Certain statements in this report contain forward-looking statements, including statements relating to the expected timing, completion and effects of the proposed merger with certain affiliates of the Munich Re Group (“Munich Re”). Forward-looking statements are statements other than historical information or statements of current condition. These forward-looking statements are based on current expectations, estimates, forecasts and projections of future company or industry performance based on management’s judgment, beliefs, current trends and market conditions. Actual outcomes and results may differ materially from what is expressed, forecasted or implied in any forward-looking statement. Forward-looking statements made by Midland may be identified by the use of words such as “will,” “expects,” “intends,” “plans,” “anticipates,” “believes,” “seeks,” “estimates,” or the negative versions of those words and similar expressions, and by the context in which they are used. There are a number of risks and uncertainties that could cause actual results to differ materially from the forward-looking statements included in this document. Factors that might cause results to differ from those anticipated include, without limitation, adverse weather conditions, changes in underwriting results affected by adverse economic conditions, fluctuations in the investment markets, changes in the retail marketplace, changes in the laws or regulations affecting the operations of the company or its subsidiaries, changes in the business tactics or strategies of the company, its subsidiaries or its current or anticipated business partners, the financial condition of the company’s business partners, acquisitions or divestitures, changes in market forces, litigation and the other risk factors that have been identified in the Company’s filings with the SEC, any one of which might materially affect the operations of the company or its subsidiaries. These and other factors that could cause Midland’s actual results to differ materially from those expressed or implied are discussed under “Risk Factors” in this annual report on Form 10-K and other filings with the Securities and Exchange Commission. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial may also materially adversely affect our proposed merger, business, financial condition and/or operating results. For a further discussion of these and other risks and uncertainties affecting Midland, see Midland’s website at www.midlandcompany.com. Midland undertakes no obligation to update any forward-looking statements, whether as a result of new information or circumstances, future events (whether anticipated or unanticipated) or otherwise. Readers are cautioned not to place undue reliance on these forward-looking statements.
The Company’s operating and administrative expenses increased 18.6% to $151.4 million in 2007 compared to $127.7 million in 2006. This increase is due primarily to expenses related to an increase in employee salaries and benefits combined with $11.9 million of expenses related to the pending merger with Munich-American Holding Corporation.
American Modern’s excess and surplus lines and credit life products were the primary drivers of the increase in direct and assumed written premiums in 2006 compared to 2005. A large percentage of the Company’s excess and surplus lines gross written premium is ceded to reinsurers. In addition, a large percentage of credit life direct and assumed written premium is ceded to an insurance affiliate of the producing agent. The growth in our credit life insurance line was assisted by the acquisition of Southern Pioneer Life Insurance Company in July of 2006. This acquisition contributed $7.8 million of direct and assumed written premiums during the second half of 2006. The improvement in profitability in 2006 compared to 2005 is due primarily to the improved underwriting results related to the long haul truck, credit life and excess and surplus lines business combined with the profits generated from Southern Pioneer Life.
No shares were repurchased in the open market under the Company’s share repurchase program during 2007 and a total of 1,086,000 shares remain authorized to repurchase under terms of this authority. The share repurchase program pertains exclusively to shares to be purchased on the open market. This program specifically excludes shares repurchased in connection with stock incentive plans.
The market value of Midland’s consolidated investment portfolio (comprised primarily of the investment holdings of American Modern) increased 6.4% to $1,097.8 million at December 31, 2007 from $1,031.4 million at December 31, 2006. This increase was due, in part, to the positive cash flow from operations combined with the reinvestment of interest and dividends received throughout 2007. The increase was partially offset by the $22.3 million decrease in unrealized appreciation in the market value of the securities held at December 31, 2007 compared to year end 2006. The decrease in the unrealized appreciation was due to a $20.5 million decrease in unrealized appreciation related to the equity portfolio combined with a $1.8 million decrease in unrealized appreciation pertaining to the fixed income portfolio. Midland’s largest equity holding, 2.4 million shares of U.S. Bancorp, decreased to $76.1 million as of December 31, 2007 from $88.8 million as of December 31, 2006.
Accounts receivable increased $6.7 million to $147.9 million at December 31, 2007 compared to $141.2 million at year end 2006. The increase is due to the corresponding increase in written premiums in 2007 compared to 2006.
Each year, the credentialed consulting actuary computes an acceptable range for property and casualty reserves, which affirms management’s recorded balance if the recorded amount is within the range. At December 31, 2007, our estimate of property and casualty net loss reserves totaled $149.2 million, which was affirmed by the company’s consulting actuary range of $138.6 million to $155.0 million. However, in light of the significant assumptions and judgments used to estimate loss reserves, there can be no assurance that the actual losses ultimately experienced will fall within the consulting actuary’s range. The range is based on a “reasonable best case” and “reasonable worst case” with varying development patterns across our lines of business. However, the development of the December 31, 2007 loss reserves could be impacted by the following:
We believe the recent favorable IBNR development was caused, in part, by lower non-catastrophe related frequency patterns than we have experienced historically, a higher level of case base redundancies, and favorable loss development in our newer lines of business. The case base redundancy was due in part to our response to the loss reserve deficiencies for the December 31, 2002 loss reserves that were ultimately discovered during 2003. In response to deficient development of reserves, management strengthened the Company’s loss reserves to reflect these changing development trends arriving at a best estimate of how these losses would ultimately settle. The higher levels of loss reserves, and their potential redundancy, were not fully contemplated in the incurred-but-not-reported loss reserves, because our experience had not been validated over an appropriate period of time.
Our 2007 catastrophe reinsurance program is similar to the 2006 structure, but includes an additional $50 million layer of protection on top of our previous $150 million cover. In addition, in August, we added an additional $50 million layer of protection on top of our $200 million coverage in place for 2007. The cost of our base catastrophe reinsurance program, which includes the purchase of the additional cover, adversely impacted our 2007 earnings by approximately $0.29 per share (diluted). The cost of our catastrophe reinsurance program has increased significantly in 2006 and 2007 due to the volatile weather patterns experienced in 2005. However, we have implemented appropriate rate increases and/or product changes in order to recoup a substantial portion of these increased costs.
The Midland Company (the “Company” or “Midland”) operates in two industries-insurance and transportation with the most significant business activities being in insurance. Midland’s insurance operations are conducted through its wholly-owned subsidiary, American Modern Insurance Group, Inc. (“American Modern”). M/G Transport Services, Inc. and MGT Services, Inc. (collectively “M/G Transport”) operate a fleet of dry cargo barges for the movement of dry bulk commodities such as petroleum coke, ores, barite, sugar and other cargos primarily on the lower Mississippi River and its tributaries. (See Note 19)
In December 2007, the FASB issued SFAS No. 141(R), Business Combinations, (SFAS No. 141(R)”), which requires the Company to record fair value estimates of contingent consideration and certain other potential liabilities during the original purchase price allocation, expense acquisition costs as incurred and does not permit certain restructuring activities previously allowed under Emerging Issues Task Force Issue No. 95-3 to be recorded as a component of purchase accounting. This statement applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning after December 15, 2008, and early adoption is prohibited. The Company is assessing the impact that SFAS No. 141(R) will have on its consolidated financial statements.
The Company had conventional lines of credit with commercial banks of $83 million at both December 31, 2007 and 2006 with none and $10 million in use under these agreements at December 31, 2007 and 2006, respectively. Borrowings under these lines of credit constitute senior debt. Total commercial paper debt outstanding at December 31, 2007 and 2006 was $8.3 million and $7.9 million, respectively.
The Company has a qualified defined benefit pension plan which provides for the payment of annual benefits to participants upon retirement. Such benefits are based on years of service and the participant’s highest compensation during five consecutive years of employment. The Company’s funding policy is to contribute annually an amount sufficient to satisfy ERISA funding requirements. Contributions are intended to provide not only for benefits attributed to service to date but also for benefits expected to be earned in the future. During 2000, the participants of the qualified pension plan were given a one-time election to opt out of the qualified pension plan and enroll in a qualified self-directed defined contribution retirement plan. All employees hired subsequent to that election are automatically enrolled in the qualified self-directed defined contribution retirement plan. The Company contributed $2.1 million, $2.8 million, and $2.3 million to the qualified self-directed retirement plan for the years 2007, 2006, and 2005, respectively.
The change in accumulated other comprehensive income is due to changes related to the unrealized gains and losses on investments, the fair value of interest rate swap, additional minimum pension liability and SFAS 158 pension adjustments as follows (amounts in 000’s):