Approximately 13.9 percent of the Company’s investment portfolio is invested in equity securities. At December 31, 2018, net unrealized investment gains on the equity portfolio totaled $43.4 million, representing $2.01 per share of the Company's December 31, 2018 book value of $26.18 per share. At December 31, 2017, net unrealized investment gains on the equity portfolio totaled $66.2 million, and represented $3.09 per share of the Company's December 31, 2017 book value of $28.14 per share. To help protect the Company from a sudden and significant decline in the value of its equity portfolio, management began investing in a limited partnership during the first quarter of 2014 to implement and maintain an equity tail-risk hedging strategy. This hedging strategy is designed to help protect the Company from significant monthly downside price volatility in the equity markets. Although the equity markets were volatile in December, the volatility was spread over an extended time period and the equity markets were down by less than 10 percent, which is the level at which the hedge generally begins to perform. As a result, the hedge provided very little protection in 2018. By maintaining this hedging strategy, management is able to reduce the level of risk contained in the Company’s financial statements without reducing the size of the equity portfolio. While there is a cost associated with this protection, management views this cost similar to the cost of an insurance policy. The cost of the hedging strategy is equal to the decline in the carrying value of the limited partnership that the Company invests in to maintain the strategy, and is reported as a realized investment loss in the Company's financial statements. The decline in the carrying value of the limited partnership primarily reflects the cost of hedging contracts that expired without value during the year, but also includes changes in the value of contracts that were still in effect at year-end.
The pool participants’ non-asbestos direct product liability claims are considered to be highly uncertain exposures due to the many uncertainties inherent in determining the loss, and the significant periods of time that can elapse between the occurrence of the loss and the ultimate settlement of the claim. The majority of the pool participants’ product liability claims arise from small to medium-sized manufacturers, contractors, petroleum distributors, and mobile home and auto dealerships. No specific claim trends are evident from the pool participants’ manufacturing clients, as the claims activity on these policies is generally isolated and can be severe. Specific product liability coverage is provided to the pool participants’ mobile home and auto dealership policyholders, and the claims from these policies tend to be relatively small. Certain construction defect claims are also reported under product liability coverage. During 2018, 29 of these claims were reported to the pool participants.
For a detailed discussion of the development experienced on prior accident years’ reserves during the past three years, see the discussion entitled “Loss and Settlement Expense Reserves” under the “Narrative Description of Business” heading in the Business Section under Part I, Item 1 of this Form 10-K.
The expected long-term rate of return on plan assets is developed considering actual historical results, current and expected market conditions, the mix of plan assets and investment strategy. The expected long-term rate of return on plan assets produced by this analysis and used in the calculation of the net periodic pension benefit costs for the years ended December 31, 2018 and 2017 was 7.00 percent and 7.00 percent, respectively. The expected long-term rate of return on plan assets used in the calculation of the net periodic postretirement benefit costs for the years ended December 31, 2018 and 2017 was 6.50 percent and 6.50 percent, respectively. The expected rate of return on plan assets to be used in the calculation of the 2019 net periodic benefit costs for the pension and postretirement benefit plans will be 7.00 percent and 6.50 percent, respectively. The actual rate of return earned on plan assets during 2018 was approximately negative 7 percent for the pension plan and negative 6 percent for the postretirement benefit plans. The expected long-term rate of return assumption is subject to the general movement of the economy, but is generally less volatile than the discount rate assumption. A decrease in the expected long-term rate of return assumption increases future expenses, whereas an increase in the assumption reduces future expenses. A 0.25 percentage point change in the expected long-term rate of return assumption for 2019 would change the Company’s net periodic pension and postretirement benefit costs by approximately $284,000. For detailed information regarding the current allocation of assets within the pension and postretirement benefit plans, see note 12 of Notes to Consolidated Financial Statements under Part II, Item 8 of this Form 10-K.
2 See note above regarding adjustments made to the development amount presented for the property and casualty insurance segment in 2016.
The Company adopted updated accounting guidance on January 1, 2018 that requires the components of net periodic pension and postretirement benefit costs/income, other than the service cost component, to be presented in the income statement outside a subtotal of income from operations, if one is presented. The Company does not report a subtotal of income from operations in its consolidated statements of income; however, in conjunction with the adoption of this updated guidance, management elected to report all components of net periodic pension and postretirement benefit income, other than the service cost component, as other income in the consolidated statements of income. The service cost component continues to be reported in other underwriting expenses. This change in reporting was applied retrospectively for comparison purposes and did not impact any of the net income amounts reported, as other income and other underwriting expenses increased by the same amounts; however, it did increase the acquisition expense ratios, and therefore the combined ratios, by 1.2 percentage points in 2018, 0.9 percentage points in 2017 and 0.8 percentage points in 2016.
The acquisition expense ratio for the property and casualty insurance segment increased to 36.1 percent in 2018 from 35.3 percent in 2017. This increase reflects an increase in policyholder dividends, as well as higher salary expense and bonus accruals.
The Company reported net income of $39.2 million ($1.84 per share) in 2017 compared to $46.2 million ($2.20 per share) in 2016. Net income declined in 2017 despite a one-time $9.1 million deferred income tax benefit resulting from the enactment of the TCJA. This decline was primarily attributed to a large amount of catastrophe and storm losses incurred by the reinsurance segment during the third quarter, as well as a reduction in the amount of favorable development experienced on prior years' reserves. Considering the extraordinary amount of catastrophe and storm losses incurred by the insurance industry during 2017, management was satisfied with the Company's results. The property and casualty insurance segment continued to perform well, as the underlying loss and settlement expense ratio improved during the second half of the year. Also encouraging was the recent improvement in the pricing environment in the property and casualty insurance segment and the reinsurance segment during the January 1, 2018 renewals.
The majority of the Company’s assets are invested in fixed maturity securities. These investments provide a substantial amount of investment income that supplements underwriting results and contributes to net earnings. As these investments mature, or are called, the proceeds are reinvested at current interest 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.
The Company’s property and casualty insurance subsidiaries have $25.0 million of surplus notes issued to Employers Mutual. The interest rate on the surplus notes was increased to 2.73 percent from 1.35 percent effective February 1, 2018. Reviews of the interest rate are conducted by the Inter-Company Committees of the boards of directors of the Company and Employers Mutual every five years, with the next review due in 2023. Payments of interest and repayments of principal can only be made out of the applicable subsidiary’s earned surplus and are subject to prior approval by the insurance commissioners of the respective states of domicile. The surplus notes are subordinate and junior in right of payment to all obligations or liabilities of the applicable insurance subsidiaries. Total interest expense incurred on these surplus notes was $654,000 in 2018 and $337,000 in 2017 and 2016. The Company’s property and casualty insurance subsidiaries received approval for the payment of the interest expense incurred for calendar year 2018, which was paid at the end of 2018.
The participants in the pooling agreement have purchased annuities from life insurance companies, under which the claimant is payee, to fund future payments that are fixed pursuant to specific claim settlement provisions. The Company’s share of case loss reserves eliminated by the purchase of those annuities was $110,000 at December 31, 2018. The Company had a contingent liability for the aggregate guaranteed amount of the annuities of $183,000 at December 31, 2018 should the issuers of those annuities fail to perform. The probability of a material loss due to failure of performance by the issuers of these annuities is considered remote.
In August 2018, the FASB issued updated guidance in Compensation-Retirement Benefits Topic 715 of the ASC. The objective of this update is to improve the effectiveness of disclosures in the notes to financial statements as part of the FASB's disclosure framework project. As it relates to the Company's footnote disclosures, this update adds to the annual disclosures the weighted-average crediting rate used in Employers Mutual's pension plans, and requires explanations for significant gains and losses in the benefit obligations of Employers Mutual's pension and postretirement benefit plans. This update removes from the Company's annual disclosures the amounts in accumulated other comprehensive income for pension and postretirement benefit plans expected to be recognized as components of net periodic benefit cost in the next fiscal year. The Company adopted these disclosure modifications in 2018.
The Company regularly monitors its investment portfolio for investments whose fair value is less than the carrying value for indications of “other-than-temporary” impairment (except for, beginning in 2018, equity securities carried at fair value, with changes in fair value recognized in net income). Several factors are used to determine whether the carrying value of an individual investment has been “other-than-temporarily” impaired. Such factors include, but are not limited to (1) the investment’s value and performance in the context of the overall markets, (2) length of time and extent the investment’s fair value has been below carrying value, (3) key corporate events, and (4) for fixed maturity securities, the amount of collateral available. For fixed maturity securities, if the present value of cash flows expected to be collected is less than the amortized cost of the security, a credit loss is deemed to exist and the security is considered “other-than-temporarily” impaired. The portion of the impairment related to a credit loss is recognized through earnings, and the portion of the impairment related to other factors, if any, is recognized through “other comprehensive income”. Alternatively, if the Company has the intent to sell a fixed maturity security that is in an unrealized loss position, or determines that it will "more likely than not" be required to sell a fixed maturity security that is in an unrealized loss position before recovery of its amortized cost basis, then the carrying value is reduced to fair value and the entire amount of the impairment is recognized through earnings.
As noted earlier, on October 29, 2018, the EMC Insurance Companies announced that they had made a strategic decision to exit personal lines business. Personal lines premiums written represent approximately six percent of the Company's total premiums written. This exit process is expected to conclude during the first quarter of 2020, and is contained entirely within the property and casualty insurance segment. Over the course of this exit, the Company expects to incur, as its share through the pooling agreement, approximately $1.2 million of expense associated with severance costs, and $729,000 from the write-off of personal lines software that was in development. Total exit cost expenses recorded in 2018 were $967,000. Other related costs, including job search assistance, are deemed immaterial.
For the reinsurance segment, the December 31, 2018 estimate of loss and settlement expense reserves for accident years 2017 and prior decreased $3.4 million from the estimate at December 31, 2017. This decrease represents 1.5 percent of the December 31, 2017 gross carried reserves and primarily reflects favorable development associated with lower estimated ultimate losses for casualty excess contracts for accident years 2008-2011 and 2016, nearly all contract types for accident year 2013, and catastrophe and per risk excess contracts for accident year 2017. The favorable development from external reinsurance recoveries in 2018 for the 2017 accident year was largely offset by the cession of the majority of those balances to Employers Mutual under the provisions of the inter-company reinsurance program.
The TCJA was signed into law on December 22, 2017. Among other provisions, the TCJA lowered the federal corporate tax rate from 35 percent to 21 percent, effective January 1, 2018. Since the change in tax rate was not effective until 2018, current tax expense in 2017 was unaffected; however, the temporary tax differences that comprised the net deferred income tax liability at the enactment date were projected to reverse at the lower 21 percent tax rate. The re-measurement of deferred income tax assets and liabilities resulted in the recognition of a $9.1 million deferred income tax benefit.
The Company files a U.S. federal income tax return, along with various state income tax returns. The Company is no longer subject to U.S. federal and state income tax examinations by tax authorities for years before 2015.
A summary of the stock option activity under Employers Mutual’s stock plans for 2018, 2017 and 2016 is as follows:
Employers Mutual did not participate in this plan in 2018, 2017 or 2016. Activity under the plan was as follows:
The participants in the pooling agreement are subject to guaranty fund assessments by states in which they write business. Guaranty fund assessments are used by states to pay policyholder liabilities of insolvent insurers domiciled in those states. Many states allow assessments to be recovered through premium tax offsets. The Company has accrued estimated guaranty fund assessments of $615,000 and $706,000 as of December 31, 2018 and 2017, respectively. Premium tax offsets of $809,000 and $897,000, which are related to prior guarantee fund payments and current assessments, have been accrued as of December 31, 2018 and 2017, respectively. The guaranty fund assessments are expected to be paid over the next two years and the premium tax offsets are expected to be realized within ten years of the payments. The participants in the pooling agreement are also subject to second-injury fund assessments, which are designed to encourage employers to employ workers with pre-existing disabilities. The Company has accrued estimated second-injury fund assessments of $2.4 million and $2.0 million as of December 31, 2018 and 2017, respectively. The second-injury fund assessment accruals are based on projected loss payments. The periods over which the assessments will be paid is not known.