The United States Congress is currently studying, or has placed on their agenda, several issues of critical importance to the Company and the insurance industry. These issues include Federal regulation on top of or in place of current state-run regulation, tort and class-action reform, extension for an additional year of the federal back-stop for terrorism losses contained in TRIA, and asbestos liability determination and funding. The Company is closely monitoring activities by the United States Congress on these issues through its membership in various trade organizations.
measure of the Company's overall underwriting profitability of the insurance business it writes and to assess the adequacy of the Company's pricing. The net loss and settlement expense ratio is meaningful in evaluating the Company's financial results, which are net of ceded reinsurance, as reflected in the consolidated financial statements. The loss and settlement expense ratios are generally calculated in the same way for GAAP and statutory accounting purposes.
One of the variables impacting the estimation of IBNR reserves is the assumption that the vast majority of future construction defect losses will continue to occur in those states in which most construction defect claims have historically arisen. Since the vast majority of these losses have been confined to a relatively small number of states, which is consistent with industry experience, there is no provision in the IBNR reserve for a significant spread of construction defect claims to other states. It is also assumed that various underwriting initiatives implemented in recent years will gradually mitigate the amount of construction defect losses experienced. These initiatives include exclusionary endorsements, increased care regarding additional insured endorsements, a general reduction in the amount of contractor business written relative to the total commercial lines book of business and underwriting restrictions on the writing of residential contractors. The estimation of the Company's IBNR reserves also does not contemplate substantial losses from potential mass torts such as Methyl Tertiary Butyl Ether (a gasoline additive that reduces emissions, but causes pollution), tobacco, silicosis, cell phones and lead. Further, consistent with general industry practice, the IBNR reserve for all liability lines does not provide for any significant retroactive expansion of coverage through judicial interpretation. If these assumptions prove to be incorrect, ultimate paid amounts on emerged IBNR claims may differ substantially from the carried IBNR reserves.
An important assumption underlying aggregate reserve estimation methods is that the claims inflation trends implicitly built into the loss and settlement expense development patterns will continue into the future. To estimate the sensitivity of the estimated ultimate loss and settlement expense payments to an unexpected change in inflationary trends, the actuarial department derived expected payment patterns separately for each major line of business. These patterns were applied to the December 31, 2004 loss and settlement expense reserves to generate estimated annual incremental loss and settlement expense payments for each subsequent calendar year. Then, for the purpose of sensitivity testing, an explicit annual inflationary trend of one percent was added to the inflationary trend that is implicitly embedded in the estimated payment pattern, and revised incremental loss and settlement expense payments were calculated. This additional unexpected claims inflation trend could arise from a variety of sources including a general increase in economic inflation, social inflation and, especially for the workers' compensation line of business, the introduction of new medical technologies and procedures, changes in the utilization of procedures and changes in life expectancy. The estimated cumulative impact that this additional unexpected one percent increase in the inflationary trend would have on the Company's results of operations over the lifetime of the underlying claims is shown below.
Workers' compensation ............. 3,357 Other liability ................... 2,879 Property .......................... 82 Homeowners ........................ 44
For the HORAD book of business, paid and incurred loss development patterns for relatively short-tail lines of business (property and marine) are based on data reported by the ceding companies. Employers Mutual has determined that there is sufficient volume and stability in the reported losses to base projections of ultimate losses on these patterns. For longer tail lines of business (casualty), industry incurred development patterns are referenced due to the instability of development patterns based on reported historical losses.
Disputes with ceding companies do not occur often. Employers Mutual performs claims audits and reviews claim reports for accuracy, completeness and adequate reserving. Most reinsurance contracts contain arbitration clauses to resolve disputes, but such disputes are generally resolved without arbitration due to the long-term and ongoing relationships that exist with those companies. There were no matters in dispute at December 31, 2004.
Asbestos and environmental losses paid by the Company have averaged only $244,000 per year over the past five years. During 2002, the Company re- evaluated the estimated ultimate loss projections for asbestos exposures. Based on this re-evaluation, the Company reallocated $176,000 of bulk IBNR reserves and $74,000 of settlement expense reserves to direct asbestos exposures. In addition, the Company diligently evaluated the adequacy of its asbestos reserves by commissioning a "ground-up" study to better quantify its exposure to asbestos liabilities. This study concluded that the Company's exposure for direct asbestos claims ranged from $1,100,000 to $5,100,000, with a point estimate of $3,000,000. Based on the results of this study, the Company elected to increase the IBNR and settlement expense reserves carried for direct asbestos exposures by $2,069,000 at December 31, 2002, to $2,985,000. The study's results for asbestos exposures on assumed reinsurance business were received during 2003, and the Company elected to increase its IBNR reserves carried for assumed asbestos exposures by $326,000 to the study's point estimate. The study and its results assume no improvement in the current asbestos litigation environment; however, continued efforts for federal legislation could reduce the ultimate loss projections for asbestos litigation below the levels currently projected for the industry.
Since 1989, the Company has included an asbestos exclusion in liability policies issued for most lines of business. The exclusion prohibits liability coverage for "bodily injury", "personal injury" or "property damage" (including any associated clean-up obligations) arising out of the installation, existence, removal or disposal of asbestos or any substance containing asbestos fibers. Therefore, the Company's present asbestos exposures are primarily limited to commercial policies issued prior to 1989. At present, the Company is defending approximately 500 asbestos bodily injury lawsuits. Most of these defenses are subject to express reservation of rights based upon the lack of an injury within the Company's policy periods because many asbestos lawsuits do not specifically allege dates of asbestos exposure or dates of injury. The Company's policyholders that have been named as defendants in these asbestos lawsuits are peripheral defendants who have had little or no exposure and are routinely dismissed from asbestos litigation with nominal or no payment at all (i.e., small contractors, insulators, electrical welding supply, furnace manufacturers, gasket, and building supply companies).
The Company's environmental claims are defined as 1) claims for bodily injury, personal injury, property damage, loss of use of property, diminution of property value, etc., allegedly due to contamination of air, and/or contamination of surface soil or surface water, and/or contamination of ground water, aquifers, wells, etc.; or 2) any/all claims for remediation or clean up of hazardous waste sites by the United States Environmental Protection Agency, or similar state and local environmental or government agencies, usually presented in conjunction with federal or local clean up statutes (i.e., CERCLA, RCRA, etc.).
To help assure that necessary case reserve adjustment are implemented on a timely basis in the future, beginning in 2005 the branch offices will be required to perform a complete inventory and review of their case reserves semi-annually, rather than annually as previously required. The first review is to be completed by the end of June and the second review is to be completed by the end of November each year.
In response to the declining interest rate environment, Employers Mutual changed several key assumptions utilized in the preparation of the actuarial valuation reports for its pension and postretirement benefit plans during 2003 and 2002. Key assumption changes include a reduction in the discount rate from 6.5 percent in 2002 to 6.0 percent in 2003 and a reduction in the expected long-term rate of return on plan assets for the pension plan from 8.0 percent in 2002 to 7.5 percent in 2003 and for the postretirement benefit plans from 6.0 percent in 2002 to 5.0 percent in 2003. In addition, the assumed health care cost trend rate utilized in the postretirement benefit plan valuation report was decreased from 12 percent in 2002 to 11 percent in 2003.
In December 2001, three of the Company's property and casualty insurance subsidiaries issued surplus notes totaling $25 million to Employers Mutual at an annual interest rate of 5.38 percent. In June 2002, the Company's reinsurance subsidiary issued an $11.0 million surplus note to Employers Mutual at an annual interest rate of 5.25 percent. Effective April 1, 2003,
$700,000 should the issuers of these annuities fail to perform under the terms of the annuities. The Company's share of the amount due from any one life insurance company does not equal or exceed one percent of its subsidiaries' policyholders' surplus.
In December 2004, the Financial Accounting Standards Board (FASB) issued SFAS No. 123 (revised 2004) "Share-Based Payment," which is a revision of SFAS No. 123 "Accounting for Stock-Based Compensation" and supersedes Accounting Principles Board (APB) Opinion No. 25 "Accounting for Stock Issued to Employees." SFAS No. 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements based on their fair values beginning with the first interim and annual periods after June 15, 2005, with earlier adoption encouraged. The pro forma disclosures previously allowed under Statement No. 123 will no longer be an alternative to financial statement recognition. The transition methods for adoption include the modified-prospective and modified-retroactive methods. The modified-prospective method requires that compensation expense be recorded for all unvested stock options that exist upon the adoption of Statement 123(R). Under the modified-retroactive method, prior periods may be restated either as of the beginning of the year of adoption or for all periods presented. The Company is currently evaluating the requirements of Statement 123(R), but does not expect adoption of this statement to have a material effect on the operating results of the Company.
Goodwill represents the excess of cost over the fair value of net assets of acquired subsidiaries. Goodwill is not amortized, but is subject to annual impairment testing to determine if the carrying value of the goodwill exceeds the estimated fair value of net assets. If the carrying amount of the subsidiary (including goodwill) exceeds the computed fair value, an impairment loss is recognized through earnings equal to the excess amount, but not greater then the balance of the goodwill. The annual impairment test is completed in the fourth quarter of each year and goodwill was not deemed to be impaired in 2004, 2003 or 2002.
The Company's reinsurance subsidiary assumes a 100 percent quota share portion of Employers Mutual's assumed reinsurance business, exclusive of certain reinsurance contracts. This includes all premiums and related losses and settlement expenses of this business, subject to a maximum loss of $1,500,000 per event. The reinsurance subsidiary does not directly reinsure any of the insurance business written by Employers Mutual; however, the reinsurance subsidiary assumes reinsurance business from the Mutual Reinsurance Bureau pool and this pool provides a very small amount of reinsurance protection to the EMC Insurance Companies. As a result, the reinsurance subsidiary's assumed exposures include a very small portion of the EMC Insurance Companies direct business, after ceded reinsurance protections purchased by the Mutual Reinsurance Bureau pool are applied. In addition, reinsurance subsidiary does not reinsure any "involuntary" facility or pool business that Employers Mutual assumes pursuant to state law. Operations of the quota share agreement give rise to inter-company balances with Employers Mutual, which are settled on a quarterly basis. The investment and income tax activities of the reinsurance subsidiary are not subject to the quota share agreement.
In 2004 the Company changed the recording of large no-fault auto claims associated with the Michigan Catastrophic Claims Association (MCCA) and began recording the reserves, which are ceded 100 percent to this association, on a gross basis. The 2003 consolidated balance sheet was restated for comparative purposes. As a result, the 2003 balances for "Reinsurance receivables" and "Losses and settlement expenses" were increased $5,859,035.
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 that 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 that it is in compliance with these laws.
The Company concluded that the accounting guidance provided by FAS 106-2 was applicable since the prescription drug benefit provided under Employers Mutual's postretirement benefit plan is actuarially equivalent to Medicare Part D. The expected subsidy reduced Employers Mutual's share of the cost of the underlying postretirement prescription drug coverage. The Company elected the retroactive method of transition to the date of the enactment of the Act.
The components of net periodic benefit cost for the Employers Mutual pension plan and postretirement benefit plans is as follows:
Postretirement benefit liabilities reflected in the Company's financial statements totaled $9,485,896 in 2004 and $8,512,179 in 2003. Net periodic postretirement benefit cost allocated to the Company for the years ended December 31, 2004, 2003 and 2002 was $1,583,172, $2,106,010 and $1,486,724, respectively.
The Company participates in several other retirement plans sponsored by Employers Mutual, including a 401(k) Plan, an Executive Non-Qualified Excess Plan and a Supplemental Retirement Plan. The Supplemental Retirement Plan was effective October 1, 2004 and replaced the Excess Retirement Benefit Agreement and the Supplemental Executive Retirement Plan. The Company's share of expenses for these plans amounted to $1,139,411, $912,103 and $703,555 in 2004, 2003 and 2002, respectively.
The carrying value of the surplus notes approximates their estimated fair value since their interest rates approximate current interest rates and the companies' credit ratings have not changed.
One of the Company's property and casualty insurance subsidiaries leases office facilities in Bismarck, North Dakota with lease terms expiring in 2014. Hamilton Mutual Insurance Company, an affiliate of Employers Mutual and a pool participant, leases office facilities for the Cincinnati branch office with lease terms expiring in 2005. Employers Mutual has entered into various leases for branch and service office facilities with lease terms expiring through 2013. Employers Mutual also leases computer software under various operating lease agreements expiring through 2005. All lease costs are included as expenses under the pooling agreement after allocation of the portion of these expenses to the subsidiaries that do not participate in the pool. The following table reflects the lease commitments of the Company as of December 31, 2004. The table reflects the Company's current 23.5 percent aggregate participation in the pooling agreement. As discussed further in note 2, the Company's aggregate participation in the pooling agreement will increase to 30.0 percent effective January 1, 2005.
December 31, -------------------------- 2004 2003 ------------ ------------ ASSETS Investment in common stock of subsidiaries (equity method) .................. $223,101,504 $176,087,397 Fixed maturity investments: Securities available-for-sale, at fair value .. 2,018,185 516,775 Short-term investments .......................... 3,262,867 3,768,427 Cash ............................................ 88,890 168,072 Accrued investment income ....................... 38,288 4,545 Income taxes recoverable ........................ 164,069 211,760 Deferred income taxes ........................... 12,621 204,310 ------------ ------------ Total assets ............................... $228,686,424 $180,961,286 ============ ============
Cash at beginning of year ............. 168,072 58,676 227,541 ----------- ----------- ----------- Cash at end of year ................... $ 88,890 $ 168,072 $ 58,676 =========== =========== =========== Income taxes received .................$ 414,477 $ - $ 2,253 Interest paid .........................$ - $ - $ -