MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL - ------- ------------------------------------------------- CONDITION AND RESULTS OF OPERATIONS. ------------------------------------
EMC Insurance Group Inc. (the "Company"), an approximately 67 percent owned subsidiary of Employers Mutual Casualty Company (Employers Mutual), is an insurance holding company with operations in property and casualty insurance, reinsurance, nonstandard risk automobile insurance and an excess and surplus lines insurance agency. Property and casualty insurance is the most significant segment, representing 71.8 percent of consolidated premium income.
The purpose of the pooling agreement is to reduce the risk of an exposure insured by any of the pool participants by spreading it among all the companies. The pooling agreement produces a more uniform and stable underwriting result from year to year for all companies in the pool than might be experienced individually. In addition, each company benefits from the capacity of the entire pool, rather than being limited to policy exposures of a size commensurate with its own assets, and from the wide range of policy forms, lines of insurance written, rate filings and commission plans offered by each of the companies. A single set of reinsurance treaties is maintained for the protection of all six companies in the pool.
The Company's reinsurance subsidiary assumes a 95 percent quota share portion of Employers Mutual's assumed reinsurance business, exclusive of certain reinsurance contracts. The reinsurance subsidiary receives 95 percent of all premiums and assumes 95 percent of all related losses and settlement expenses of this business. Since 1993, losses in excess of $1,000,000 per event are retained by Employers Mutual. The reinsurance subsidiary does not reinsure any of Employers Mutual's direct insurance business, nor any "involuntary" facility or pool business that Employers Mutual assumes pursuant to state law. In addition, the reinsurance subsidiary is not liable for credit risk in connection with the insolvency of any reinsurers of Employers Mutual.
The excess and surplus lines insurance agency provides insurance agents access to the excess and surplus lines markets and also functions as managing underwriter for such lines for Employers Mutual and several of the pool members.
Losses and settlement expenses have declined steadily over the last three years, reflecting favorable development in the provision for insured events of prior years and a decrease in catastrophe and storm losses. The majority of the favorable development in the provision for insured events of prior years has come from the property and casualty insurance subsidiaries, which have benefited from state reform measures in workers' compensation insurance and various cost control functions implemented by Employers Mutual to minimize losses. Favorable development has also been experienced in the reinsurance subsidiary and the nonstandard risk auto insurance subsidiary, but to a lesser degree. Catastrophe and storm losses increased only slightly in 1995, despite a substantial increase in hurricane and storm activity. This small increase is the result of careful underwriting and a reduction of coastal exposures in the assumed reinsurance business.
Other expenses have increased slightly over the last three years. These increases are primarily attributable to the property and casualty insurance subsidiaries and reflect higher commission rates associated with writing more property insurance and additional expenses associated with the various cost control functions that have been implemented to control losses.
Investment income increased substantially in 1995 after showing modest growth in 1994 and declining in 1993. The increase for 1995 is primarily due to a larger invested asset base earning income. The amounts for 1994 and 1993 were impacted by the transfer of $24,853,000 to Employers Mutual in 1993 in connection with changes to the property and casualty insurance subsidiaries' pooling agreement and the reinsurance subsidiary's quota share agreement.
Realized gains on investments increased significantly in 1995, reflecting profits recognized on the sale of mutual funds invested in equity securities. The amounts for 1994 and 1993 are primarily the result of calls and prepayments on fixed maturity securities.
Effective January 1, 1993 the Company adopted two new accounting standards and implemented an accounting change which resulted in an increase in net income of $2,621,000 ($.26 per share). Following is a brief explanation of each item:
* The Company adopted SFAS 109, "Accounting for Income Taxes" as a cumulative effect adjustment to income. The Company recognized a benefit of $5,595,000 ($.55 per share), net of a valuation allowance of $1,000,000.
($ in thousands) 1995 1994 1993 -------- -------- -------- Premiums earned .......................... $116,439 $115,412 $109,585 Losses and settlement expenses ........... 74,926 77,872 79,777 Other expenses ........................... 40,030 36,606 33,621 -------- -------- -------- Underwriting gain (loss) ................. 1,483 934 (3,813) Net investment income .................... 15,428 14,080 13,243 Realized investment gains ................ 1,027 334 405 -------- -------- -------- Operating income before income taxes ..... $ 17,938 $ 15,348 $ 9,835 ======== ======== ======== Incurred losses and settlement expenses: Insured events of the current year ..... $ 87,411 $ 84,204 $ 81,355 Decrease in provision for insured events of prior years ................ (12,485) (6,332) (1,578) -------- -------- -------- Total losses and settlement expenses $ 74,926 $ 77,872 $ 79,777 ======== ======== ======== Catastrophe and storm losses ............. $ 5,671 $ 4,919 $ 3,811 ======== ======== ========
Premium income has increased over the last three years, but has been limited by rate competition and the shift of large commercial insureds to alternative risk mechanisms. Rate levels declined in 1995 in response to competitive pressures and favorable experience. In spite of this, rate adequacy deteriorated only slightly due to careful underwriting, significant reform measures implemented by several states to control the administrative costs of workers' compensation claims and internal cost management programs. New marketing programs implemented in 1994, and expanded in 1995, have increased the amount of property insurance written and have also helped to highlight the subsidiaries' other products. During 1995, production increases in direct (controlled) business were partially offset by decreases in mandatory assigned risk programs, resulting in a small increase in total premiums earned. The decrease in the mandatory assigned risk premiums is looked at favorably as losses associated with this type of business are generally higher than losses from direct business. Direct business production for 1996 is not expected to increase significantly as the market conditions that have limited production over the last several years are not expected to change.
Investment income has grown steadily over the last three years, primarily due to an increase in the invested asset base. The amounts for 1995 and 1994 reflect interest income earned on $13,148,000 received from Employers Mutual in 1994 in connection with the gross-up of reserve amounts associated with the National Workers' Compensation Reinsurance Pool at December 31, 1993.
($ in thousands) 1995 1994 1993 -------- -------- -------- Premiums earned ............................ $ 35,826 $ 37,256 $ 33,324 Losses and settlement expenses ............. 23,744 30,565 27,872 Other expenses ............................. 11,584 11,408 11,492 -------- -------- -------- Underwriting gain (loss) ................... 498 (4,717) (6,040) Net investment income ...................... 6,068 5,354 6,090 Realized investment gains .................. 13 116 201 Other income ............................... 344 434 259 -------- -------- -------- Operating income before income taxes ....... $ 6,923 $ 1,187 $ 510 ======== ======== ======== Incurred losses and settlement expenses: Insured events of the current year ....... $ 26,668 $ 29,270 $ 25,359 (Decrease) increase in provision for insured events of prior years .......... (2,924) 1,295 2,513 -------- -------- -------- Total losses and settlement expenses $ 23,744 $ 30,565 $ 27,872 ======== ======== ======== Catastrophe losses ......................... $ 932 $ 1,424 $ 5,141 ======== ======== ========
Premium income declined in 1995 after increasing in both 1994 and 1993. The majority of the decrease in 1995 production can be attributed to the cancellation of four large national pro rata treaties that had experienced poor underwriting results over the last several years. During 1995, more emphasis was placed upon writing excess of loss business and on increasing participation on existing contracts that had favorable terms. This movement towards excess of loss business was prompted by the continued deterioration of pro rata rates and greater control over the pricing of excess of loss business. While pro rata business continued to be written, the emphasis was on local and regional accounts. Some national account pro rata business was retained, but the terms provide appropriate limitations and protection for catastrophe exposures. The reinsurance subsidiary continues to emphasize profitability over production and therefore cancelled several unprofitable aircraft and marine accounts at the end of 1995. Despite these cancellations, premium volume for 1996 is expected to increase.
Underwriting results have improved significantly over the last three years, reflecting a decline in catastrophe losses and favorable development in the provision for insured events of prior years. The large decrease in catastrophe losses in 1994 was partially offset by an increase in crop hail losses and a deterioration of results in the pro rata business. Results for 1993 reflect $1,678,000 of underwriting losses associated with two reinsurance contracts that were commuted in 1993.
Effective June 30, 1993, Employers Mutual commuted the portion of the quota share agreement that pertained to a casualty pool that is in a run-off position. In connection with this change in the quota share agreement, the Company's liabilities decreased $19,783,000 and invested assets decreased $17,806,000. The reserve discount amount of $1,977,000 was recorded as deferred income and is being amortized into operations over the estimated settlement period of the reserves, which is ten years. The amount recognized as income totaled $344,000, $434,000 and $259,000 in 1995, 1994 and 1993, respectively.
Operating results for the three years ended December 31, 1995 are as follows:
Operating income before income taxes was $483,000, $505,000 and $103,000 for 1995, 1994 and 1993, respectively. The results for 1995 and 1994 reflect a new management plan put into effect which places more emphasis on writing excess and surplus lines business through Employers Mutual's agency force. Operating results for 1993 were negatively impacted by the termination of business with a large agency that had previously represented over 50 percent of this segment's volume.
Estimating asbestos and environmental related reserves is very difficult due to many uncertainties surrounding these types of claims. Such uncertainties include the fact that the legal definition of asbestos and environmental damage is still evolving, the assignment of responsibility varies widely by state and claims often emerge long after the policy has expired, making assignment of damages to the appropriate party and to the time period covered by a particular policy difficult. In establishing reserves for these types of claims, management monitors the relevant facts concerning each claim, the current status of the legal environment, the social and political conditions and the claim history and trends within the Company and the industry.
During 1995, the Company changed its methodology for establishing Incurred But Not Reported (IBNR) reserves for asbestos and environmental exposures related to the direct insurance business issued by the members of the pooling agreement. Prior to 1995, IBNR reserves were calculated by applying a factor to the case basis reserves. IBNR reserve levels produced with this methodology tended to vary from year to year due to the relatively small amount of case basis reserves carried for these types of claims. At December 31, 1995, the Company allocated a portion of the current IBNR reserve to these exposures to reflect estimated ultimate losses. No additional IBNR reserves were established for the direct insurance business.
During 1995, Employers Mutual attempted to improve its disclosure of asbestos and environmental exposures related to its assumed reinsurance business, some of which is ceded to the Company's reinsurance subsidiary, by mailing supplemental questionnaires to its ceding reinsurers. Many of these reinsurers responded with more detailed information than they had previously provided. Using this additional information, Employers Mutual allocated a portion of the current bulk IBNR reserve to asbestos and environmental exposures. No additional bulk IBNR reserves were established on the business assumed by the Company's reinsurance subsidiary.
The Company maintains a portion of the investment portfolio in relatively short-term and highly liquid investments to ensure the availability of funds to meet claims and expenses. The remainder of the investment portfolio is invested in securities with maturities that approximate the anticipated liabilities of the insurance issued. Net unrealized holding gains on fixed maturity securities available-for-sale totaled $3,472,000 at December 31, 1995. This compares to net unrealized holding losses of $1,317,000 at December 31, 1994 and net unrealized holding gains of $2,068,000 at December 31, 1993. Since the Company does not actively trade in the bond market, such fluctuations in the market value of these investments are not expected to have a material impact on the operations of the Company, as forced liquidations of investments are not anticipated. The Company closely monitors the bond market and makes appropriate adjustments in investment policy as changing conditions warrant. A valuation allowance was established in 1994 related to the tax benefits associated with the unrealized holding losses at December 31, 1994 due to the uncertainty concerning the future realization of these benefits.
The majority of the Company's assets are invested in fixed maturities. These investments provide a substantial amount of income which supplements underwriting results and contributes to net earnings. As these investments mature the proceeds will be reinvested at current 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 depending on the interest rate level.
During 1995, the Company invested $13,550,000 of short-term funds and maturing U.S. Treasury Bills into mutual funds invested in equity securities. The overall liquidity position of the Company was not affected by these investments. Net unrealized holding gains on equity securities totaled $818,000 at December 31, 1995.
In November of 1995 the Financial Accounting Standards Board issued a special report titled "A Guide to Implementation of Statement 115 on Accounting for Certain Investments in Debt and Equity Securities." This report contained a provision that allowed entities a one-time option to reassess the appropriateness of the classifications of all securities held and to reclassify securities from the held-to-maturity category without calling into question the intent of that enterprise to hold other debt securities to maturity in the future. The Company elected to take advantage of this option and reclassified $80,534,719 of municipal and corporate bonds from the held- to-maturity category to the available-for-sale category in the fourth quarter of 1995 in order to achieve more flexibility in its investment portfolio.
During 1995, the Company generated positive cash flows from operations of $24,651,000. This compares to positive cash flows from operations of $39,006,000 in 1994, which included $13,148,000 related to the gross-up of reserve amounts associated with the National Workers' Compensation Reinsurance Pool. Negative operating cash flows of $8,794,000 in 1993 included $24,853,000 paid to Employers Mutual in connection with the change in the property and casualty insurance subsidiaries' pooling agreement relating to the voluntary assumed reinsurance business and the commutation of two reinsurance contracts under the reinsurance subsidiary's quota share agreement.
As of December 31, 1995, the Company had no material commitments for capital expenditures.
The National Association of Insurance Commissioners (NAIC) adopted certain risk-based capital standards for property and casualty insurance companies in 1994. Risk-based capital requirements attempt to measure minimum statutory capital needs based upon the risks in a company's mix of products and investment portfolio. The Company's insurance subsidiaries' ratio of total adjusted capital to risk-based capital at December 31, 1995 is well in excess of the minimum level required.
A major source of cash flows for the Company is dividend payments from its subsidiaries. State insurance regulations restrict the maximum amount of dividends insurance companies can pay without prior regulatory approval. See note 7 of Notes to Consolidated Financial Statements for additional information regarding dividend restrictions. The Company collected $3,200,000, $3,068,000 and $860,000 of dividends from its insurance subsidiaries in 1995, 1994 and 1993, respectively and $1,000,000 from its insurance agency in 1995. The Company paid cash dividends to stockholders totaling $5,662,000, $5,422,000 and $5,303,000 in 1995, 1994 and 1993, respectively. For the last three years, Employers Mutual has received 50 percent of its dividends in common stock under the Company's dividend reinvestment and common stock purchase plan.
The NAIC is in the process of developing model legislation to govern insurance company investments. An exposure draft was released in August of 1994 and a model law is expected to be ratified by the NAIC in 1996. This model law is not expected to have a material impact on the operations of the Company's insurance subsidiaries.
The NAIC is currently working on a project to codify statutory accounting principles. The goal of this project is to establish a uniform set of accounting rules and regulations that will be utilized by all insurance companies when preparing financial reports submitted to regulatory authorities. Issue papers documenting the NAIC's position on the proposed accounting treatment of many items have been released for comment; however, many complex and controversial issues have not been addressed at this time or are in the process of being reexamined by the NAIC. As a result, the Company is unable to determine what impact, if any, this project will have on the statutory surplus of its insurance subsidiaries when enacted.
Management has established and maintains a system of internal controls that are designed to provide assurance as to the integrity and reliability of the financial statements, the protection of assets from unauthorized use, and the execution and recording of transactions in accordance with management's authorization. The system of internal controls provides for appropriate division of responsibility. Certain aspects of these systems and controls are tested periodically by the Company's internal auditors. Management considers the recommendations of its internal auditors and independent public accountants concerning the Company's internal controls and takes the necessary actions that are cost-effective in the circumstances to respond appropriately to the recommendations presented. Management believes that as of December 31, 1995, the Company's system of internal controls was adequate to accomplish the objectives described herein.
The Audit Committee of the Board of Directors, composed solely of outside directors, met during the year with management and the independent accountants to review and discuss audit findings and other financial and accounting matters. The independent accountants and the internal auditors have free access to the Audit Committee, with and without management present, to discuss the results of their audit work.
/s/ E.H. Creese - ------------------------------------ E.H. Creese, C.P.A. Senior Vice President, Treasurer and Chief Financial Officer
As discussed in notes 1, 10, 11 and 13 to the consolidated financial statements, the Company changed its method of computing unearned premiums in 1993 and implemented the provisions of the Financial Accounting Standards Board's Statements No. 106, "Employers Accounting for Postretirement Benefits Other Than Pensions", No. 109, "Accounting for Income Taxes", and No. 115, "Accounting for Certain Investments in Debt and Equity Securities".
Cash .............................................. 1,198,436 1,258,221 Accrued investment income ......................... 5,749,619 5,560,633 Accounts receivable ............................... 726,181 1,280,550 Deferred policy acquisition costs ................. 8,714,769 8,393,635 Deferred income taxes (note 11) ................... 11,921,182 14,190,499 Intangible assets, including goodwill, at cost less accumulated amortization of $1,809,156 and $1,674,643 .................................. 1,748,664 1,883,177 Reinsurance receivables (note 3) .................. 12,916,943 14,935,048 Prepaid reinsurance premiums (note 3) ............. 1,805,881 2,121,033 Other assets ...................................... 1,015,352 1,575,540 ------------ ------------
December 31, -------------------------- 1995 1994 ------------ ------------ LIABILITIES Losses and settlement expenses (notes 2,3,5 and 6) $205,422,109 $203,181,615 Unearned premiums (notes 2 and 3) ................. 48,767,147 47,672,570 Other policyholders' funds ........................ 3,593,328 3,102,609 Indebtedness to related party ..................... 428,463 937,356 Income taxes payable .............................. 2,538,669 1,736,000 Postretirement benefits (note 13) ................. 4,489,812 4,086,674 Deferred income (note 2) .......................... 940,009 1,283,662 Other liabilities ................................. 9,812,678 8,642,703 ------------ ------------
Retained earnings ................................. 62,089,294 50,402,812 Treasury stock, at cost (7,585 shares in 1995 and 10,931 shares in 1994) ...................... (100,421) (110,067) ------------ ------------ Total stockholders' equity ................. 136,888,758 116,726,689 ------------ ------------
Year ended December 31, ---------------------------------------- 1995 1994 1993 ------------ ------------ ------------ REVENUES: Premiums earned (notes 2 and 3) ..... $162,266,250 $164,829,379 $156,437,538 Investment income, net (note 10) .... 23,173,794 20,929,680 20,779,951 Realized investment gains (note 10) 1,043,730 519,567 684,445 Other income (note 2) ............... 343,653 433,979 259,217 ------------ ------------ ------------ 186,827,427 186,712,605 178,161,151 ------------ ------------ ------------ LOSSES AND EXPENSES: Losses and settlement expenses (notes 2,3 and 5) ........ 108,152,278 116,944,054 120,355,299 Dividends to policyholders .......... 3,739,533 3,103,788 2,494,284 Amortization of deferred policy acquisition costs .......... 32,152,616 31,701,789 30,717,175 Other underwriting expenses ......... 18,467,091 16,286,206 15,575,257 ------------ ------------ ------------ 162,511,518 168,035,837 169,142,015 ------------ ------------ ------------ Income before income taxes and cumulative effect of changes in accounting principles .... 24,315,909 18,676,768 9,019,136 ------------ ------------ ------------ INCOME TAXES (note 11): Current ........................... 6,907,754 5,265,482 1,903,128 Deferred .......................... 59,327 (94,441) (18,027) ------------ ------------ ------------ 6,967,081 5,171,041 1,885,101 ------------ ------------ ------------ Income before cumulative effect of changes in accounting principles .................. 17,348,828 13,505,727 7,134,035
Year ended December 31, ---------------------------------------- 1995 1994 1993 ------------ ------------ ------------ EARNINGS PER COMMON SHARE: Income before cumulative effect of changes in accounting principles $ 1.62 $ 1.29 $ .70
Average number of shares outstanding 10,685,344 10,431,925 10,197,999 ============ ============ ============
UNREALIZED HOLDING GAINS (LOSSES) ON FIXED MATURITY SECURITIES AVAILABLE- FOR-SALE, NET OF TAX: Beginning of year .................. (1,316,596) 2,068,451 -
----------- ----------- ----------- End of year ........................ $ 817,965 $ - $ (19,800) ----------- ----------- -----------
TREASURY STOCK AT COST: Beginning of year ................. (110,067) (81,386) (483,344) Purchase of shares for the treasury (653,967) (28,681) (126,948) Sale of shares from the treasury .. 663,613 - 528,906 ------------ ------------ ------------ End of year ....................... (100,421) (110,067) (81,386) ------------ ------------ ------------ Total stockholders' equity ...... $136,888,758 $116,726,689 $109,633,769 ============ ============ ============
Year ended December 31, ------------------------------------- 1995 1994 1993 ----------- ----------- ----------- CASH FLOWS FROM OPERATING ACTIVITIES: Net income ........................... $17,348,828 $13,505,727 $ 9,755,379 ----------- ----------- ----------- Adjustments to reconcile net income to net cash provided by (used in) operating activities: Cumulative effect of changes in accounting principles, net of tax ............................ - - (2,621,344) Losses and settlement expenses ... 2,240,494 5,372,801 8,010,617 Unearned premiums ................ 1,094,577 1,731,514 650,196 Other policyholders' funds ....... 490,719 247,816 (840,604) Deferred policy acquisition costs (321,134) (694,771) 413,967 Indebtedness of related party (note 4) ................. (508,893) 13,228,868 (8,639,436) Accrued investment income ........ (188,986) (725,182) (242,595) Accrued income taxes: Current ........................ 802,669 1,186,000 (118,000) Deferred ....................... 59,327 (94,441) (18,027) Provision for amortization ....... (82) 4,101 (23,072) Realized investment gains ........ (1,043,730) (519,567) (684,445) Postretirement benefits .......... 403,138 549,225 255,782 Reinsurance receivables .......... 2,018,105 3,542,358 9,389,384 Prepaid reinsurance premiums ..... 315,152 711,151 805,733 Amortization of deferred income .. (343,653) (433,979) (259,217) Other, net ....................... 2,284,532 706,967 225,040 ----------- ----------- ----------- 7,302,235 24,812,861 6,303,979 Cash provided by the commutation of outstanding reinsurance balances by the reinsurance subsidiary (note 2) ............ - 686,962 -
CASH FLOWS FROM FINANCING ACTIVITIES: Issuance of common stock .......... 2,859,364 2,403,285 1,670,536 Dividends paid to stockholders .... (5,662,346) (5,422,164) (5,303,032) Sales (purchases) of treasury stock, net ...................... 9,646 (28,681) 401,958 ------------ ------------ ----------- Net cash used in financing activities ............... (2,793,336) (3,047,560) (3,230,538) ------------ ------------ ------------ NET (DECREASE) INCREASE IN CASH ..... (59,785) 583,018 (1,334,309) Cash at beginning of year ........... 1,258,221 675,203 2,009,512 ------------ ------------ ------------ Cash at end of year ................. $ 1,198,436 $ 1,258,221 $ 675,203 ============ ============ ============
Ceded reinsurance activities are reported on the basis of Statement of Financial Accounting Standards (SFAS) 113, "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts." SFAS 113 requires a gross (rather than net) balance sheet presentation for ceded reinsurance amounts and addresses the recognition of gain or loss resulting from reinsurance transactions and appropriate financial statement disclosure of reinsurance activities.
The Company's carrying value for investments is reduced to its estimated realizable value if a decline in the market value is deemed other than temporary. Such reductions in carrying value are recognized as realized losses and charged to income. Premiums and discounts on debt securities are amortized over the life of the security as an adjustment to yield using the effective interest method. Realized gains and losses on disposition of investments are included in net income. The cost of investments sold is determined on the first-in, first-out method. Included in investments at December 31, 1995 and 1994 are securities on deposit with various regulatory authorities as required by law amounting to $11,971,564 and $11,331,550, respectively.
The cost of retiree health care and life insurance benefits relating to the Company's participation in Employers Mutual's postretirement benefits plans is recognized on the basis of SFAS 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." Benefits provided under these plans are unfunded and are subject to change.
Deferred income taxes are provided for temporary differences between financial statement carrying values of assets and liabilities and their respective tax bases on the basis of SFAS 109, "Accounting for Income Taxes." A valuation allowance is established to reduce deferred tax assets to their net realizable value if it is "more likely than not" that a tax benefit will not be realized.
Earnings per common share are computed by dividing earnings by the weighted average number of common shares outstanding during each year.
The three property and casualty insurance subsidiaries of the Company and two subsidiaries 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 and assumes from Employers Mutual an amount equal to its participation in the pool. All losses, settlement expenses and other underwriting and administrative expenses, excluding the voluntary reinsurance business assumed by Employers Mutual from unaffiliated insurance companies, are prorated among the parties on the basis of participation in the pool. Operations of the pool give rise to intercompany balances with Employers Mutual, which are settled on a quarterly basis. The investment activities and income tax liabilities of the pool participants are not subject to the pooling agreement.
Premiums assumed by the reinsurance subsidiary from Employers Mutual amounted to $36,433,443, $39,899,335 and $34,445,978 in 1995, 1994 and 1993, respectively. It is customary in the reinsurance business for the assuming company to compensate the ceding company for the acquisition expenses it incurred in the generation of the business. Commissions paid by the reinsurance subsidiary to Employers Mutual amounted to $8,224,060, $9,387,371 and $7,170,782 in 1995, 1994 and 1993, respectively.
The reinsurance subsidiary pays an annual override commission to Employers Mutual in connection with the $1,000,000 cap on losses per event, which totaled $1,912,756, $2,094,715 and $1,808,527 in 1995, 1994 and 1993, respectively. The reinsurance subsidiary also pays for 95 percent of the outside reinsurance protection Employers Mutual purchases to protect itself from catastrophic losses on the assumed reinsurance business. This cost is recorded as a reduction to the premiums received by the reinsurance subsidiary and amounted to $1,983,579 in 1995, $2,836,067 in 1994 and $2,438,919 in 1993. Employers Mutual retained losses and settlement expenses totaling $1,103,442 in 1995, $7,019,772 in 1994 and $615,000 in 1993 under this agreement.
The reinsurance subsidiary has an aggregate excess of loss reinsurance treaty with Employers Mutual which provides protection from a large accumulation of retentions resulting from multiple catastrophes in any one calendar year. The coverage provided is $2,000,000, excess of $3,000,000 ($2,500,000 in 1994 and 1993) aggregate losses retained, excess of $200,000 per event. Maximum recovery is limited to $2,000,000 ($4,000,000 in 1994 and 1993) per accident year. The reinsurance subsidiary recovered $0, $0 and $143,501 under this treaty and paid reinstatement premiums of $0, $0 and $208,470 in 1995, 1994 and 1993, respectively. Total premiums paid to Employers Mutual amounted to $499,950, $557,842 and $708,445 in 1995, 1994 and 1993, respectively.
In conjunction with the implementation of the $1,000,000 cap on losses assumed under the quota share agreement, the reinsurance subsidiary terminated its catastrophe reinsurance treaty with Employers Mutual effective January 1, 1993. This treaty paid losses in excess of $1,000,000 resulting from any one catastrophe, subject to a maximum loss of $3,000,000. Maximum recovery was limited to $6,000,000. The reinsurance subsidiary recovered $306,250 under this treaty in 1993.
Effective October 31, 1993, Employers Mutual commuted the portion of the quota share agreement that pertained to a voluntary pool that handles large "highly protected" risks. In connection with this change in the quota share agreement, the Company's liabilities decreased $3,827,201 and invested assets decreased $2,619,776. Employers Mutual reimbursed the Company $1,207,425 for commissions incurred to generate this business. No reserve discount was calculated as this business involved short-tail property coverage.
As of December 31, 1995, deductions for reinsurance ceded to two unaffiliated reinsurers aggregated $8,774,115, which represented a significant portion of the total prepaid reinsurance premiums and reinsurance receivables for losses and settlement expenses. These amounts reflect the property and casualty insurance subsidiaries' pool participation percentage of amounts ceded by Employers Mutual to these organizations in connection with its role as "service carrier". Under these arrangements, Employers Mutual writes business for these organizations on a direct basis and then cedes 100 percent of this business to these organizations. Credit risk associated with these amounts is minimal as all companies participating in these organizations are responsible for the liabilities of such organizations on a pro rata basis.
The effect of reinsurance on premiums written and earned, and losses and settlement expenses incurred for the three years ended December 31, 1995 is presented below.
Prior to December 31, 1993, the parties to the pooling agreement recorded amounts assumed from the National Workers' Compensation Reinsurance Pool on a net basis. Under this approach, reserves for outstanding losses and unearned premiums were reported as liabilities under "Indebtedness to Related Party" in the Company's consolidated financial statements. Effective December 31, 1993, the parties to the pooling agreement began recording these amounts as outstanding losses and unearned premiums. As a result, outstanding losses increased $11,436,543, unearned premiums increased $1,711,288 and indebtedness to related party decreased $13,147,831. There was no income effect from this reclassification. The Company collected the balance due from Employers Mutual in the first quarter of 1994.
Ceded reserves for losses and settlement expenses, beginning of year .......................... 14,146,874 17,454,679 25,253,507 ------------ ------------ ------------ Net reserves for losses and settlement expenses, beginning of year .......................... 189,034,741 179,667,173 190,135,358 ------------ ------------ ------------ Incurred losses and settlement expenses: - ---------------------- Provision for insured events of the current year .......... 123,876,601 123,343,829 119,896,526
Underwriting results of the Company are significantly influenced by estimates of loss and settlement expense reserves. Changes in reserve estimates are reflected in operating results in the year such changes are recorded. During the last three years the Company has experienced favorable development in the provision for insured events of prior years. The majority of the favorable development has come from the property and casualty insurance subsidiaries, which have benefited from state reform measures in workers' compensation insurance and various cost control functions implemented by Employers Mutual to minimize losses. Favorable development has also been experienced in the reinsurance subsidiary and the nonstandard risk auto insurance subsidiary, but to a lesser degree.
The property and casualty insurance subsidiaries have historically experienced favorable development in their reserves and current reserving practices have not been relaxed; however, the level of favorable development experienced in 1995 is not expected to continue.
Prior to 1995, the members of the pooling agreement calculated IBNR reserves for asbestos and environmental claims by applying a factor to the case basis reserves. IBNR reserve levels produced with this methodology tended to vary from year to year due to the relatively small amount of case basis reserves carried for these types of claims. At December 31, 1995, a portion of the current IBNR reserve was allocated to these exposures to reflect estimated ultimate losses. No additional IBNR reserves were established.
Estimating loss and settlement expense reserves for asbestos and environmental related claims is very difficult due to the many uncertainties surrounding these types of claims. Such uncertainties include the fact that the legal definition of asbestos and environmental damage is still evolving, the assignment of responsibility varies widely by state and claims often emerge long after the policy has expired, making assignment of damages to the appropriate party and to the time period covered by a particular policy difficult. In establishing reserves for these types of claims, management monitors the relevant facts concerning each claim, the current status of the legal environment, the social and political conditions and the claim history and trends within the Company and the industry.
Statutory surplus of the Company's insurance subsidiaries was $97,385,213 and $86,820,039 at December 31, 1995 and 1994, respectively. Statutory net income of the Company's insurance subsidiaries was $17,170,163, $13,430,353 and $8,788,458 for the three years ended December 31, 1995.
The National Association of Insurance Commissioners utilizes a risk-based capital model to help state regulators assess the capital adequacy of insurance companies and identify property/casualty insurers that are in (or are perceived as approaching) financial difficulty by establishing minimum capital needs based on the risks applicable to the operations of the individual insurer. The risk-based capital requirements for property and casualty insurance companies measure three major areas of risk: asset risk, credit risk and underwriting risk. Companies having less statutory surplus than required by the risk-based capital requirements are subject to varying degrees of regulatory scrutiny and intervention, depending on the severity of the inadequacy. The Company's insurance subsidiaries' ratio of total adjusted capital to risk-based capital at December 31, 1995 is well in excess of the minimum level required.
Income taxes .................... - - 5,595,177 Postretirement benefits ......... - - (2,165,900) Unearned premiums ............... - - (807,933) ------------ ------------ ------------ Net income, GAAP basis .............. $ 17,348,828 $ 13,505,727 $ 9,755,379 ============ ============ ============
The amortized cost and estimated market value of securities held-to- maturity and available-for-sale as of December 31, 1995 are as follows. The estimated market value is based on quoted market prices, where available, or on values obtained from independent pricing services.
Gross Gross Estimated Amortized unrealized unrealized market December 31, 1995 cost gains losses value ----------------- ------------ ----------- ----------- ------------ Securities held-to-maturity: Fixed maturity securities: U.S. treasury securities and obligations of U.S. government corporations and agencies ............. $115,512,952 $ 9,136,643 $ (909)$124,648,686 Obligations of states and political subdivisions ......... 37,972,295 805,805 - 38,778,100 Mortgage-backed securities ........... 37,955,569 1,930,393 - 39,885,962 ------------ ----------- ----------- ------------ Total securities held-to-maturity $191,440,816 $11,872,841 $ (909)$203,312,748 ============ =========== =========== ============
Equity securities ........ 14,771,422 1,239,341 - 16,010,763 ------------ ----------- ----------- ------------ Total securities available-for-sale $151,871,361 $ 6,614,867 $ (114,896)$158,371,332 ============ =========== =========== ============
The amortized cost and estimated market value of securities held-to- maturity and available-for-sale as of December 31, 1994 are as follows.
Gross Gross Estimated Amortized unrealized unrealized market December 31, 1994 cost gains losses value ----------------- ------------ ----------- ----------- ------------ Securities held-to-maturity: Fixed maturity securities: U.S. treasury securities and obligations of U.S. government corporations and agencies ............. $102,480,740 $ 1,239,742 $(1,142,326)$102,578,156 Obligations of states and political subdivisions ......... 78,423,605 876,074 (3,804,723) 75,494,956 Debt securities issued by foreign governments 583,309 7,411 - 590,720 Public utilities ....... 8,622,154 - (370,847) 8,251,307 Corporate securities ... 13,052,550 17,625 (574,197) 12,495,978 Mortgage-backed securities ........... 40,487,362 469,879 (1,646,870) 39,310,371 ------------ ----------- ----------- ------------ Total securities held-to-maturity $243,649,720 $ 2,610,731 $(7,538,963)$238,721,488 ============ =========== =========== ============
Securities available-for sale: Fixed maturity securities: U.S. treasury securities $ 15,835,019 $ - $ - $ 15,835,019 Obligations of states and political subdivisions ......... 55,274,052 1,275,408 (2,436,572) 54,112,888 Debt securities issued by foreign governments 1,994,980 - (110,260) 1,884,720 Corporate securities ... 4,250,000 - - 4,250,000 Other debt securities .. 454,941 - (45,172) 409,769 ------------ ----------- ----------- ------------ Total securities available-for-sale $ 77,808,992 $ 1,275,408 $(2,592,004)$ 76,492,396 ============ =========== =========== ============
Securities available-for-sale: Due in one year or less ................... $ 4,661,697 $ 4,706,611 Due after one year through five years ..... 51,336,077 51,891,447 Due after five years through ten years .... 49,477,831 52,246,301 Due after ten years ....................... 31,624,334 33,516,210 ------------ ------------ Totals .................................. $137,099,939 $142,360,569 ============ ============
Proceeds from calls, prepayments and sales of securities held-to-maturity and available-for-sale and realized investment gains and losses were as follows. There were no sales of securities classified as held-to-maturity during 1995; all activity is due to calls, prepayments and maturities.
Year ended December 31, ------------------------------------- 1995 1994 1993 ----------- ----------- ----------- Fixed maturity securities held-to-maturity: Proceeds from calls and prepayments $ 6,492,429 $26,469,534 $37,759,956 Gross realized investment gains ... 32,733 501,628 706,059 Gross realized investment losses .. 2,388 1,027 9,682
Year ended December 31, ------------------------------------- 1995 1994 1993 ----------- ----------- ----------- Interest on fixed maturities .......... $22,895,745 $20,886,029 $20,862,221 Dividends on equity securities ........ 235,451 14,167 65,065 Interest on short-term investments .... 821,560 597,896 442,160 Other interest ........................ - 1,552 - ----------- ----------- ----------- Total investment income ........... 23,952,756 21,499,644 21,369,446 Investment expense .................... 778,962 569,964 589,495 ----------- ----------- ----------- Net investment income ............. $23,173,794 $20,929,680 $20,779,951 =========== =========== ===========
Year ended December 31, ------------------------------------- 1995 1994 1993 ----------- ----------- ----------- Fixed maturity securities ........... $ 6,577,226 $(4,450,612) $ 3,134,016 Applicable income taxes ............. (1,788,614) 1,065,565 (1,065,565) ----------- ----------- ----------- Total fixed maturity securities ... 4,788,612 (3,385,047) 2,068,451 ----------- ----------- ----------- Equity securities ................... 1,239,341 30,000 112,000 Applicable income taxes ............. (421,376) (10,200) 10,200 ----------- ----------- ----------- Total equity securities ........... 817,965 19,800 122,200 ----------- ----------- -----------
Temporary differences between the consolidated financial statement carrying amount and tax basis of assets and liabilities that give rise to significant portions of the deferred tax asset at December 31, 1995 and 1994 relate to the following:
Less valuation allowance .......................... (1,000,000) (1,447,643) ----------- ----------- Total deferred income tax asset ............... 18,216,829 18,221,386 ----------- ----------- Deferred policy acquisition costs ................. (2,963,021) (2,853,836) Net unrealized holding gains ...................... (2,209,990) - Other, net ........................................ (1,122,636) (1,177,051) ----------- ----------- Total gross deferred income tax liability ..... (6,295,647) (4,030,887) ----------- ----------- Net deferred income tax asset ............... $11,921,182 $14,190,499 =========== ===========
The valuation allowance decreased $447,643 in 1995 after increasing by the same amount in 1994. This change in the valuation allowance relates to tax benefits associated with unrealized holding losses on fixed maturity securities available-for-sale that existed at December 31, 1994 but no longer exist at December 31, 1995. The valuation allowance of $1,000,000 at December 31, 1995 relates to the tax benefits associated with postretirement benefit deductions that are scheduled to reverse more than fifteen years into the future. The valuation allowance was established due to the uncertainty concerning the future realization of these tax benefits.
Based upon anticipated future taxable income and consideration of all other available evidence, management believes that it is "more likely than not" that the Company's net deferred income tax asset will be realized. The Company has had cumulative taxable income in the five-year period of 1991 through 1995 of approximately $54,181,000.
The actual income tax expense for the years ended December 31, 1995, 1994 and 1993 differed from the "expected" tax expense for those years (computed by applying the United States federal corporate tax rate of 35 percent (34 percent in 1994 and 1993) to income before income taxes and cumulative effect of changes in accounting principles) as follows:
Year ended December 31, ------------------------------------- 1995 1994 1993 ----------- ----------- ----------- Computed "expected" tax expense ...... $ 8,510,568 $ 6,350,101 $ 3,066,506 Increases (decreases) in tax resulting from: Tax-exempt interest income ....... (2,190,686) (2,034,273) (1,171,612) Change in accrual of prior year taxes .......................... - (209,734) (252,839) Settlement of tax examinations ... 182,309 147,098 117,497 Proration of tax-exempt interest 235,330 223,484 123,342 Other, net ....................... 229,560 694,365 2,207 ----------- ----------- ----------- Income taxes ................... $ 6,967,081 $ 5,171,041 $ 1,885,101 =========== =========== ===========
Comprehensive income tax expense (benefit) included in the consolidated financial statements for the years ended December 31, 1995, 1994 and 1993 was as follows:
The following tables set forth the funded status and the components of the net periodic pension cost for the Employers Mutual defined benefit retirement plan, based upon a measurement date of November 1, 1995, 1994 and 1993, respectively:
Projected benefit obligation for service rendered to date .......... $(66,544,344) $(69,337,553) $(44,579,398) Plan assets at fair value ........... 72,048,850 66,760,033 51,625,386 ------------ ------------ ------------ Plan assets greater (less) than projected benefit obligation ...... 5,504,506 (2,577,520) 7,045,988 Unrecognized net loss from past experience different from that assumed and effects of changes in assumptions ............ 625,332 12,201,810 4,440,487 Prior service cost not yet recognized in net periodic pension cost ...... 3,765,174 3,955,406 4,374,510 Unrecognized portion of initial net asset ......................... (5,031,812) (6,107,252) (7,182,692) ------------ ------------ ------------ Prepaid pension cost ........ $ 4,863,200 $ 7,472,444 $ 8,678,293 ============ ============ ============
The unrecognized net asset is being recognized over 12.5 to 15.2 years beginning January 1, 1987. Prior service costs are being amortized over 12 to 14 years beginning January 1, 1993. The weighted average discount rate used to measure the projected benefit obligation was 7.00 percent for 1995, 7.25 percent for 1994 and 6.75 percent for 1993. The assumed long-term rate of return on plan assets was 8.00 percent for 1995, 1994 and 1993. The rate of increase in future compensation levels used in measuring the projected benefit obligation was 5.30 percent in 1995, 1994 and 1993. Pension expense for the Company amounted to $572,062, $298,021 and $103,846 in 1995, 1994 and 1993, respectively.
The Company adopted SFAS 106 as of January 1, 1993. The Company's transition obligation as of January 1, 1993 amounted to $2,165,900 ($.21 per share), net of income tax benefits of $1,115,767, and was recorded as a cumulative effect adjustment to income.
Year ended December 31, ---------------------------------------- 1995 1994 1993 ------------ ------------ ------------ Actuarial present value of benefit obligations: Retirees ........................ $ 8,319,946 $ 7,404,314 $ 7,874,628 Fully eligible active plan participants .................. 4,775,324 4,859,467 5,681,430 Other active plan participants .. 6,705,681 6,767,662 7,783,183 ------------ ------------ ------------ Total ......................... 19,800,951 19,031,443 21,339,241
Service cost - benefits earned during the period ............... $ 907,297 $ 1,027,634 $ 596,498 Interest cost on accumulated postretirement benefit obligation 1,361,790 1,412,961 999,526 Net amortization and deferral ..... 409,556 571,595 - ------------ ------------ ------------ Net periodic postretirement benefit cost ................ $ 2,678,643 $ 3,012,190 $ 1,596,024 ============ ============ ============
Prior service costs are being amortized over 8.9 to 10 years beginning January 1, 1993. The assumed weighted average annual rate of increase in the per capita cost of covered health care benefits (i.e. the health care cost trend rate) for 1996 is 11.75 percent for individuals under age 65 and 10.00 percent for individuals age 65 and older, and is assumed to decrease gradually to 5.50 percent in 2005 and remain at that level thereafter. The health care cost trend rate assumption has a significant effect on the amounts reported. For example, a one-percentage-point increase in the assumed health care cost trend rate for each future year would increase the accumulated postretirement benefit obligation as of December 31, 1995 by $2,623,928 and the aggregate of the service and interest cost components of net periodic postretirement benefit cost for the year ended December 31, 1995 by $437,272. The weighted average discount rate used in determining the accumulated postretirement benefit obligation was 7.00 percent for 1995, 7.25 percent for 1994 and 6.75 percent for 1993.
Employers Mutual has several stock plans which utilize the common stock of the Company. The Company receives the current fair market value for any shares issued under the plans and all costs of the plans are borne by Employers Mutual or the company employing the individual optionees.
During 1995, Employers Mutual maintained two separate stock option plans for the benefit of officers and key employees of Employers Mutual and its subsidiaries. A total of 500,000 shares were reserved for issuance under the 1993 Employers Mutual Incentive Stock Option Plan (1993 Plan) and a total of 600,000 shares were reserved for the 1982 Employers Mutual Incentive Stock Option Plan (1982 Plan). Prior to 1995, options were also exercisable under the 1979 Employers Mutual Incentive Stock Option Plan (1979 Plan). All options under the 1979 Plan were either exercised or expired at December 31, 1994.
The Senior Executive Compensation and Stock Option Committee (the "Committee") of Employers Mutual's Board of Directors (the "Board") is the administrator of the plans. Option prices are determined by the Committee but can not be less than the fair market value of the stock on the date of grant.
During 1995, 119,550 options were granted under the 1993 plan at prices ranging from $10.00 to $10.38 and 88,645 options were exercised under the plans at prices ranging from $7.81 to $9.75. A summary of Employers Mutual's incentive stock option plans is as follows:
Year ended December 31, ---------------------------- 1995 1994 1993 -------- -------- -------- Shares available for purchase, beginning of year ...................... 463,940 486,546 55,720 Share registered for use in plan ......... - - 500,000 Shares purchased under plan .............. (17,895) (22,606) (24,160) Shares deregistered ...................... - - (45,014) -------- -------- -------- Shares available for purchase, end of year 446,045 463,940 486,546 ======== ======== ========
Year ended December 31, ---------------------------- 1995 1994 1993 -------- -------- -------- Shares available for purchase, beginning of year ...................... 188,099 194,048 - Shares registered for use in the plan .... - - 200,000 Shares purchased under plan .............. (2,531) (5,949) (5,952) -------- -------- -------- Shares available for purchase, end of year 185,568 188,099 194,048 ======== ======== ======== 15. COMMON STOCK
The Company maintains a Dividend Reinvestment and Common Stock Purchase Plan which provides stockholders with the option of reinvesting cash dividends in additional shares of the Company's common stock. Participants may also purchase additional shares of common stock without incurring broker commissions by making optional cash contributions to the plan. Any holder of shares of common stock is eligible to participate in the plan. During 1995, 1994 and 1993, Employers Mutual elected to participate in the Dividend Reinvestment Plan by reinvesting 50 percent of its dividends in additional shares of the Company's common stock. Activity under the plan was as follows:
Year ended December 31, --------------------------- 1995 1994 1993 -------- -------- -------- Shares available for purchase, beginning of year ....................... 537,660 758,266 944,453 Shares purchased under plan ............... (173,099) (220,606) (186,187) -------- -------- -------- Shares available for purchase, end of year 364,561 537,660 758,266 ======== ======== ======== Range of purchase prices .................. $10.00 $ 8.75 $10.00 to to to $14.75 $ 9.50 $10.25
The Company from time to time repurchases shares of its outstanding common stock in the open market or through negotiated purchases for the purpose of providing shares for use in the Company's Dividend Reinvestment and Common Stock Purchase Plan. The Company also repurchases shares of its outstanding common stock in connection with the issuance of new shares under Employers Mutual's stock option plans. Treasury stock activity was as follows:
Year ended December 31, ---------------------------- 1995 1994 1993 -------- -------- -------- Treasury shares, beginning of year ....... 10,931 8,090 49,392 Repurchased shares ....................... 56,096 2,841 12,568 Reissued shares .......................... (59,442) - (53,870) -------- -------- -------- Treasury shares, end of year ............. 7,585 10,931 8,090 ======== ======== ======== Average cost ............................. $ 11.66 $ 10.07 $ 10.06 ======== ======== ======== Gain on sale ............................. $115,166 $ - $ 23,261 ======== ======== ========
The carrying amount of (1) cash, (2) indebtedness to related party, (3) accounts receivable, (4) accounts payable and (5) accrued expenses approximate fair market value because of the short maturity of these instruments.
Earnings per share*.... $ .22 $ .37 $ .31 $ .39 ============ ============ ============ ============
Earnings per share:* Income from operations ........ $ .21 $ .14 $ .02 $ .33 Income from accounting changes .26 - - - ------------ ------------ ------------ ------------ Total ............ $ .47 $ .14 $ .02 $ .33 ============ ============ ============ ============