The Company’s wholly-owned subsidiary, Farm and City Insurance Company, discontinued writing direct nonstandard risk automobile insurance business in 2004, but continued to participate in the pooling agreement. Effective December 31, 2007, Farm and City was merged into one of the Company’s other property and casualty insurance subsidiaries. This merger did not have any impact on the Company’s 30 percent aggregate participation in the pooling agreement.
Under the terms of the quota share agreement, the reinsurance subsidiary receives reinstatement premium income that is collected by Employers Mutual from the ceding companies when reinsurance coverage is reinstated after a loss event; however, the cap on losses assumed per event contained in the quota share agreement is automatically reinstated without cost to the reinsurance subsidiary. This arrangement can produce unusual underwriting results for the reinsurance subsidiary when a large event occurs because the reinstatement premium income received by the reinsurance subsidiary may approximate, or exceed, the amount of losses retained.
During 2007, management completed an evaluation of the statutory surplus position of each of the Company’s insurance subsidiaries. Based on this evaluation, management determined that the reinsurance subsidiary had an adequate amount of surplus to support its current and anticipated level of business, and therefore redeemed the $11 million of surplus notes issued to Employers Mutual during the fourth quarter. The $25 million of surplus notes issued by the property and casualty insurance subsidiaries and held by Employers Mutual were not redeemed; however, the Inter-Company Committees of the Company and Employers Mutual approved an increase in the interest rate on these notes from the current 3.09 percent to 3.60 percent effective February 1, 2008, subject to regulatory approval.
The methodology used in estimating formula IBNR loss reserves assumes consistency in claims reporting patterns and immaterial changes in loss development patterns. Implicit in this assumption is that future IBNR claims emergence relative to IBNR claims that have emerged following prior year-ends will reflect the change in frequency and severity trends underlying the rate adequacy adjustments. If this projected relationship proves to be inaccurate, future IBNR claims may differ substantially from the estimated IBNR loss reserves. The following table displays the impact that a five percent variance in IBNR emergence from the projected level reflected in the December 31, 2007 IBNR factors would have on the Company’s results of operations. This variance in IBNR emergence could occur in one year or over multiple years, depending when the claims were reported. A variance in IBNR emergence would also affect the Company’s financial position in that the Company’s equity would be impacted by an amount equivalent to the change in net income. A variance of this type would typically be recognized in loss and settlement expense reserves and, accordingly, would not have a material effect on liquidity because the claims have not been paid. A five percent variance in IBNR emergence is considered reasonably likely based on the range of actuarial indications developed during the analysis of the property and casualty insurance segment’s carried reserves.
Following is a summary of the carried loss and settlement expense reserves for the property and casualty insurance segment at December 31, 2007 and 2006.
To date, actual losses paid have been minimal due to the plaintiffs’ failure to identify an exposure to any asbestos-containing product associated with the pool participant’s policyholders. Defense costs, on the other hand, are more significant due to the large number of parties involved in the litigation and the length of time required to obtain a favorable judgment. Whenever possible, the pool participants have participated in cost sharing agreements with other insurance companies to reduce overall asbestos claim expenses.
Following is a summary of the claim activity associated with asbestos, environmental and products liability exposures for 2007, 2006 and 2005:
Premiums earned for the reinsurance segment declined 1.3 percent to $72,223,000 in 2007 from $73,199,000 in 2006. A decline in MRB premiums (which is associated with an account that was not renewed) is primarily responsible for the decline in premium income during 2007. An increase in brokered reinsurance business partially offset the decline in MRB premiums. During both the January 2008 and July 2007 renewal periods, premium rates on reinsurance contract renewals decreased slightly, with a portion of the decline attributed to program restructurings with increased retentions. Due to the continued competitiveness of the market, rates are expected to continue declining in 2008. Employers Mutual’s strategy for growth in this competitive market is to pursue foreign property business, primarily in Europe and Japan.
The loss and settlement expense ratio for the property and casualty insurance segment increased to 62.2 percent in 2007 from 56.0 percent in 2006. This increase is attributed to an increase in both large losses (greater than $250,000) and catastrophe and storm losses, a decrease in the amount of favorable development experienced on prior years’ reserves, and a moderate decline in premium rate levels. An increase in claim frequency was offset by a decline in average claim size, the latter based on the individual case loss reserves established by the branch offices. The increase in catastrophe and storm losses was largely driven by losses associated with the Greensburg, Kansas tornado, which totaled $6,256,000. The steady decline in premium rate levels over the past two years resulted in an approximate 2.7 percentage point increase in the loss and settlement expense ratio in 2007.
The reinsurance subsidiary recognized $1,343,000 of commission income in the first quarter of 2006 in connection with Employers Mutual’s reduced participation in the MRB pool. This commission income reimbursed the reinsurance subsidiary for expenses previously incurred to generate the reinsurance business that was transferred to the new assuming companies of the MRB pool on January 1, 2006. This commission income, however, was partially offset by $688,000 of deferred policy acquisition costs that were expensed in the first quarter of 2006 as a result of the reduction in pool participation.
All non-investment grade fixed maturity securities held at December 31, 2007 (Great Lakes Chemical Corporation and US Freightways Corporation) were in an unrealized gain position. The Company does not purchase non-investment grade securities. Any non-investment grade securities held by the Company are the result of rating downgrades that occurred subsequent to their purchase.
The following table reflects the Company’s contractual obligations as of December 31, 2007. Included in the table are the estimated payments that the Company expects to make in the settlement of its loss reserves and with respect to its long-term debt. One of the Company’s property and casualty insurance subsidiaries leases office facilities in Bismarck, North Dakota with lease terms expiring in 2014. Employers Mutual has entered into various leases for branch and service office facilities with lease terms expiring through 2021. 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 table reflects the Company’s current 30.0 percent aggregate participation in the pooling agreement.
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 $2,024,000 at December 31, 2007. The Company has a contingent liability of $2,024,000 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.
Interest rate risk includes the price sensitivity of a fixed maturity security to changes in interest rates, and the affect on future earnings from short-term investments and maturing long-term investments given a change in interest rates. The following analysis illustrates the sensitivity of the Company’s financial instruments to selected changes in market rates and prices. A hypothetical one percent increase in interest rates as of December 31, 2007 would result in a corresponding pre-tax decrease in the fair value of the fixed maturity portfolio of approximately $41,880,000, or 4.7 percent. In addition, a hypothetical one percent decrease in interest rates at December 31, 2007 would result in a corresponding decrease in pre-tax income over the next twelve months of approximately $719,000, assuming the current maturity and prepayment patterns. The Company monitors interest rate risk through the analysis of interest rate simulations, and adjusts the average duration of its fixed maturity portfolio by investing in either longer or shorter term instruments given the results of interest rate simulations and judgments of cash flow needs. The effective duration of the Company’s fixed maturity portfolio at December 31, 2007 was 3.75 years.
The Company’s insurance subsidiaries are required to file financial statements with state regulatory authorities. The accounting principles used to prepare these statutory financial statements follow prescribed or permitted accounting practices that differ from GAAP. Prescribed statutory accounting principles include state laws, regulations and general administrative rules issued by the state of domicile, as well as a variety of publications and manuals of the National Association of Insurance Commissioners (NAIC). Permitted accounting practices encompass all accounting practices not prescribed, but allowed by the state of domicile. The Company’s insurance subsidiaries had no permitted accounting practices during 2007, 2006 and 2005.
Employers Mutual maintains two separate incentive stock option plans for the benefit of officers and key employees of Employers Mutual and its subsidiaries. A total of 1,000,000 shares of the Company’s common stock have been reserved for issuance under the 1993 Employers Mutual Casualty Company Incentive Stock Option Plan (1993 Plan) and a total of 1,500,000 shares have been reserved for issuance under the 2003 Employers Mutual Casualty Company Incentive Stock Option Plan (2003 Plan).