The Company’s three property and casualty insurance subsidiaries and two subsidiaries and an affiliate 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, with the exception of any voluntary reinsurance business assumed from nonaffiliated insurance companies, and assumes from Employers Mutual an amount equal to its participation in the pool. All premiums, losses, settlement expenses, and other underwriting and administrative expenses, excluding the voluntary reinsurance business assumed by Employers Mutual from nonaffiliated insurance companies, are prorated among the parties on the basis of participation in the pool. Employers Mutual negotiates reinsurance agreements that provide protection to the pool and each of its participants, including protection against losses arising from catastrophic events. The aggregate participation of the Company’s property and casualty insurance subsidiaries is 30 percent.
During 2008, management continued to focus its efforts on writing profitable business in the increasingly competitive insurance marketplace, and maintaining adequate and consistent loss and settlement expense reserves. Management was also confronted with a record amount of catastrophe and storm losses and spent a considerable amount of time and effort ensuring that all claims were inspected and adjusted in a timely manner. Management also evaluated and implemented a new investment strategy and determined that the Company’s reinsurance subsidiary would begin writing Germany-based assumed reinsurance business on a direct basis (outside of the quota share agreement) effective January 1, 2009. In addition, management spent a considerable amount of time analyzing the impact that the financial crisis had on the funded status of Employers Mutual’s employee benefit plans and determining appropriate contribution amounts. Following is a detailed discussion of these issues.
Absent the excessive level of storm losses experienced during 2008, management believes that the Company’s underlying book of business continued to perform reasonably well and within expectations, considering the competitive market conditions. The record level of storm losses that occurred during 2008 was not caused by a concentration of exposures, but rather the large number of severe storms that occurred and the wide geographical region affected by those storms.
Management recognizes that policyholders are counting on the Company to help them get their lives back in order after a storm loss occurs, and takes that responsibility very seriously. This was demonstrated repeatedly throughout the year as the Company adjusted and paid these claims in a timely manner, many within days of the loss event. The Company’s various branch locations, aided by the Company’s proprietary claims system, were able to share claims adjusting resources with other branches to quickly settle the large number of claims resulting from these storms and minimize the cost of external resources.
An actuarial evaluation of case loss reserve adequacy has been performed each quarter since 2004. Beginning in 2007, if that analysis indicates that the aggregate reserves of the individual claim files established by the claims department combined with the carried bulk case loss reserve (if any) are above or below management’s best estimate of the Company’s overall liability, an adjustment is made in the bulk case loss reserve to bring the total of the case and bulk loss reserves to management’s best estimate of the Company’s overall liability.
Premiums written for the reinsurance segment increased $4,735,000, or 7.1 percent, in 2007; however, this increase reflected a negative $3,440,000 portfolio adjustment made in the first quarter of 2006 in connection with Employers Mutual’s reduced participation in the MRB pool. Excluding this adjustment, written premiums increased $1,295,000, or 1.9 percent, during 2007.
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 these annuities was $1,882,000 at December 31, 2008. The Company’s contingent liability is $1,882,000 at December 31, 2008 should the issuers of the annuities fail to perform under the terms of the annuities. The probability of a material loss due to failure of performance by the issuers of these annuities is considered remote. The Company’s share of the amount due from any one life insurance company does not equal or exceed one percent of its subsidiaries’ aggregate policyholders’ surplus.
Operations of the pool give rise to inter-company balances with Employers Mutual, which are settled on a quarterly basis. The investment and income tax activities of the pool participants are not subject to the pooling agreement. The pooling agreement provides that Employers Mutual will make up any shortfall or difference resulting from an error in its systems and/or computational processes that would otherwise result in the required restatement of the pool participants’ financial statements.
Employers Mutual retains 10.5 percent of the gross assumed premiums written subject to cession to the reinsurance subsidiary as compensation for the $2,000,000 cap on losses assumed per event, which totaled $8,636,718, $8,329,929 and $7,774,480 in 2008, 2007 and 2006, respectively. In 2005, the reinsurance subsidiary paid for the outside reinsurance protection Employers Mutual purchased to protect itself from catastrophic losses on the assumed reinsurance business it retained in excess of the cap, excluding reinstatement premiums. The reinsurance subsidiary’s premiums earned for 2006 reflect a reduction of $508,333 associated with the runoff of the unearned premium on the outside reinsurance protection purchased in 2005, which expired on April 30, 2006. Employers Mutual retained losses and settlement expenses in excess of the $2,000,000 cap totaling $11,195,887 in 2008, ($52,664) in 2007 and $1,029,236 in 2006. The reinsurance subsidiary assumes all foreign currency exchange gain/loss associated with contracts incepting on January 1, 2006 and thereafter that are subject to the quota share agreement. The net foreign currency exchange gain (loss) assumed by the reinsurance subsidiary was $256,606 in 2008, ($512,281) in 2007 and ($61,055) in 2006.
Other long-term investments, consisting primarily of holdings in limited partnerships and limited liability companies, are valued by the various fund managers. In management’s opinion, these values reflect fair value at December 31, 2008 and 2007.
A small number of the Company’s securities are not priced by the independent pricing service. These securities are reported as Level 3 fair value measurements, since no reliable observable inputs are used in their valuations. The largest of these investments is the Class B shares of Insurance Services Office Inc. (ISO). Prior to the fourth quarter of 2008, the Company reported this investment at the fair value obtained from the Securities Valuation Office (SVO) of the NAIC. The SVO establishes a per share price for ISO Class B shares by averaging all Class B trades during the past year and reviewing the quarterly valuations of the Class A shares produced by a nationally recognized independent firm (the Class B shares were assigned a 40 percent marketability discount from the fair value of the Class A shares). The SVO valuation is typically performed twice a year, and resulted in a fair value of $10,180,245 for the Class B shares held by the Company at December 31, 2007. During the fourth quarter of 2008, the Company modified the valuation process for this investment by implementing a 20 percent marketability discount from the fair value of the Class A shares. This reduction in the marketability discount was implemented in recognition of a Form S-1 filing made by ISO with the Securities and Exchange Commission during 2008 in preparation for a planned initial public offering. At the completion of the initial public offering, ISO will continue to have two classes of stock; however, there will be a defined conversion plan that will result in all Class B shares being converted into Class A shares within 30 months. As a result, the marketability discount associated with the Class B shares will be well below the 20 percent discount utilized by the Company at year-end. In addition, the Company has a commitment from ISO that the offering price for the initial public offering will not be less than the fair value of the shares as determined by the nationally recognized independent firm. Applying a 20 percent marketability discount to the third quarter valuation of the Class A shares performed by the nationally recognized independent firm resulted in a fair value of $14,965,502 for the Class B shares. The other equity security included in the Level 3 fair value measurement category continues to be reported at the fair value obtained from the SVO. The SVO establishes a per share price for this security based on an annual review of that company’s financial statements. This review is typically performed during the second quarter, and resulted in a fair value for the shares held by the Company of $3,641 at December 31, 2008 and $6,719 at December 31, 2007.
The remaining three securities not priced by the Company’s independent pricing service during 2008 were fixed maturity securities. One of the fixed maturity securities was classified as a Level 3 fair value measurement and was carried at its amortized cost of $46,795 at December 31, 2007. This security matured during 2008. The other two fixed maturity securities are classified as Level 2 fair value measurements and are carried at aggregate fair values of $7,162,662 at December 31, 2008 and $8,610,855 at December 31, 2007. The fair values for these two fixed maturity securities were obtained from the Company’s investment custodian using an independent pricing service which utilizes similar pricing techniques as the Company’s independent pricing service.
Employers Mutual has various employee benefit plans, including a defined benefit retirement plan (pension) and a supplemental retirement plan. Employers Mutual also has two postretirement benefit plans that provide retiree healthcare and life insurance coverage. Although the Company has no employees of its own, it is responsible for its share of the expenses and related prepaid assets and liabilities of these plans under the terms of the pooling agreement and the cost allocation methodologies applicable to subsidiaries that do not participate in the pooling agreement (see note 2). Accordingly, the Company’s consolidated balance sheets reflect the Company’s share of the total plans’ prepaid assets and liabilities.
Employers Mutual also offers postretirement benefit plans which provide certain health care and life insurance benefits for retired employees. Substantially all of its employees may become eligible for those benefits if they reach normal retirement age and have attained the required length of service while working for Employers Mutual. The health care postretirement plan requires contributions from participants and contains certain cost sharing provisions such as coinsurance and deductibles. The life insurance plan is noncontributory. The benefits provided under both plans are subject to change.
During 2008, a total of 5,160 options were exercised at prices ranging from $18.62 to $20.20. Activity under the plan was as follows:
On March 10, 2008, the Company’s Board of Directors authorized a $15,000,000 stock repurchase program. This program became effective immediately and does not have an expiration date. The timing and terms of the purchases will be determined by management based on market conditions and will be conducted in accordance with the applicable rules of the Securities and Exchange Commission. Common stock purchased under this program is being retired by the Company. On October 31, 2008, the Company’s Board of Directors announced an extension of the stock repurchase program, authorizing an additional $10,000,000. As of December 31, 2008, 565,563 shares of common stock had been repurchased at a cost of $14,262,245.