIPLES FOR: Income taxes (note 11) .......... - 5,595,177 - Postretirement benefits (note 13) - (2,165,900) - Unearned premiums (note 1) ...... - (807,933) - ------------ ------------ ------------ Net income ................. $ 13,505,727 $ 9,755,379 $ 215,692 ============ ============ ============
See accompanying Notes to Consolidated Financial Statements.
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
Consolidated Statements of Income, Continued
Year ended December 31, ---------------------------------------- 1994 1993 1992 ------------ ------------ ------------ EARNINGS PER COMMON SHARE:
Income before cumulative effect of changes in accounting principles $ 1.29 $ .70 $ .02
Cumulative effect of changes in accounting principles for: Income taxes ................. - .55 - Postretirement benefits ...... - (.21) - Unearned premiums ............ - (.08) - ------------ ------------ ------------ Total ...................... $ 1.29 $ .96 $ .02 ============ ============ ============ Average number of shares outstanding 10,431,925 10,197,999 10,071,901 ============ ============ ============
Pro forma amounts, assuming retroactive application of new method of calculating unearned premiums:
Net income ............................... $ 10,563,312 $ 344,420 ============ ============ Earnings per common share ................ $ 1.04 $ .03 ============ ============
See accompanying Notes to Consolidated Financial Statements.
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
Consolidated Statements of Stockholders' Equity
Year ended December 31, ------------------------------------- 1994 1993 1992 ----------- ----------- ----------- Common stock, beginning of year ........ $10,325,329 $10,161,760 $10,082,675 Issuance of common stock: Stock option plans ................. 41,694 31,252 79,085 Dividend reinvestment plan ......... 220,606 132,317 - ----------- ----------- ----------- Common stock, end of year .............. 10,587,629 10,325,329 10,161,760 ----------- ----------- -----------
Additional paid-in capital, beginning of year .................... 55,021,926 53,507,459 52,838,624 Additional paid-in capital from issuance of common stock: Stock option plans ................. 349,390 279,234 669,320 Dividend reinvestment plan ......... 1,791,595 1,211,972 - Gain (loss) on sale of treasury stock .. - 23,261 (485) ----------- ----------- ----------- Additional paid-in capital, end of year 57,162,911 55,021,926 53,507,459 ----------- ----------- -----------
Unrealized holding gains on fixed maturity securities available-for- sale, net of tax, beginning of year .. 2,068,451 - - Unrealized holding (losses) gains on revaluation of fixed maturity securities available-for-sale, net of tax (notes 1 and 10) .......... (3,385,047) 2,068,451 - ----------- ----------- ----------- Unrealized holding (losses) gains on fixed maturity securities available- for-sale, net of tax, end of year .... (1,316,596) 2,068,451 - ----------- ----------- -----------
Unrealized holding losses on equity securities available-for-sale, net of tax, beginning of year ........ (19,800) (142,000) (326,375) Unrealized holding gains on revaluation of equity securities available-for-sale, net of tax ....... 19,800 122,200 184,375 ----------- ----------- ----------- Unrealized holding losses on equity securities available-for-sale, net of tax, end of year .............. $ - $ (19,800) $ (142,000) ----------- ----------- -----------
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
Consolidated Statements of Stockholders' Equity, continued
Year ended December 31, ---------------------------------------- 1994 1993 1992 ------------ ------------ ------------ Retained earnings, beginning of year $ 42,319,249 $ 37,866,902 $ 42,891,128 Net income .......................... 13,505,727 9,755,379 215,692 Dividends on common stock ($.52 per share in 1994, 1993 and 1992): Cash dividends .................. (3,510,555) (3,443,465) (5,103,890) Dividends reinvested in shares of common stock .............. (1,911,609) (1,859,567) (136,028) ------------ ------------ ------------ Retained earnings, end of year ...... 50,402,812 42,319,249 37,866,902 ------------ ------------ ------------
Treasury stock at cost, beginning of year ................. (81,386) (483,344) (341,616) Purchase of shares for the treasury (28,681) (126,948) (315,749) Sale of shares from the treasury .... - 528,906 174,021 ------------ ------------ ------------ Treasury stock at cost, end of year (110,067) (81,386) (483,344) ------------ ------------ ------------ Total stockholders' equity ..... $116,726,689 $109,633,769 $100,910,777 ============ ============ ============
See accompanying Notes to Consolidated Financial Statements.
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
Consolidated Statements of Cash Flows
Year ended December 31, ------------------------------------- 1994 1993 1992 ----------- ----------- ----------- CASH FLOWS FROM OPERATING ACTIVITIES: Net income ........................... $13,505,727 $ 9,755,379 $ 215,692 ----------- ----------- ----------- Adjustments to reconcile net income to net cash provided by (used in) operating activities: Cumulative effect of changes in accounting principles, net of tax ............................ - (2,621,344) - Losses and settlement expenses ... 5,372,801 8,010,617 33,143,232 Unearned premiums ................ 1,731,514 650,196 4,122,176 Other policyholders' funds ....... 247,816 (840,604) 880,866 Deferred policy acquisition costs (694,771) 413,967 (2,189,375) Indebtedness of related party (note 4) ................. 13,228,868 (8,639,436) 2,261,884 Accrued investment income ........ (725,182) (242,595) (168,511) Accrued income taxes: Current ........................ 1,186,000 (118,000) (2,390,000) Deferred ....................... (94,441) (18,027) (1,501,430) Provision for amortization ....... 4,101 (23,072) 23,660 Realized investment gains ........ (519,567) (684,445) (384,283) Postretirement benefits .......... 549,225 255,782 - Reinsurance receivables .......... 3,542,358 9,389,384 (12,828,945) Prepaid reinsurance premiums ..... 711,151 805,733 (945,813) Amortization of deferred income .. (433,979) (259,217) - Other, net ....................... 706,967 225,040 1,184,844 ----------- ----------- ----------- 24,812,861 6,303,979 21,208,305 Cash (used in) provided by the change in the property and casualty insurance subsidiaries' pooling agreement (note 2) ..... - (4,426,945) 29,402,411
Cash provided by the commutation of outstanding reinsurance balances by the reinsurance subsidiary (note 2) ............ 686,962 - -
Cash used in the commutation of two reinsurance contracts under the reinsurance subsidiary's quota share agreement (note 2) - (20,425,955) - ----------- ----------- ----------- Total adjustment ............. 25,499,823 (18,548,921) 50,610,716 ----------- ----------- ----------- Net cash provided by (used in) operating activities $39,005,550 $(8,793,542) $50,826,408 ----------- ----------- -----------
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
Consolidated Statements of Cash Flows, continued
Year ended December 31, ----------------------------------------- 1994 1993 1992 ------------- ------------ ------------ CASH FLOWS FROM INVESTING ACTIVITIES: Purchases of fixed maturity securities held-to-maturity ..... $ (93,131,676) $ - $ - Maturities of fixed maturity securities held-to-maturity ..... 41,099,534 - - Purchases of fixed maturity securities available for sale ... (193,422,946) - - Maturities of fixed maturity securities available-for-sale ... 208,880,152 - - Sales of equity securities available-for-sale .............. 500,000 1,043,068 - Purchases of fixed maturity securities ...................... - (266,682,915)(316,878,492) Maturities of fixed maturity securities ...................... - 274,909,330 270,821,880 Net sales of short-term investments 699,964 1,420,288 797,191 Final settlement on sale of life subsidiary ...................... - - 474,356 ------------- ------------ ------------ Net cash (used in) provided by investing activities .. (35,374,972) 10,689,771 (44,785,065) ------------- ------------ ------------
CASH FLOWS FROM FINANCING ACTIVITIES: Issuance of common stock .......... 491,676 331,568 748,405 Dividends paid to stockholders (note 14(c)) ....... (3,510,555) (3,443,465) (5,103,890) Purchase of treasury stock, net ... (28,681) (118,641) (278,241) ------------- ------------ ------------ Net cash used in financing activities ............... (3,047,560) (3,230,538) (4,633,726) ------------- ------------ ------------ NET INCREASE (DECREASE) IN CASH ..... 583,018 (1,334,309) 1,407,617 Cash at beginning of year ........... 675,203 2,009,512 601,895 ------------- ------------ ------------ Cash at end of year ................. $ 1,258,221 $ 675,203 $ 2,009,512 ============= ============ ============
Income taxes paid ................... $ 3,795,381 $ 2,021,128 $ 4,650,795 Interest paid ....................... 33,672 - 387,351
See accompanying Notes to Consolidated Financial Statements.
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Principles of consolidation and basis of presentation
EMC Insurance Group Inc., an approximately 67 percent owned subsidiary of Employers Mutual Casualty Company (Employers Mutual), is an insurance holding company with operations in property and casualty insurance, reinsurance, nonstandard risk automobile insurance and excess and surplus lines insurance management. EMC Insurance Group Inc. and its subsidiaries are referred to herein as the "Company".
The Company's subsidiaries include EMCASCO Insurance Company, Illinois EMCASCO Insurance Company, Dakota Fire Insurance Company, EMC Reinsurance Company, Farm and City Insurance Company and EMC Underwriters, Ltd.
The consolidated financial statements have been prepared on the basis of generally accepted accounting principles (GAAP) which differ in some respects from those followed in reports to insurance regulatory authorities. All significant intercompany balances and transactions have been eliminated.
Property and Casualty Insurance, Reinsurance and Nonstandard Risk Automobile Insurance Operations
Premiums are recognized as revenue ratably over the terms of the respective policies. Effective January 1, 1993, the property and casualty insurance subsidiaries changed their method of calculating unearned premiums from the monthly pro rata method to the daily pro rata method. The property and casualty insurance subsidiaries changed their accounting method because of management's belief that the new method provides for a more accurate matching of revenues and expenses over the terms of the underlying insurance policies. This change resulted in a cumulative increase in unearned premiums of $1,109,799 and a decrease in income of $807,933 ($.08 per share), net of income tax benefits of $301,866.
Certain costs of acquiring new business, principally commissions, premium taxes and variable underwriting expenses, have been deferred. Such costs are being amortized as premium revenue is recognized. The method followed in computing deferred policy acquisition costs limits the amount of such deferred costs to their estimated realizable value, which gives effect to the premium to be earned, related investment income, losses and loss settlement expenses and certain other costs expected to be incurred as the premium is earned.
Unpaid losses and settlement expenses are based on estimates of reported and unreported claims and related settlement expenses. Changes in estimates are reflected in current operating results. The provisions for losses and settlement expenses are considered adequate to cover the ultimate net cost of losses and claims incurred to date net of estimated salvage and subrogation recoverable. Since the provisions are necessarily based on estimates, the ultimate liability may be more or less than such provisions.
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements, Continued
Excess and Surplus Lines Operations
Income is derived from fees and commissions which are realized when earned. Costs of doing business are expensed as incurred.
Reinsurance Ceded
Ceded reinsurance activities are reported on the basis of Statement of Financial Accounting Standards No. 113 (SFAS 113), "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts." SFAS 113 requires a gross (rather than net) balance sheet presentation for ceded reinsurance amounts and addresses the recognition of gain or loss resulting from reinsurance transactions and appropriate financial statement disclosure of reinsurance activities.
Investments
Effective December 31, 1993, the Company adopted Statement of Financial Accounting Standards No. 115 (SFAS 115) "Accounting for Certain Investments in Debt and Equity Securities." SFAS 115 requires that investments in all debt securities and those equity securities with readily determinable market values be classified into one of three categories: held-to-maturity, trading or available-for-sale. Classification of investments is based upon management's current intent. Debt securities which management has a positive intent and ability to hold until maturity are classified as securities held-to-maturity and are carried at amortized cost. Unrealized holding gains and losses on securities held-to-maturity are not reflected in the consolidated financial statements. Debt and equity securities that are held for current resale are classified as trading securities and are carried at market value, with unrealized holding gains and losses included in earnings. All other debt and equity securities not included in the above two categories are classified as securities available-for-sale and are carried at market value, with unrealized holding gains and losses reported as a separate component of stockholders' equity, net of tax. Adoption of this statement had no effect on the income of the Company. Unrealized holding (losses) gains on securities available-for- sale had the effect of (decreasing) increasing stockholders' equity by ($1,316,596) and $2,048,651 at December 31, 1994 and 1993, respectively, net of income taxes of $0 and $1,055,365. At December 31, 1994 and 1993, the Company did not have any investments categorized as trading securities.
Prior to December 31, 1993, investments in fixed maturities were carried at amortized cost and equity securities were carried at market value. Changes in unrealized holding gains and losses resulting from the revaluation of equity securities were reported as direct increases and decreases in stockholders' equity. Unrealized holding gains and losses on fixed maturities were not recognized in the consolidated financial statements.
Short-term investments represent money market funds and are carried at cost.
	 EMC INSURANCE GROUP INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements, Continued
The Company's carrying value for investments is reduced to its estimated realizable value if a decline in the market value is deemed other than temporary. Such reductions in carrying value are recognized as realized losses and charged to income. Premiums and discounts on debt securities are amortized over the life of the security as an adjustment to yield using the effective interest method. Realized gains and losses on disposition of investments are included in net income. The cost of investments sold is determined on the first-in, first-out method. Included in investments at December 31, 1994 and 1993 are securities on deposit with various regulatory authorities as required by law amounting to $11,331,550 and $11,329,402, respectively.
Effective December 31, 1994, the Company adopted Statement of Financial Accounting Standards No. 119 (SFAS 119), "Disclosure about Derivative Financial Instruments and Fair Value of Financial Instruments." Adoption of this statement had no effect on current disclosures as the Company did not hold or issue any derivative financial instruments at December 31, 1994.
Pension Benefits
Net periodic pension cost relating to the Company's employee participation in Employers Mutual's Retirement Plan is computed on the basis of Statement of Financial Accounting Standards No. 87, "Employers' Accounting for Pensions." It is the Company's policy to fund pension costs according to regulations provided under the Internal Revenue Code. Assets held in the plan are a mix of equity, debt and guaranteed interest securities and real estate funds.
Postretirement Benefits other than Pensions
Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 106 (SFAS 106), "Employers' Accounting for Postretirement Benefits Other Than Pensions." Under SFAS 106, the cost of postretirement benefits other than pensions must be recognized on an accrual basis as employees perform services to earn the benefits. Prior to 1993, the cost of retiree health care and life insurance benefits were recognized as expenses when paid.
Postemployment Benefits
Effective January 1, 1994, the Company adopted Statement of Financial Accounting Standards No. 112 (SFAS 112), "Employers Accounting for Postemployment Benefits." SFAS 112 requires that the cost of certain postemployment benefits that vest or accumulate be accrued over the period of an employee's service. Adoption of this standard had no effect on the income of the Company.
Income Taxes
The Company files a consolidated Federal income tax return with its subsidiaries. Consolidated income tax/benefit is allocated among the entities based upon separate tax liabilities.
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements, Continued
Deferred income taxes are provided for temporary differences between financial statement carrying values of assets and liabilities and their respective tax bases. Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 109 (SFAS 109), "Accounting for Income Taxes." Under SFAS 109, deferred tax assets are recognized for deductible temporary differences and operating loss and tax credit carryforwards, and then a valuation allowance is established to reduce that deferred tax asset if it is "more likely than not" that the related tax benefits will not be realized. 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. The effect on deferred tax assets and liabilities from a change in tax rates is recognized in income in the period that includes the enactment date. Prior to 1993, the Company computed deferred income taxes in accordance with Statement of Financial Accounting Standards No. 96.
Earnings per Share
Earnings per common share are computed by dividing earnings by the weighted average number of common shares outstanding during each year.
Intangible Assets
Goodwill, which represents the excess of cost over the fair value of net assets of acquired subsidiaries, is being amortized on a straight-line basis over 25 years. The Company reviews the recoverability of the unamortized balance of goodwill on a periodic basis using discounted cash flows.
Reclassifications
Certain amounts previously reported in prior years' consolidated financial statements have been reclassified to conform to current year presentation.
2. AFFILIATION AND TRANSACTIONS WITH AFFILIATES
Property and Casualty Insurance Subsidiaries
The three property and casualty insurance subsidiaries of the Company and two subsidiaries of Employers Mutual are parties to reinsurance pooling agreements with Employers Mutual (collectively the "pooling agreement"). Under the terms of the pooling agreement, each company cedes to Employers Mutual all of its insurance business and assumes from Employers Mutual an amount equal to its participation in the pool. All losses, settlement expenses and other underwriting and administrative expenses, excluding the voluntary reinsurance business assumed by Employers Mutual from unaffiliated insurance companies, are prorated among the parties on the basis of participation in the pool. Operations of the pool give rise to intercompany balances with Employers Mutual, which are settled on a quarterly basis. The investment programs and income tax liabilities of the pool participants are not subject to the pooling agreement.
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements, Continued
Effective January 1, 1992, the aggregate participation of the property and casualty insurance subsidiaries was increased to 22 percent from 17 percent. In connection with this change in pool participation, the Company's liabilities increased $31,427,861 and invested assets increased $29,402,411. The Company reimbursed Employers Mutual $2,025,450 for commissions incurred to generate this business.
Employers Mutual voluntarily assumes reinsurance business from nonaffiliated insurance companies and cedes 95 percent of this business to the Company's reinsurance subsidiary, exclusive of certain reinsurance contracts. Prior to 1993, amounts not ceded to the reinsurance subsidiary were retained by Employers Mutual and were subject to cession to the pool members. Effective January 1, 1993, the pooling agreement was amended so that the voluntary assumed reinsurance business written by Employers Mutual is no longer subject to cession to the pool members. As a result, amounts assumed from nonaffiliates have declined from the amount's assumed in 1992. In connection with this change in the pooling agreement, the Company's liabilities decreased $4,470,204 and invested assets decreased $4,426,945. Employers Mutual reimbursed the Company $43,259 for commissions incurred to generate this business.
Reinsurance Subsidiary
As noted above, the reinsurance subsidiary assumes a 95 percent quota share portion of Employers Mutual's assumed reinsurance business, exclusive of certain reinsurance contracts. The reinsurance subsidiary receives 95 percent of all premiums and assumes 95 percent of all related losses and settlement expenses of this business. The reinsurance subsidiary does not reinsure any of Employers Mutual's direct insurance business, nor any "involuntary" facility or pool business that Employers Mutual assumes pursuant to state law. In addition, the reinsurance subsidiary is not liable for credit risk in connection with the insolvency of any reinsurers of Employers Mutual.
Effective January 1, 1993, the quota share agreement was amended so that losses in excess of $1,000,000 per event are retained by Employers Mutual. The reinsurance subsidiary pays an annual override commission to Employers Mutual for this additional protection, which totaled $2,094,715 in 1994 and $1,808,527 in 1993. The reinsurance subsidiary also pays for 95 percent of the outside reinsurance protection Employers Mutual purchases to protect itself from catastrophic losses on the assumed reinsurance business. This cost is recorded as a reduction to the premiums received by the reinsurance subsidiary and amounted to $2,563,041 in 1994 and $2,866,825 in 1993. Employers Mutual retained losses and settlement expenses totaling $7,019,772 in 1994 and $615,000 in 1993 under this agreement.
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements, Continued
In conjunction with this amendment to the quota share agreement, the reinsurance subsidiary terminated its catastrophe reinsurance treaty with Employers Mutual effective January 1, 1993. This treaty paid losses in excess of $1,000,000 resulting from any one catastrophe, subject to a maximum loss of $3,000,000. Maximum recovery was limited to $6,000,000. The reinsurance subsidiary recovered $306,250 and $4,125,000 under this treaty and paid reinstatement premiums of $0 and $1,033,030 in 1993 and 1992, respectively. Total premiums paid to Employers Mutual amounted to $0 and $2,253,579 in 1993 and 1992, respectively.
Effective June 30, 1993, Employers Mutual commuted the portion of the quota share agreement that pertained to a casualty pool that is in a run-off position. In connection with this change in the quota share agreement, the Company's liabilities decreased $19,783,037 and invested assets decreased $17,806,179. The reserve discount amount of $1,976,858 was recorded as deferred income and is being amortized into operations over the estimated settlement period of the reserves, which is ten years. The amount recognized as income totaled $433,979 in 1994 and $259,217 in 1993.
Effective October 31, 1993, Employers Mutual commuted the portion of the quota share agreement that pertained to a voluntary pool that handles large "highly protected" risks. In connection with this change in the quota share agreement, the Company's liabilities decreased $3,827,201 and invested assets decreased $2,619,776. Employers Mutual reimbursed the Company $1,207,425 for commissions incurred to generate this business. No reserve discount was calculated as this business involved short-tail property coverage.
During 1994, the reinsurance subsidiary commuted all outstanding reinsurance balances ceded to Employers Mutual under catastrophe and aggregate excess of loss reinsurance treaties related to accident years 1991 through 1993. In connection with these commutations, the Company's assets and liabilities increased $686,962. There was no income effect from these commutations.
Premiums assumed by the reinsurance subsidiary from Employers Mutual amounted to $39,899,335, $34,445,978 and $34,777,710 in 1994, 1993 and 1992, respectively. It is customary in the reinsurance business for the assuming company to compensate the ceding company for the acquisition expenses it incurred in the generation of the business. Commissions paid by the reinsurance subsidiary to Employers Mutual amounted to $11,482,086, $8,979,309 and $10,242,650 in 1994, 1993 and 1992, respectively.
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements, Continued
The reinsurance subsidiary has an aggregate excess of loss treaty with Employers Mutual which provides protection from a large accumulation of retentions resulting from multiple catastrophes in any one calendar year. The coverage provided is $2,000,000 excess of $2,500,000 aggregate losses retained, excess of $200,000 per event. Maximum recovery is limited to $4,000,000 per accident year. The reinsurance subsidiary recovered $0, $143,501, and $4,221,444 under this treaty and paid reinstatement premiums of $0, $208,470 and $744,561 in 1994, 1993 and 1992, respectively. Total premiums paid to Employers Mutual amounted to $557,842, $708,445 and $1,124,561 in 1994, 1993 and 1992, respectively.
Nonstandard Risk Automobile Insurance Subsidiary
The nonstandard risk automobile insurance subsidiary has a reinsurance treaty on an excess of loss basis with Employers Mutual which provides reinsurance for 100 percent of each loss in excess of $100,000, up to $1,000,000. Recoveries under this treaty totaled $71,567, $0 and $0 in 1994, 1993 and 1992, respectively. Premiums paid to Employers Mutual amounted to $49,659, $42,065 and $35,377 in 1994, 1993 and 1992, respectively.
Services Provided by Employers Mutual
Employers Mutual provides various services to all of it's subsidiaries. Such services include data processing, claims, financial, actuarial, auditing, marketing and underwriting. Costs of these services are charged to the subsidiaries outside the pooling agreement based upon a number of criteria, including usage and number of transactions. Costs not charged to these subsidiaries are charged to the pool and each pool participant shares in the total cost in proportion to its participation percentage.
3. REINSURANCE CEDED
The parties to the pooling agreement cede insurance business to other insurers in the ordinary course of business for the purpose of limiting their maximum loss exposure through diversification of their risks. In its consolidated financial statements, the Company treats risks to the extent they are reinsured as though they were risks for which the Company is not liable. Insurance ceded by the pool participants does not relieve their primary liability as the originating insurers. Employers Mutual evaluates the financial condition of the reinsurers of the parties to the pooling agreement and monitors concentrations of credit risk arising from similar geographic regions, activities or economic characteristics of the reinsurers to minimize exposure to significant losses from reinsurer insolvencies. The parties to the pooling agreement also assume insurance from involuntary pools and associations in conjunction with direct business written in various states.
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements, Continued
Prior to 1993, the reinsurance subsidiary ceded reinsurance business to Employers Mutual and other nonaffiliated reinsurers in the ordinary course of business for the purpose of limiting its maximum loss exposure. Effective January 1, 1993, the quota share agreement with Employers Mutual was amended so that losses in excess of $1,000,000 per event are retained by Employers Mutual. In conjunction with this amendment to the quota share agreement, the reinsurance subsidiary terminated its catastrophe reinsurance contracts with Employers Mutual and the nonaffiliated reinsurers. Effective January 1, 1993, the reinsurance subsidiary no longer cedes reinsurance to unaffiliated reinsurers and only cedes reinsurance to Employers Mutual under an aggregate "excess of loss" treaty. As a result, reinsurance receivables and prepaid reinsurance premiums for the Company have decreased from 1992 amounts.
As of December 31, 1994, deductions for reinsurance ceded to two unaffiliated reinsurers aggregated $10,066,293, which represented a significant portion of the total prepaid reinsurance premiums and reinsurance receivables for losses and settlement expenses. These amounts reflect the property and casualty insurance subsidiaries' pool participation percentage of amounts ceded by Employers Mutual to these organizations in connection with its role as "service carrier". Under these arrangements, Employers Mutual writes business for these organizations on a direct basis and then cedes 100 percent of this business to these organizations. Credit risk associated with these amounts is minimal as all companies participating in these organizations are responsible for the liabilities of such organizations on a pro rata basis.
The effect of reinsurance on premiums written and earned, and losses and settlement expenses incurred for the three years ended December 31, 1994 is presented below. Amounts for the years ended December 31, 1994 and 1993 reflect (1) the change in the property and casualty insurance subsidiaries' pooling agreement whereby effective January 1, 1993, the voluntary assumed reinsurance business written by Employers Mutual is no longer subject to cession to the pool members and (2) the amendment to the reinsurance subsidiary's quota share agreement whereby effective January 1, 1993, losses in excess of $1,000,000 per event are retained by Employers Mutual and the reinsurance subsidiary therefore no longer purchases catastrophe protection (see note 2).
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements, Continued
Year ended December 31, ---------------------------------------- 1994 1993 1992 ------------ ------------ ------------ Premiums Written Direct ......................... $143,444,388 $135,277,129 $138,829,576 Assumed from nonaffiliates ..... 5,843,091 6,636,942 16,467,613 Assumed from affiliates ........ 158,646,332 147,620,705 150,070,741 Ceded to nonaffiliates ......... (8,890,119) (10,701,482) (17,721,207) Ceded to affiliates ............ (132,100,537) (120,898,914) (129,826,840) ------------ ------------ ------------ Net premiums written ......... $166,943,155 $157,934,380 $157,819,883 ============ ============ ============ Premiums Earned Direct ......................... $140,012,247 $137,141,457 $142,391,771 Assumed from nonaffiliates ..... 5,988,228 6,758,364 14,980,642 Assumed from affiliates ........ 156,839,482 148,366,487 140,442,245 Ceded to nonaffiliates ......... (9,601,270) (11,507,217) (16,775,394) Ceded to affiliates ............ (128,409,308) (124,321,553) (133,628,977) ------------ ------------ ------------ Net premiums earned .......... $164,829,379 $156,437,538 $147,410,287 ============ ============ ============ Losses and Settlement Expenses Incurred Direct ......................... $113,680,306 $ 97,842,980 $112,579,261 Assumed from nonaffiliates ..... 2,774,689 6,575,099 17,415,319 Assumed from affiliates ........ 108,594,530 107,369,274 114,359,445 Ceded to nonaffiliates ......... (3,077,305) (5,845,414) (16,862,082) Ceded to affiliates ............ (105,028,166) (85,586,640) (105,404,110) ------------ ------------ ------------ Net losses and settlement expenses incurred .......... $116,944,054 $120,355,299 $122,087,833 ============ ============ ============
4. REINSURANCE ASSUMED
Prior to December 31, 1993, the parties to the pooling agreement recorded amounts assumed from the National Workers' Compensation Reinsurance Pool on a net basis. Under this approach, reserves for outstanding losses and unearned premiums were reported as liabilities under "Indebtedness to Related Party" in the Company's consolidated financial statements. Effective December 31, 1993, the parties to the pooling agreement began recording these amounts as outstanding losses and unearned premiums and restated all prior year consolidated financial statements for comparative purposes. There was no income effect from this reclassification. In connection with this gross-up of balances, amounts due from Employers Mutual increased $13,147,831 at December 31, 1993. Under the terms of the pooling agreement, these balances were settled in the first quarter of 1994.
5. LIABILITY FOR LOSSES AND SETTLEMENT EXPENSES
The following table sets forth a reconciliation of beginning and ending reserves for losses and settlement expenses of the Company. Amounts presented are on a net basis, with a reconciliation of beginning and ending reserves to the gross amounts presented in the consolidated financial statements in accordance with SFAS 113 (see note 1).
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements, Continued
Year ended December 31, ---------------------------------------- 1994 1993 1992 ------------ ------------ ------------ Gross reserves for losses and settlement expenses, beginning of year .......................... $197,121,852 $215,388,865 $158,814,130
Ceded reserves for losses and settlement expenses, beginning of year .......................... 17,454,679 25,253,507 13,951,033 ------------ ------------ ------------ Net reserves for losses and settlement expenses, beginning of year .......................... 179,667,173 190,135,358 144,863,097 ------------ ------------ ------------ Incurred losses and settlement expenses: ------------------------- Provision for insured events of the current year ............ 123,343,829 119,896,526 116,615,951
(Decrease) increase in provision for insured events of prior years .......................... (6,399,775) 458,773 5,471,882 ------------ ------------ ------------ Total incurred losses and settlement expenses ...... 116,944,054 120,355,299 122,087,833 ------------ ------------ ------------ Payments: --------- Losses and settlement expenses attributable to insured events of the current year ............ 48,771,573 47,600,851 46,436,360
Losses and settlement expenses attributable to insured events of prior years ................. 59,491,875 45,508,460 53,810,715
Payment related to the commutation of the reinsurance subsidiary's catastrophe and aggregate excess of loss reinsurance treaties ... (686,962) - -
Payment related to the change in the property and casualty insurance subsidiaries' pooling agreement ...................... $ - $ 4,373,629 $(23,431,503)
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements, Continued
Year ended December 31, ---------------------------------------- 1994 1993 1992 ------------ ------------ ------------ Payment related to the commutation of two reinsurance contracts under the reinsurance subsidiary's quota share agreement ...................... $ - $ 21,904,001 $ -
Adjustment related to the gross-up of reserve amounts associated with the National Workers' Compensation Reinsurance Pool .. - 11,436,543 - ------------ ------------ ------------ Total payments .............. 107,576,486 130,823,484 76,815,572 ------------ ------------ ------------ Net reserves for losses and settlement expenses, end of year 189,034,741 179,667,173 190,135,358
Ceded reserves for losses and settlement expenses, end of year 14,146,874 17,454,679 25,253,507 ------------ ------------ ------------ Gross reserves for losses and settlement expenses, end of year $203,181,615 $197,121,852 $215,388,865 ============ ============ ============
Underwriting results of the Company are significantly influenced by estimates of loss and settlement expense reserves. Changes in reserve estimates are reflected in operating results in the year such changes are recorded. During 1992, the property and casualty insurance subsidiaries and the nonstandard risk automobile insurance subsidiary strengthened prior year reserves on certain lines of business and the reinsurance subsidiary experienced a time lag in the reporting of assumed reinsurance business. During 1993, the property and casualty insurance companies continued to strengthen reserves on certain lines of business while the reinsurance subsidiary experienced adverse development on losses associated with Hurricane Andrew. These reserve increases in 1992 and 1993 were partially offset by reserve decreases on other lines of business, resulting in a net increase in the Company's estimate of prior year reserves of $5,471,882 in 1992 and $458,773 in 1993. During 1994, the reinsurance subsidiary experienced adverse development on certain contracts. These reserve increases were offset by significant reserve decreases in the property and casualty insurance subsidiaries and the nonstandard risk automobile insurance subsidiary. As a result, the net decrease in the Company's estimate of prior year reserves in 1994 amounted to $6,399,775.
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements, Continued
6. ENVIRONMENTAL RELATED CLAIMS
Estimating loss and settlement reserves for asbestos and environmental related claims is very difficult due to the following uncertainties surrounding these types of claims: the legal definition of asbestos and environmental damage is still evolving, the assignment of responsibility varies widely by state, defense costs are often much greater than the claim costs and claims often emerge long after the policy has expired, making assignment of damages to the appropriate party and to the time period covered by a particular policy difficult. In establishing reserves for these types of claims, management monitors the relevant facts concerning each claim, the current status of the legal environment, the social and political conditions and the claim history and trends within the Company and the industry. Reserves for asbestos and environmental related claims at December 31, 1994 and 1993 were $749,807 and $550,773, respectively.
7. RETAINED EARNINGS
Retained earnings of the Company's insurance subsidiaries available for distribution as dividends to EMC Insurance Group Inc. are limited by law to the statutory unassigned surplus of each of the subsidiaries as of the previous December 31, as determined in accordance with accounting practices prescribed by insurance regulatory authorities of the state of domicile of each subsidiary. Subject to this limitation, the maximum dividend that may be paid by Iowa corporations without prior approval of the insurance regulatory authorities is restricted to the greater of 10 percent of statutory surplus as regards policyholders as of the preceding December 31, or net income of the preceding calendar year on a statutory basis. Both Illinois and North Dakota impose restrictions which are similar to those of Iowa on the payment of dividends and distributions. At December 31, 1994, $15,513,214 was available for distribution in 1995 to EMC Insurance Group Inc. without prior approval.
Statutory surplus of the Company's insurance subsidiaries was $86,820,039 and $78,681,248 at December 31, 1994 and 1993, respectively. Statutory net income (loss) of the Company's insurance subsidiaries was $13,430,353, $8,788,458 and ($3,960,393) for the three years ended December 31, 1994.
During 1994, the National Association of Insurance Commissioners implemented the Risk-Based Capital (RBC) model. The risk-based capital requirements for property and casualty insurance companies measure three major areas of risk facing property and casualty insurers: asset risk, credit risk and underwriting risk. Companies having less statutory surplus than required by the risk-based capital requirements are subject to varying degrees of regulatory scrutiny and intervention, depending on the severity of the inadequacy. The Company's insurance subsidiaries' ratio of total adjusted capital to risk-based capital at December 31, 1994 is well in excess of the minimum level required.
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements, Continued
8. RECONCILIATION OF STATUTORY NET INCOME AND SURPLUS
A reconciliation of net income and surplus from that reported on a statutory basis to that reported in the accompanying consolidated financial statements on a GAAP basis is as follows:
Year ended December 31, ------------------------------------- 1994 1993 1992 ----------- ----------- ----------- Statutory net income (loss) ........... $13,697,482 $ 8,761,472 $(3,118,589) Change in deferred policy acquisition costs ................... 694,771 (413,967) 2,189,375 Change in salvage and subrogation accrual ............................. 5,851 (232,760) 742,233 Change in other policyholders' funds .. (247,816) 840,604 (880,866) Change in pension accrual ............. (298,021) (103,846) 622,177 GAAP postretirement benefit cost in excess of statutory cost ......... (314,583) (216,091) - Deferred income tax benefit ........... 94,441 18,027 1,501,430 Statutory gain on sale of life subsidiary ..................... - - (474,356) Prior year taxes and related interest (180,770) 817 (387,351) GAAP basis amortization of reserve discount on commutation of reinsurance contract ................ 433,979 259,217 - Statutory reserve discount on commutation of reinsurance contract - (1,976,858) - Other, net ............................ (379,607) 197,420 21,639 ----------- ----------- ----------- Income before cumulative effect of changes in accounting principles, GAAP basis .......................... 13,505,727 7,134,035 215,692
Cumulative effect of changes in accounting principles for:
Income taxes ...................... - 5,595,177 - Postretirement benefits ........... - (2,165,900) - Unearned premiums ................. - (807,933) - ----------- ----------- ----------- Net income, GAAP basis ................ $13,505,727 $ 9,755,379 $ 215,692 =========== =========== ===========
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements, Continued
Year ended December 31, ---------------------------------------- 1994 1993 1992 ------------ ------------ ------------ Statutory surplus .................. $ 94,317,215 $ 85,830,140 $ 83,331,013 Deferred policy acquisition costs .. 8,393,635 7,698,864 8,112,831 Accrued salvage and subrogation .... 1,799,443 1,793,592 2,026,352 Other policyholders' funds payable (3,102,609) (2,854,793) (3,695,397) Pension asset ...................... 1,407,714 1,705,735 1,809,581 GAAP postretirement benefit liability in excess of statutory liability ........................ (1,672,780) (1,358,197) - Deferred income tax asset .......... 14,190,499 13,040,693 7,065,221 Goodwill ........................... 1,883,177 2,017,690 2,152,203 Excess statutory reserves over statement reserves .......... 2,044,268 - 8,007 GAAP basis reserve discount on commutation of reinsurance contract in excess of statutory recognition ...................... (1,283,662) (1,717,641) - Unrealized holding (losses) gains on fixed maturity securities available-for-sale ............... (1,316,596) 3,134,016 - Other .............................. 66,385 343,670 100,966 ------------ ------------ ------------ Stockholders' equity, GAAP basis ... $116,726,689 $109,633,769 $100,910,777 ============ ============ ============
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements, Continued
9. SEGMENT INCOME
Differences between Electronic and Circulated 10-K's ----------------------------------------------------
1) The index to exhibits in the electronic format indicates if the exhibits are included in the direct transmission or are filed under Form SE. The circulated document contains the page numbers of the exhibits.
2) Exhibit 28 was filed in hard copy under Form SE and is not included in the filed under EDGAR.