The Company has devoted a substantial amount of time and resources during the last two years to improve the adequacy and consistency of its loss and settlement expense reserves. Case reserve adequacy was highly emphasized throughout 2004 and resulted in a significant, but unanticipated, increase in case reserves in the property and casualty insurance segment during the fourth quarter of 2004. During 2005, management worked diligently with the branch offices to implement new claim management processes and automated claim system enhancements in order to achieve greater consistency and timeliness in the establishment and monitoring of case reserve estimates. These initiatives have been successful and management believes that the Company’s loss and settlement expense reserves have been restored to their historically adequate level. At December 31, 2005, the Company’s loss and settlement expense reserves are at the high end of the range of actuarial indications, which is very similar to the Company’s analysis of its reserve position at year-end 2004. During 2005, the Company experienced favorable development on prior years’ reserves, which provides confirming evidence of the Company’s strong reserve position. In addition, current analysis supports the conclusion that newly reported claims continue to be reserved at high levels of adequacy.
The Company’s net written premiums increased significantly in 2005 due to the property and casualty insurance subsidiaries’ increased participation in the pooling agreement; however, net written premiums for the pool declined 1.1 percent in 2005. This decline reflects a decrease in new business, an increase in ceded premiums and a decline in the number of rate increases the Company was able to implement due to increased competition in the marketplace and the Company’s current level of rate adequacy. Policy retention has remained at high levels over the last several years, but policy count has declined as a result of increased competition for good business and Company initiatives to exit unprofitable business. Management is attempting to reverse this trend through improved product management initiatives and technology improvements that will make it easier for agents to do business with the Company.
Assumed reinsurance losses tend to be reported later than direct losses. This lag is reflected in loss projection factors for assumed reinsurance that tend to be higher than for direct business. The result is that assumed reinsurance IBNR reserves as a percentage of total reserves tend to be higher than for direct reserves. IBNR reserves totaled $73,987,000 and $66,092,000 at December 31, 2005 and 2004, respectively, and for both years accounted for approximately 55 percent of the reinsurance segment’s total loss reserves. IBNR reserves are, by nature, less precise than case reserves. A five percent change in IBNR reserves at December 31, 2005 would equate to a $3,699,000 change in loss reserves, which would represent 5.6 percent of net income and 0.9 percent of stockholders’ equity.
1 Products includes the portion of asbestos and environmental claims reported above that are non-premises/operations claims.
Loss and settlement expense reserves are estimates at a given time of what an insurer expects to pay on incurred losses, based on facts and circumstances then known. During the loss settlement period, which may be many years, additional facts regarding individual claims become known, and accordingly, it often becomes necessary to refine and adjust the estimates of liability on a claim. Such changes in reserves for losses and settlement expenses are reflected in operating results in the year such changes are recorded.
Segment information and consolidated net income for the three years ended December 31, 2005 are as follows:
Premiums written for the property and casualty insurance segment increased 37.9 percent to $350,646,000 in 2005 from $254,267,000 in 2004. This increase is attributed to the change in pool participation and includes a portfolio adjustment of $29,631,000, which serves as an offset to the increase in the unearned premium reserve. Excluding this portfolio adjustment, premiums written increased 26.3 percent in 2005. Looking at the net pool numbers, which are not impacted by the change in pool participation, premiums written declined 1.1 percent in 2005. During 2005, commercial lines new business premium increased approximately 1.6 percent and personal lines new business premium decreased approximately 12.2 percent. However, policy retention increased to 86.1 percent in commercial lines and remained relatively steady in the personal lines at 82.2 percent for property and 82.6 percent for auto. In light of current rate levels and the quality of the Company’s book of business, management is receptive to opportunities to write new business, but continues to stress profitability over production.
The loss and settlement expense ratio for the reinsurance segment increased to 63.5 percent in 2005 from 55.9 percent in 2004. The increase in the 2005 ratio is attributed to a decline in the amount of favorable development experienced on prior years’ reserves, an increase in the severity of losses on working layer business and an increase in catastrophe and storm losses. The favorable development experienced on prior years’ reserves in 2005 and 2004 is attributed to the HORAD book of business. Catastrophe and storm losses for 2005 amounted to $5,415,000, which reflects $4,500,000 from Hurricanes Katrina, Rita and Wilma (each capped at the $1,500,000 occurrence limit per event), approximately $675,000 from tropical storm Erwin and $219,000 of adverse development from a 2004 hurricane. Catastrophe losses in 2004 amounted to $5,011,000, with three hurricanes being capped at the $1,500,000 occurrence limit per event. As previously noted, Employers Mutual retained a significant amount of hurricane losses in excess of the $1,500,000 cap per event in 2005. This prompted changes to the terms and conditions of the quota share agreement for 2006, including an increase in the cap on losses assumed per event from $1,500,000 to $2,000,000.
Acquisition and other expenses increased 24.2 percent to $140,001,000 in 2005 from $112,707,000 in 2004. These increases are primarily attributed to the Company’s increased participation in the pooling agreement. The acquisition expense ratio increased to 33.6 percent in 2005 from 32.6 percent in 2004. This increase reflects higher salary expenses, hurricane-related assessment costs and an increase in policyholder dividends.
The calculation of 2004 net income per share was impacted by the Company’s follow-on stock offering in which 2.0 million new shares of common stock were issued on October 20, 2004. The Company earned approximately $170,000 of additional interest income on the net proceeds of the stock offering during the fourth quarter of 2004; however, this additional interest income was not sufficient to avoid an approximate 3.0 percent dilution in the 2004 net income per share calculation.
The Company participates in a securities lending program administered by Mellon Bank, N.A. whereby certain fixed maturity securities from the investment portfolio are loaned to other institutions for short periods of time. The Company receives a fee for each security loaned out under this program and requires initial collateral, primarily cash, equal to 102 percent of the market value of the loaned securities. The cash collateral that secures the Company’s loaned securities is invested in a Delaware statutory trust that is managed by Mellon Bank. The earnings from this trust are used, in part, to pay the fee the Company receives for each security loaned under the program.
The main objectives in managing the investment portfolios of the Company are to maximize after-tax investment return while minimizing credit risks, in order to provide maximum support for the underwriting operations. Investment strategies are developed based upon many factors including underwriting results and the Company’s resulting tax position, regulatory requirements, fluctuations in interest rates and consideration of other market risks. Investment decisions are centrally managed by investment professionals and are supervised by the investment committees of the respective board of directors for each of the Company’s subsidiaries.
The Private Securities Litigation Reform Act of 1995 provides issuers the opportunity to make cautionary statements regarding forward-looking statements. Accordingly, any forward-looking statement contained in this report is based on management’s current beliefs, assumptions and expectations of the Company’s future performance, taking into account all information currently available to management. These beliefs, assumptions and expectations can change as the result of many possible events or factors, not all of which are known to management. If a change occurs, the Company’s business, financial condition, liquidity, results of operations, plans and objectives may vary materially from those expressed in the forward-looking statements. The risks and uncertainties that may affect the actual results of the Company include, but are not limited to, the following: catastrophic events and the occurrence of significant severe weather conditions; the adequacy of loss and settlement expense reserves; state and federal legislation and regulations; changes in our industry, interest rates or performance of financial markets and the general economy; rating agency actions and other risks and uncertainties inherent to the Company’s business, including those contained in this report under the heading “Risk Factors.” When the Company uses the words “believe”, “expect”, “anticipate”, “estimate” or similar expressions, the Company intends to identify forward-looking statements. You should not place undue reliance on these forward-looking statements.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
EMC Insurance Group Inc., a 57 percent owned subsidiary of Employers Mutual Casualty Company (Employers Mutual), is an insurance holding company with operations in property and casualty insurance and reinsurance. Both commercial and personal lines of insurance are written, with a focus on medium-sized commercial accounts. Approximately 37 percent of the premiums written are in Iowa and contiguous states. The term “Company” is used interchangeably to describe EMC Insurance Group Inc. (Parent Company only) and EMC Insurance Group Inc. and its subsidiaries.
The amortized cost and estimated fair value of fixed maturity securities at December 31, 2005, by contractual maturity, are shown below. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
The Company participates in several other retirement plans sponsored by Employers Mutual, including a 401(k) Plan and an Executive Non-Qualified Excess Plan. The Company’s share of expenses for these plans amounted to $1,064,546, $1,139,411 and $912,103 in 2005, 2004 and 2003, 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. Employers Mutual has entered into various leases for branch and service office facilities with lease terms expiring through 2017. 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, 2005.