EMC Insurance Group Inc., a 59.2 percent owned subsidiary of Employers Mutual Casualty Company (Employers Mutual), is an insurance holding company with operations in property and casualty insurance and reinsurance. Property and casualty insurance is the most significant segment, representing 81.1 percent of consolidated premiums earned in 2008. For purposes of this discussion, the term “Company” is used interchangeably to describe EMC Insurance Group Inc. (Parent Company only) and EMC Insurance Group Inc. and its subsidiaries. Employers Mutual and all of its subsidiaries (including the Company) and an affiliate are referred to as the “EMC Insurance Companies.”
Operations of the pool give rise to inter-company balances with Employers Mutual, which are settled on a quarterly basis. The investment and income tax activities of the pool participants are not subject to the pooling agreement. The pooling agreement provides that Employers Mutual will make up any shortfall or difference resulting from an error in its systems and/or computation processes that would otherwise result in the required restatement of the pool participants’ financial statements.
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 loss event occurs because the reinstatement premium income received by the reinsurance subsidiary may approximate, or even exceed, the amount of losses retained.
Central to management’s business plan to increase new business production is a focus on the Company’s only distribution channel, the independent insurance agent. Management spent a considerable amount of time during 2008 working closely with local branch underwriting and marketing personnel and their independent insurance agents to identify new business opportunities desirable to the Company. Supporting this focus on new business opportunities are sophisticated underwriting tools (including tools with predictive modeling and monitoring capabilities) that help determine whether individually submitted applications, as well as renewal business, are acceptable, along with the appropriate price for each individual risk. These underwriting tools produce information in real time to underwriters as they consider a new risk, or renew an existing risk. Management also implemented data mining software that is capable of producing easily accessible, highly insightful summary information that is quickly constructed from the vast amounts of data contained in Employers Mutual’s claims system. Such information is being used to alert management of conditions that have affected the pool participants’ underwriting results. Once alerted, management can quickly adjust underwriting practices and/or pricing in an effort to address and mitigate any developing adverse trends.
On February 13, 2009, the Company announced that Employers Mutual had recently began informing its independent agents that EMC Insurance Companies had recently submitted plans to regulatory authorities in the states of Georgia, Louisiana, Mississippi, North Carolina, Pennsylvania and Virginia seeking to withdraw from personal lines programs in those states. This action is being taken due to management’s conclusion, based on a number of factors, that these states offer only limited long-term growth and profit potential. Additionally, personal lines business does not represent a large part of the marketing plans of the local branch offices affected. The combination of these factors results in a disproportionately high cost of conducting personal lines business in these states.
The planned exit from personal lines business in these six states should in no way be construed as a diminished emphasis on personal lines business. Rather, this action is being taken so that the EMC Insurance Companies’ resources can be directed toward territories which offer the greatest potential for long-term growth and profitability.
Through its participation in the pooling agreement, the Company had approximately $2,700,000 in personal lines written premiums in these states in 2008, which represented less than 1.0 percent of the Company’s total written premiums. It is anticipated that the entire withdrawal process could take from 24 to 30 months.
Over the past several years management has devoted a substantial amount of time and resources to improving the adequacy and consistency of the Company’s case loss reserves by implementing procedures and guidelines that assist claims personnel in establishing and maintaining proper reserve amounts. Because of these improvements in the claims handling process, favorable development on prior years’ case loss reserves has been experienced during the past three years.
From management’s perspective, investors and potential investors should not place undue emphasis on the composition of the Company’s underwriting results (i.e. the breakdown between the amount of favorable development reported on prior years’ reserves versus the indicated current accident year results) because, as explained below, the Company’s reserving methodology does not lend itself to that type of analysis very well. Management believes that it is important for investors and potential investors to have an appropriate understanding of the Company’s reserving methodology so that they are able to properly interpret the Company’s results of operations and make informed investment decisions. Following is a brief discussion of the Company’s reserving methodology.
As part of the ongoing effort to enhance the effectiveness of the Company’s reserving process, the methodology was expanded during 2007 to include bulk case loss reserves. These bulk reserves supplement the aggregate reserves of the individual claim files and are used to help maintain a consistent level of overall case loss reserve adequacy. Bulk case loss reserves (both positive and negative) are established when necessary to keep the estimated adequacy of the Company’s carried case loss reserves at a level consistent with management’s best estimate of the Company’s overall liability. For financial reporting purposes, bulk case loss reserves are included in case loss reserves.
Without a proper understanding of the Company’s reserving methodology, the current and more recent accident year combined ratios can be misinterpreted. For example, the Company reported a combined ratio of 108.3 percent in 2008. If the large amount of favorable development experienced on prior years’ reserves during this period is excluded from the calculation, it would appear that the 2008 accident year generated a combined ratio of 117.4 percent. However, as has been the case for other recent accident years, management believes that the 2008 accident year combined ratio will continue to decline as claims are settled, and will ultimately settle in a range between 111 and 115 percent.
It is management’s intention to continue to apply this reserving methodology on a consistent basis. With reasonably consistent levels of reserve adequacy, management expects earnings from favorable development of prior accident year reserves to continue in future years. For that reason, management believes that less emphasis should be placed on the composition of the Company’s underwriting results between the current and prior accident years, and more emphasis should be placed on where the Company’s carried reserves fall within the range of actuarial indications.
At December 31, 2008, the Company’s loss and settlement expense reserves were in the upper quarter of the range of actuarial indications, which is consistent with the actuarial analysis completed at December 31, 2007. Although the actuarial analysis as of December 31, 2008 indicates that the Company’s loss and settlement expense reserves are at a high level of adequacy, management is not able to predict whether, or to what extent, the Company will continue to experience favorable development on its reserves.
During 2008, the Company experienced a record $50,800,000 of catastrophe and storm losses. This unusually high level of catastrophe and storm losses is attributed to several severe storm systems that produced wind, tornado and hail losses over a wide geographic region of the Midwest, including a devastating EF5 tornado that struck Parkersburg, Iowa, as well as Hurricanes Gustav and Ike. Catastrophe and storm losses added 13.0 percentage points to the Company’s combined ratio in 2008, compared to 5.5 points in 2007.
During the second quarter of 2008, management evaluated and implemented a new investment strategy targeting high-quality residential mortgage-backed securities. This investment strategy, which is being administered by Harris Investment Management, Inc., was designed to take advantage of the liquidity-induced market dislocation that existed in the securitized residential mortgage marketplace and targeted AAA rated residential mortgage-backed securities (no securities backed by subprime mortgages were purchased). The investments were diversified with respect to key risk factors (such as vintage, originator and geography), have a weighted-average life of 4.4 years and have a weighted-average book yield of 7.8 percent. The Company committed $40,000,000 to this strategy and all of the funds were invested as of December 31, 2008.
As a result of regulatory changes in Germany, Employers Mutual ceased being an approved reinsurer in Germany effective January 1, 2009. To avoid the loss of approximately $5,000,000 of assumed reinsurance business because of this regulatory change, management determined that the Company’s reinsurance subsidiary will begin writing this business on a direct basis (outside the quota share agreement) effective January 1, 2009. Since this business will be written outside the quota share agreement, it will not be subject to the $2,000,000 cap on losses per event. Management has determined that this business has a low risk of generating losses above $2,000,000 per event and has therefore elected to not purchase stand-alone reinsurance coverage for these risks.
The financial crisis that began in 2008 had a significant impact on the funded status of Employers Mutual’s employee benefits plans, as the fair value of the assets in the pension and postretirement benefit plans declined significantly. Management has historically maintained a funding level within the pension plan that was sufficiently high enough to avoid any restrictions on the payment of retirement benefits to employees. Due to the severe and sudden decline in the fair value of the plan assets during 2008, management decided that maintaining such a high funding level was not practicable. The concern was not that some employees might have restrictions placed on their retirement benefit payouts, but rather that a large contribution, coupled with a recovery in the financial markets, could result in excessive overfunding of the pension plan. Management ultimately decided to contribute $15,000,000 to the pension plan, which was deemed sufficient to maintain an adequate funding level.
As regards the postretirement benefit plans, management has historically funded the Voluntary Employee Beneficiary Association (“VEBA”) trust that supports those plans at the maximum tax deductible amount. Due to the significant decline in the funded status of the VEBA trust that occurred during 2008, the maximum tax deductible amount increased substantially from prior years. Recognizing this as an opportunity to improve the funded status of the VEBA trust, management elected to contribute the maximum tax deductible amount of $12,200,000 in 2008.
One assumption underlying aggregate reserve estimation methods is that the claims inflation trends implicitly built into the historical 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, 2008 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 variance 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 unexpected claims inflation trend could arise from a variety of sources including a change 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 unexpected one percent variance in the inflationary trend would have on the Company’s results of operations over the lifetime of the underlying claims is shown below. A variance in the inflationary trend 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 one percent variance in the projected inflationary trend 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.
A fourth assumption is that IBNR emergence as a percentage of reported losses is historically consistent and will continue at the historical level. The following table displays the estimated impact on the Company’s results of operations, for the latest ten accident years, of a five percent variance in IBNR losses from the level anticipated in the loss projection factors. Under this scenario, future loss payments would be expected to vary from actuarial reserve estimates by these amounts. This variance in IBNR emergence could occur in one year or over multiple years. 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.
The property and casualty insurance subsidiaries have exposure to environmental and asbestos claims arising primarily from the other liability line of business. This exposure is closely monitored by management, and the IBNR loss reserves have been established to cover estimated ultimate losses. Currently, asbestos reserves are based on the results of an independent consultant’s ground-up study of the pool participants’ asbestos exposures that was completed in 2006. These reserves were increased in 2008 based on an examination of the implied three-year survival ratio (ratio of loss reserves to the three-year average of loss payments). Environmental reserves are established in consideration of the implied three-year survival ratio. Estimation of ultimate liabilities for these exposures is unusually difficult due to unresolved issues such as whether coverage exists, the definition of an occurrence, the determination of ultimate damages and the allocation of such damages to financially responsible parties. Therefore, any estimation of these liabilities is subject to greater than normal variation and uncertainty, and ultimate payments for losses and settlement expenses for these exposures may differ significantly from the carried reserves.
At December 31, 2008, there was no backlog in the processing of assumed reinsurance information. Approximately $78,573,000, or 54 percent, of the reinsurance segment’s carried reserves were reported by the ceding companies. Employers Mutual receives loss reserve and paid loss data from the ceding companies on individual excess-of-loss business. If a claim involves a single or small group of claimants, a summary of the loss and claim outlook is normally provided. Summarized data is provided for catastrophe claims and pro rata business, which is subject to closer review if inconsistencies are suspected.
Following is a summary of the carried loss and settlement expense reserves for the reinsurance segment at December 31, 2008 and 2007.
Disputes with ceding companies do not occur often. Employers Mutual performs claims audits and encourages prompt reporting of reinsurance claims. Employers Mutual also 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, 2008.
The plaintiffs in the silicosis lawsuits are sandblasters, gravel and concrete workers, ceramic workers and road construction workers. All of these lawsuits are subject to express reservation of rights based upon the lack of an injury within the applicable policy periods because many silica lawsuits, like asbestos lawsuits, do not specifically allege dates of exposure or dates of injury. The pool participants’ policyholders (a refractory product manufacturer, small local concrete and gravel companies and a concrete cutting machine manufacturer) that have been named as defendants in these silica lawsuits have had little or no exposure and are routinely dismissed from silica litigation with nominal or no payment. While the expense of handling these lawsuits is high, it is not proportional to the number of plaintiffs, and is mitigated to some extent through cost sharing agreements with other insurance companies.
The Company’s current exposures to environmental claims include losses involving petroleum haulers, lead contamination, and soil and groundwater contamination in the State of Indiana. Claims from petroleum haulers are generally caused by overturned commercial vehicles and overfills at commercial and residential properties. Exposures for accident year losses preceding the 1980s include municipality exposures for closed landfills, small commercial businesses involved with disposing waste at landfills, leaking underground storage tanks and contamination from dry cleaning operations.
In 2004, the pool participants were presented with eight contamination claims filed against four of their petroleum marketers in Iowa and Indiana. The claims filed in Indiana were dismissed during 2007. These claims arose out of alleged contamination of municipal public water systems by the gasoline additive Methyl Tertiary Butyl Ether (“MTBE”). All MTBE lawsuits initiated in a number of states, including the states of Iowa and Indiana, were moved to their respective Federal courts and were then transferred to the United States District Court for the Southern District of New York, where they were consolidated. The pool participants are defending these claims under commercial auto policies which afford broadened pollution liability coverage for overfills. These claims are subject to express reservations of rights based upon the lack of property damage within the policy periods, because these lawsuits do not specifically allege dates of property damage or contamination, or any contamination that resulted from an overfill.
The Company has exposure to construction defect claims arising from general liability policies issued by the pool participants to contractors. Most of the pool participants’ construction defect claims are concentrated in a limited number of states, and the pool participants have taken steps to mitigate this exposure. Construction defect is a highly uncertain exposure due to such issues as whether coverage exists, definition of an occurrence, determination of ultimate damages, and allocation of such damages to financially responsible parties. Newly reported construction defect claims numbered 373, 345 and 410 in 2008, 2007 and 2006, respectively, and produced incurred losses and paid settlement expenses of approximately $2,855,000, $2,755,000 and $3,315,000 in each respective period. Incurred losses and paid settlement expenses on all construction defect claims totaled approximately $4,180,000 in 2008. At December 31, 2008, the Company carried case loss reserves of approximately $5,387,000 on 569 open construction defect claims.
The Company’s assumed casualty excess reinsurance business is also considered a highly uncertain exposure due to the significant periods of time that can elapse during the settlement of the underlying claims, and the fact that a reinsurance company generally has less knowledge than the ceding company about the underlying book of business and the ceding company’s reserving practices. Employers Mutual attempts to account for this uncertainty by establishing bulk IBNR loss reserves, using conservative assumed treaty limits and, to a much lesser extent, booking of individual treaty IBNR loss reserves (if reported by the ceding company) or establishing additional case loss reserves if the reported case loss reserves appear inadequate on an individual claim. While Employers Mutual is predominantly a property reinsurer, it does write casualty excess business oriented mainly towards shorter tail casualty lines of coverage. Employers Mutual avoids reinsuring large company working layer casualty risks, and does not write risks with heavy product liability exposures, risks with obvious latent injury manifestation, medical malpractice, and “for profit” Directors and Officers coverage. A small amount of casualty excess business on large companies is written, but generally on a “clash” basis only (layers above the limits written for any individual policyholder).
Prices or valuation techniques that require significant unobservable inputs. The unobservable inputs may reflect the Company’s own assumptions about the assumptions that market participants would use.
U.S. government-sponsored agencies and corporate securities (including fixed-rate corporate bonds, medium-term notes, and retail notes) are priced by determining a bullet (non-call) spread scale for each issuer for maturities going out to forty years. These spreads represent credit risk and are obtained from the new issue market, secondary trading, and dealer quotes. An option adjusted spread model is incorporated to adjust spreads of issues that have early redemption features. The final spread is then added to the U.S. Treasury curve. For notes with odd coupon payment dates, a cash discounting yield/price routine calculates prices from final yields.
Mortgage-backed securities are priced with models using spreads and other information solicited from Wall Street buy- and sell-side sources, including primary and secondary dealers, portfolio managers, and research analysts, to produce pricing for each tranche. To determine a tranche’s price, first the cash flow for each tranche is generated (using consensus prepayment speed assumptions including, as appropriate, a proprietary prepayment projection based on historical statistics of the underlying collateral), then a benchmark yield is determined (in relation to the U.S. Treasury curve for the maturity corresponding to the tranche’s average life estimate), and finally collateral performance and tranche level attributes are incorporated to adjust the benchmark yield to determine the tranche-specific spread. This is then used to discount the cash flows to generate the price. When cash flows or other security structure or market information is not available to appropriately price a security, broker quotes may be used with a zero spread bid-side valuation, resulting in the same values for the mean and ask prices.
On a quarterly basis, the Company receives from its independent pricing service a list of fixed maturity securities that were priced solely from broker quotes. Since this is not an observable input, any fixed maturity security in the Company’s portfolio that is on this list is classified as a Level 3 fair value measurement. At January 1, 2008, one of the Company’s fixed maturity securities (Continental Airlines) was on this list and was reported at the fair value provided by the independent pricing service ($697,000). This security was subsequently priced by the independent pricing service using observable inputs (as described above), and was transferred from the Level 3 fair value measurement category to the Level 2 fair value measurement category on March 31, 2008.
The estimated fair values obtained from the independent pricing sources are reviewed by the Company for reasonableness and any discrepancies are investigated for final valuation. For fixed maturity securities, this includes comparing valuations from the independent pricing source, the Company’s investment custodian, the SVO, and an analytical service for fixed maturity securities. For equity securities, a similar comparison is done between the valuations from the independent pricing service, the Company’s investment custodian, and the SVO. From these comparisons, material variances are identified and resolved to determine the final valuation used in the financial statements.
Deferred policy acquisition costs and related amortization are calculated separately for the property and casualty insurance segment and the reinsurance segment. The method followed in computing deferred policy acquisition costs limits the amount of such deferred costs to the estimated realizable value, which gives effect to the premium to be earned, related investment income, losses and settlement expenses and certain other costs expected to be incurred as the premium is earned. Deferred policy acquisition costs were not subject to limitation at December 31, 2008, and management does not anticipate future limitations to be likely due to the current adequacy of premium rates in both the insurance and reinsurance marketplaces.
The discount rate utilized in the valuations is based on an analysis of the total rate of return that could be generated by a hypothetical portfolio of high-quality bonds created to generate cash flows that match the plans’ expected benefit payments. No callable bonds are used in this analysis and the discount rate produced by this analysis is compared to interest rates of applicable published indices for reasonableness. The discount rates used in the pension benefit valuations at December 31, 2008, 2007 and 2006 were 6.25 percent, 6.00 percent and 5.75 percent, respectively. The discount rates used in the postretirement benefit valuations at December 31, 2008, 2007 and 2006 were 6.25 percent, 6.25 percent and 5.75 percent, respectively. A 0.25 percentage point decrease in the discount rates used in the 2008 valuations would increase the Company’s net periodic pension and postretirement benefit costs for 2009 by approximately $131,000. Conversely, a 0.25 percentage point increase in the 2008 discount rates would decrease the Company’s net periodic pension and postretirement benefit costs for 2009 by approximately $122,000.
The expected long-term rate of return on plan assets is developed considering actual historical results, current and expected market conditions, the mix of plan assets and investment strategy. The expected long-term rate of return on plan assets produced by this analysis and used in the pension valuations at December 31, 2008, 2007 and 2006 was 7.50 percent. The expected long-term rate of return on plan assets used in the postretirement benefit valuations at December 31, 2008, 2007 and 2006 was 6.00 percent. The actual rate of return earned on plan assets during 2008, which was significantly impacted by the financial crisis, was approximately negative 35 percent for the pension plan and negative 16 percent for the postretirement benefit plans. The expected long-term rate of return assumption is subject to the general movement of the economy, but is generally less volatile than the discount rate assumption. A decrease in the expected long-term rate of return assumption increases future expenses, whereas an increase in the assumption reduces future expenses. A 0.25 percentage point change in the 2008 expected long-term rate of return assumption would change the Company’s net periodic pension and postretirement benefit costs for 2009 by $129,000. For detailed information regarding the current allocation of assets within the pension and postretirement benefit plans, see note 11 of Notes to Consolidated Financial Statements under Item 8 of this Form 10-K.
The health care cost trend rate assumption represents the anticipated change in the cost of health care benefits due to factors outside of the plan. These factors include health care inflation, changes in health care utilization and delivery patterns, technological advances, and the overall health of the plan participants. The health care cost trend rate assumption is based on published information and general economic conditions. The health care cost trend rate assumption for 2008 was 9 percent, and is assumed to decrease gradually to 5 percent in 2012 and remain at that level thereafter.
In accordance with SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans,” the funded status of defined benefit retirement or other postretirement plans is recognized as a net asset or liability on the balance sheet. Future changes in the funded status of the plans will be recognized through other comprehensive income. In accordance with SFAS No. 158, the pension and postretirement benefit plans’ assets and obligations were measured as of the end of the Company’s fiscal year beginning in 2008.
The Company reported a net loss of $1,705,000 ($0.13 per share) in 2008 compared to net income of $42,478,000 ($3.09 per share) in 2007. The net loss for 2008 is primarily attributed to two factors: a record amount of catastrophe and storm losses and a record amount of “other-than-temporary” investment impairment losses generated by the severe and prolonged turmoil in the financial markets. Other factors contributing to the net loss for 2008 include an expected decline in the amount of favorable development experienced on prior years’ reserves, and a moderate, but steady, decline in overall premium rate levels.
Premiums earned for the property and casualty insurance segment decreased 1.6 percent to $315,598,000 in 2008 from $320,836,000 in 2007 as new business premium was not sufficient to offset the premium lost from declining rate levels and business not retained. New business policy counts were up in 2008, and helped generate a slight increase in total policy count in both the commercial and personal lines of business. However, while personal lines new business premium increased 9.9 percent, commercial lines new business premium declined 8.9 percent. The decline in commercial lines new business premium is attributed to a combination of declining rates (rate declines are larger in commercial lines of business) and reduced exposures on new business (with a corresponding reduction in premium). The growth in personal lines new business premium is occurring in selected territories which management has identified as having greater profit potential. Retention rates remain above industry standards, with commercial lines declining slightly to 86.2 percent, personal auto remaining steady at 87.5 percent, and personal property increasing slightly to 86.6 percent.
Premiums earned for the reinsurance segment increased 2.1 percent to $73,720,000 in 2008 from $72,223,000 in 2007. This increase is primarily attributed to the HORAD book of business and reflects an increase in both the estimate of earned but not reported (EBNR) premiums and accrued reinstatement premiums. Under the terms of the quota share agreement, the reinsurance segment receives reinstatement premium income that is collected by Employers Mutual from the ceding companies when 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. The increases in premium income in the HORAD book of business were largely offset by a decline in the amount of business assumed from the MRB pool. Both the MRB and HORAD books of business have suffered from the loss of a few accounts, increased retentions by some of the ceding companies and lower premium rates driven by increased rate competition. This was evident during the January and July renewal seasons as the reinsurance segment experienced an overall decline in the average rate on-line for its accounts. There was some additional minor deterioration in rates during the July renewal period, but increased terms on those accounts with recent loss experience kept overall rate adequacy at a fairly consistent level with that achieved on the January renewals. The January 2009 renewals saw some modest increases in reinsurance rates, and further increases in reinsurance rates are expected during 2009 due to the decline in industry capital noted above.
The loss and settlement expense ratio for the property and casualty insurance segment increased to 73.7 percent in 2008 from 62.2 percent in 2007. A record amount of Midwest storm losses, along with losses associated with Hurricanes Gustav and Ike, were the driving force behind this increase. Catastrophe and storm losses more than doubled to a record $42,729,000 in 2008 from $20,732,000 in 2007. These storm losses contributed 13.5 percentage points to the loss and settlement expense ratio in 2008, an increase of 7.0 percentage points over the comparable ratio in 2007. The record level of catastrophe and storm losses was caused by several severe storm systems that produced wind, tornado and hail losses over a wide geographic region of the Midwest, including a devastating EF5 tornado that struck Parkersburg, Iowa. Losses associated with Hurricanes Gustav and Ike totaled $3,065,000 and $3,185,000, respectively. Surprisingly, the majority of the property and casualty insurance segment’s losses from Hurricane Ike occurred in the Midwest. When the massive hurricane advanced away from the coast of Texas, it merged with a cold front traveling across the Midwest and generated a significant amount of wind damage in Ohio and Kentucky.
An expected decline in the amount of favorable development experienced on prior years’ reserves also contributed to the increase in the loss and settlement expense ratio of the property and casualty insurance segment. Lastly, the moderate, but steady, decline in premium rate levels over the past several years is estimated to have added approximately 3 percentage points to the loss and settlement expense ratio in 2008.
For the property and casualty insurance segment, the acquisition expense ratio declined to 34.8 percent in 2008 from 37.1 percent in 2007. This decrease is attributed to declines in the amount of expense related to policyholder dividends, contingent commissions (in the form of agents’ profit share), executive bonuses and contingent salaries, and postretirement benefits. The decline in policyholder dividend expense is largely due to a decrease in the estimated dividend payable on several of the Company’s safety dividend groups. The declines in executive bonuses and contingent salaries, as well as agents’ profit share expenses, reflect the large decline in underwriting profitability that occurred during 2008. The decline in postretirement benefits expense reflects a decrease in the service cost component and the amortization of a prior service credit resulting from a plan amendment that became effective in the first quarter.
Net investment income declined 0.2 percent to $48,403,000 in 2008 from $48,482,000 in 2007. Investment income was negatively impacted by the elimination of dividends on the perpetual preferred stocks of Federal Home Loan Mortgage Corporation (Freddie Mac) and the Federal National Mortgage Association (Fannie Mae), as well as a reduction in yields on cash and short term investments. There was a significant amount of call activity on the Company’s U.S. government agency securities during 2008 as a result of the declining interest rate environment. The proceeds from these called securities were invested in short-term securities until attractive long-term opportunities were identified.
The Company reported net realized investment losses of $24,456,000 in 2008 compared to net realized investment gains of $3,724,000 in 2007. Included in the 2008 loss amount is $16,017,000 of “other-than-temporary” investment impairment losses recognized on 38 equity securities as a result of the severe and prolonged turmoil in the financial markets, and $14,904,000 of losses recognized on the perpetual preferred stocks of Freddie Mac and Fannie Mae when these companies were placed under conservatorship by the U.S. government. For comparative purposes, “other-than-temporary” investment impairment losses for 2007 totaled $1,277,000 on 14 equity securities.
The Company reported an income tax benefit of $8,585,000 in 2008, compared to income tax expense of $16,441,000 in 2007. The relatively high ratio of income tax benefit to pretax loss for 2008 reflects the fact that a significant amount of Company’s investment income is received in the form of tax-exempt interest income.
Net income was $42,478,000 ($3.09 per share) in 2007, down 20.7 percent from the record net income of $53,547,000 ($3.91 per share) reported in 2006. This decrease was attributed to a large decline in underwriting profits in the property and casualty insurance segment, and was associated with an increase in both large losses 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. The reinsurance segment also experienced a decline in premium rate levels during 2007; however, the declines were smaller than those experienced in the direct insurance market. Consequently, underwriting results of the reinsurance segment remained strong during 2007. An increase in investment income was insufficient to offset the decline in underwriting income.
Premiums earned increased 0.4 percent to $393,059,000 in 2007 from $391,615,000 in 2006. This increase was attributed to the property and casualty insurance segment, as the reinsurance segment’s premium income declined for the year. Despite a continued decline in premium rate levels, the property and casualty insurance segment was able to achieve a small increase in top line growth by increasing new business premium and maintaining high retention levels. On an overall basis, rate competition increased moderately in the property and casualty insurance marketplace during 2007.
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 was associated with an account that was not renewed) was 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.
Losses and settlement expenses increased 8.5 percent to $247,839,000 in 2007 from $228,453,000 in 2006. The loss and settlement expense ratio increased to 63.1 percent in 2007 from 58.3 percent in 2006. Both of these increases were attributed to the property and casualty insurance segment, as the reinsurance segment reported a decline in its loss and settlement expense ratio in 2007.
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 was 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 previous two years resulted in an approximate 2.7 percentage point increase in the loss and settlement expense ratio in 2007.
The loss and settlement expense ratio for the reinsurance segment decreased to 66.9 percent in 2007 from 68.5 percent in 2006. This decline was primarily attributed to a smaller increase in the bulk IBNR loss reserve for the HORAD book of business. Favorable reserve development experienced in both 2007 and 2006 was primarily from the HORAD book of business, with the 2007 development largely coming from the 2004-2006 accident years and the 2006 development primarily coming from the 2004 and 2005 accident years. Catastrophe losses for 2007 include $321,000 assumed from MRB for the Greensburg, Kansas tornado.
Income tax expense decreased 27.9 percent to $16,441,000 in 2007 from $22,818,000 in 2006. The effective tax rates were 27.9 percent in 2007 and 29.9 percent in 2006. The decline in the effective tax rate in 2007 primarily reflected the large decline in pre-tax income earned relative to the amount of tax-exempt interest income earned.
The Company maintains a portion of its investment portfolio in relatively short-term and highly liquid investments to ensure the availability of funds to pay claims and expenses. At December 31, 2008, approximately 35 percent of the Company’s fixed maturity securities were in U.S. government or U.S. government-sponsored agency securities. This is down from approximately 55 percent at December 31, 2007 due to a significant amount of call activity on the Company’s U.S. government agency securities that occurred during 2008 due to the declining interest rate environment. The proceeds from these called securities were initially invested in short-term securities, until suitable long-term investment opportunities could be identified. A variety of maturities are maintained in the Company’s portfolio to assure adequate liquidity. The maturity structure of the fixed maturity securities is also established by the relative attractiveness of yields on short, intermediate and long-term securities. The Company does not invest in high-yield, non-investment grade debt securities. Any non-investment grade securities held by the Company are the result of rating downgrades that occurred subsequent to their purchase.
The Company considers itself to be a long-term investor and generally purchases fixed maturity securities with the intent to hold them to maturity. Despite this intent, the Company currently classifies purchases of fixed maturity securities as available-for-sale to provide flexibility in the management of its investment portfolio. At December 31, 2008, the Company had a net unrealized holding loss, net of deferred taxes, on its fixed maturity securities available-for-sale of $5,468,000, compared to a net unrealized holding gain, net of deferred taxes, of $12,298,000 at December 31, 2007. The fluctuation in the fair value of these investments is primarily due to changes in the interest rate environment during this time period, but also reflects a widening of risk premium spreads over U.S. Treasuries for corporate and U.S. government-sponsored agency securities. Since the Company does not actively trade in the bond market, such fluctuations in the fair value of these investments are not expected to have a material impact on the operations of the Company, as forced liquidations of investments is not anticipated. The Company closely monitors the bond market and makes appropriate adjustments in its portfolio as conditions warrant.
The Company’s cash balance was $183,000 and $263,000 at December 31, 2008 and 2007, respectively.
Employers Mutual contributed $15,000,000, $3,500,000 and $27,596,000 to its pension plan in 2008, 2007 and 2006, respectively, and plans to contribute approximately $25,000,000 to the pension plan in 2009. The Company reimbursed Employers Mutual $4,555,000, $1,069,000 and $8,410,000 for its share of the pension contributions in 2008, 2007 and 2006, respectively. Employers Mutual contributed $12,200,000, $3,800,000 and $5,100,000 to its postretirement benefit plans in 2008, 2007 and 2006, respectively, and expects to contribute approximately $2,800,000 to the postretirement benefit plans in 2009. The Company reimbursed Employers Mutual $3,495,000, $1,083,000 and $1,455,000 for its share of the postretirement benefit plan contributions in 2008, 2007 and 2006, respectively.
The Company’s property and casualty insurance subsidiaries have $25,000,000 of surplus notes issued to Employers Mutual. Effective February 1, 2008, the interest rate on these surplus notes was increased from 3.09 percent to 3.60 percent. Future reviews of the interest rate will be conducted by the Inter-Company Committees of the Boards of Directors of the Company and Employers Mutual every five years. Payment of interest and repayment of principal can only be made out of the applicable subsidiary’s statutory surplus and is subject to prior approval by the insurance commissioner of the respective state of domicile. The surplus notes are subordinate and junior in right of payment to all obligations or liabilities of the applicable insurance subsidiaries. Prior to December 31, 2007, the Company’s reinsurance subsidiary had $11,000,000 of surplus notes issued to Employers Mutual. These surplus notes were redeemed in the fourth quarter of 2007, along with accrued interest. Total interest expense incurred on these surplus notes was $889,000, $1,111,000 and $1,112,000 in 2008, 2007 and 2006, respectively. At December 31, 2008, EMCASCO Insurance Company and Illinois EMCASCO Insurance Company had received approval for the payment of interest accrued on the surplus notes during 2008, while Dakota Fire Insurance Company had not received the necessary approval.
The Company recorded “other-than-temporary” investment impairment losses totaling $30,921,000 on 40 equity securities during 2008, and $1,277,000 on 14 equity securities during 2007. Included in the 2008 amount is $14,904,000 of impairment losses on the perpetual preferred stocks of Freddie Mac and Fannie Mae resulting from the U.S. government placing these companies under conservatorship. The Company sold these perpetual preferred stocks during the fourth quarter of 2008 and recognized an additional loss of $141,000.
All non-investment grade fixed maturity securities held at December 31, 2008 (Great Lakes Chemical Corporation, American Airlines and US Freightways Corporation) had an aggregate unrealized loss of $1,050,000. 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.
Included in the realized loss amount of $5,749,000 attributed to securities that had been in an unrealized loss position for over twelve months is $5,700,000 associated with the perpetual preferred stock of Freddie Mac. This security experienced a significant decline in value during the third quarter when the U.S. government placed the company under conservatorship. Prior to the third quarter, the value of this security was only marginally under the Company’s carrying value.
The following table reflects the Company’s contractual obligations as of December 31, 2008. 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.
Interest expense on long-term debt reflects the interest expense on the surplus notes issued by the Company’s property and casualty insurance subsidiaries to Employers Mutual. Interest on the surplus notes is subject to approval by the issuing company’s state of domicile. The balance shown under the heading “More than 5 years” represents interest expense for years six through ten. Since the surplus notes have no maturity date, total interest expense could be greater than the amount shown. Dakota Fire was not granted approval to pay its 2008 surplus note interest at the end of 2008. The table above assumes such approval will be granted in 2009 and annually thereafter.
The participants in the pooling agreement are subject to guaranty fund assessments by states in which they write business. Guaranty fund assessments are used by states to pay policyholder liabilities of insolvent insurers domiciled in those states. Many states allow these assessments to be recovered through premium tax offsets. Estimated guaranty fund assessments of $1,506,000 and $1,714,000 and related premium tax offsets of $936,000 and $1,057,000 have been accrued as of December 31, 2008 and 2007, respectively. The guaranty fund assessments are expected to be paid over the next two years and the premium tax offsets are expected to be realized within ten years of the payments. The participants in the pooling agreement are also subject to second-injury fund assessments, which are designed to encourage employers to employ a worker with a pre-existing disability. Estimated second-injury fund assessments of $1,576,000 and $1,656,000 have been accrued as of December 31, 2008 and 2007, respectively. The second-injury fund assessment accruals are based on projected loss payments. The periods over which the assessments will be paid is not known.
The Company invests in high quality fixed maturity securities, thus minimizing credit quality risk. At December 31, 2008, the portfolio of long-term fixed maturity securities consisted of 0.6 percent U.S. Treasury, 33.9 percent government agency, 8.8 percent mortgage-backed, 36.3 percent municipal, and 20.4 percent corporate securities. At December 31, 2007, the portfolio of long-term fixed maturity securities consisted of 0.6 percent U.S. Treasury, 54.3 percent government agency, 1.3 percent mortgage-backed, 30.3 percent municipal, and 13.5 percent corporate securities.
Ratings for preferred stocks and fixed maturity securities with initial maturities greater than one year are assigned by nationally recognized statistical rating organizations (referred to generically as NRSROs, which includes such organizations as Moody’s Investor’s Services, Inc., Standard and Poor, etc.). NRSROs’ rating processes seek to evaluate the quality of a security by examining the factors that affect returns to investors. NRSROs’ ratings are based on quantitative and qualitative factors, as well as the economic, social and political environment in which the issuing entity exists. The quantitative factors include debt coverage, sales and income growth, cash flows and liquidity ratios. Qualitative factors include management quality, access to capital markets and the quality of earnings and balance sheet items. Ratings for securities with initial maturities less than one year are based on ratings of NRSROs, or the credit rating of the issuer’s parent company. For further discussion of credit risk and related topics (impairment losses on equity securities, residential mortgage-backed securities, unrealized losses in the investment portfolios, and non-investment grade securities held by the Company) see the section entitled "Investment Impairments and Considerations” within this Management’s Discussion and Analysis of Financial Condition and Results of Operations.
Prepayment risk refers to changes in prepayment patterns that can shorten or lengthen the expected timing of principal repayments and thus the average life and the effective yield of a security. Such risk exists primarily within the portfolio of mortgage-backed securities. Prepayment risk is monitored regularly through the analysis of interest rate simulations. At December 31, 2008, the effective duration of the mortgage-backed securities is 6.7 years with an average life of 5.3 years and a current yield of 5.7 percent. At December 31, 2007, the effective duration of the mortgage-backed securities was 2.3 years, with an average life of 2.9 years and a current yield of 6.9 percent.
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 the performance of financial markets and the general economy; rating agency actions and other risks and uncertainties inherent to the Company’s business, some of which are discussed under Part I, Item 1A of this Form 10-K under the heading “Risk Factors”. Management intends to identify forward-looking statements when using the words “believe”, “expect”, “anticipate”, “estimate”, “project” or similar expressions. Undue reliance should not be placed on these forward-looking statements.
There are inherent limitations in the effectiveness of any internal control, including the possibility of human error and the circumvention or overriding of controls. Accordingly, adequate internal controls can provide only reasonable assurance with respect to financial statement preparation. Further, because of changes in conditions, the effectiveness of internal control may vary over time.
We have audited EMC Insurance Group Inc. and Subsidiaries’ internal control over financial reporting as of December 31, 2008, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). EMC Insurance Group Inc. and Subsidiaries’ management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.
In our opinion, EMC Insurance Group Inc. and Subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 31, 2008, based on the COSO criteria.
We have audited the accompanying consolidated balance sheets of EMC Insurance Group Inc. and Subsidiaries as of December 31, 2008 and 2007, and the related consolidated statements of income, comprehensive income, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2008. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of EMC Insurance Group Inc. and Subsidiaries at December 31, 2008 and 2007, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2008, in conformity with U.S. generally accepted accounting principles.
As discussed in Note 1 to the consolidated financial statements, in response to new accounting standards, the Company changed its methods of accounting for its pension and other post-retirement benefits effective December 31, 2006 and January 1, 2008, and for the treatment of income tax contingencies effective January 1, 2007.
Ceded reinsurance amounts with nonaffiliated reinsurers relating to reinsurance receivables for paid and unpaid losses and settlement expenses and prepaid reinsurance premiums are reported on the balance sheet on a gross basis. Amounts ceded to Employers Mutual relating to the affiliated reinsurance pooling agreement (see note 2) have not been grossed up because the contracts provide that receivables and payables may be offset upon settlement.
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 equal to 102 percent of the fair value of the loaned securities. The collateral is primarily cash, but other forms of collateral are occasionally accepted, including letters of credit or U.S. Treasury securities. The cash collateral is invested in a Delaware business trust that is managed by Mellon Bank. In this trust, cash collateral funds of the Company are pooled with cash collateral funds of other security lenders administered by Mellon Bank, and these funds are invested in securities with high credit quality standards, maturity restrictions, and liquidity levels consistent with the short-term nature of securities lending transactions. The acceptable investments include time deposits, commercial paper, floating rate notes, asset-backed floating rate notes, and repurchase agreements. The earnings from this trust are used, in part, to pay the fee the Company receives for each security loaned under the program. The Company has a slight risk of a minor loss associated with the collateral pool if the aggregate fair value of the collateral pool were to decline below the aggregate liability represented by the collateral, assuming all securities loaned and backed by the collateral pool were returned.
The Company has no stock-based compensation plans of its own; however, Employers Mutual has several stock plans that utilize the common stock of the Company. The Company receives the current fair value for all shares issued under these plans. The Company recognizes compensation expense for options granted as the requisite service period is rendered, with the compensation expense based on the fair value of the stock options. Employers Mutual also has a stock appreciation rights (SAR) agreement in effect with an executive officer of the Company. The SAR agreement is based upon the market price of the Company’s common stock, and because it will be settled in cash, it is considered to be a liability-classified award.
In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities.” SFAS 159 permits reporting entities to choose, at specified election dates, to measure eligible items at fair value (the “fair value option”). The unrealized gains and losses on items for which the fair value option has been elected will be reported in earnings. As it relates to the Company’s financial reporting, the Company would be permitted to elect fair value recognition of fixed maturity and equity investments currently classified as either available-for-sale or held-to-maturity, and report the unrealized gains and losses from these investments in earnings going forward. Electing the fair value option for an existing held-to-maturity security will not call into question the intent of an entity to hold other fixed maturity securities to maturity in the future. The provisions of this statement are effective beginning with the first fiscal year that begins after November 15, 2007. The Company adopted the requirements of SFAS 159 effective January 1, 2008, but did not elect the fair value option. Therefore, adoption of this statement had no effect on the operating results of the Company.
Premiums assumed by the reinsurance subsidiary from Employers Mutual amounted to $73,617,740, $71,002,733 and $66,268,178 in 2008, 2007 and 2006, respectively. It is customary in the reinsurance business for the assuming company to compensate the ceding company for the acquisition expenses incurred in the generation of the business. Commissions paid by the reinsurance subsidiary to Employers Mutual amounted to $15,766,979, $17,386,129 and $15,650,305 in 2008, 2007 and 2006, respectively.
As a result of regulatory changes in Germany, Employers Mutual ceased being an approved reinsurer in Germany beginning January 1, 2009. To avoid the loss of approximately $5,000,000 of assumed reinsurance business because of this regulatory change, management determined that the Company’s reinsurance subsidiary will begin writing this business on a direct basis (outside the quota share agreement) effective January 1, 2009. Since this business will be written outside the quota share agreement, it will not be subject to the $2,000,000 cap on losses per event. Management has determined that this business has a low risk of generating losses above $2,000,000 per event and has therefore elected to not purchase stand-alone reinsurance coverage for these risks.
Investment expenses are based on actual expenses incurred by the Company plus an allocation of other investment expenses incurred by Employers Mutual, which is based on a weighted average of total invested assets and number of investment transactions. Investment expenses allocated to the Company by Employers Mutual amounted to $1,464,337, $1,455,808 and $1,310,193 in 2008, 2007 and 2006, respectively.
Effective January 1, 2006 the board of directors of the MRB pool approved the admission of two new assuming companies to the pool. This reduced Employers Mutual’s participation in the pool from a one-third share to an approximate one-fifth share (one company is only assuming property exposures). The premiums written assumed from affiliates and net premiums written amounts for 2006 include a negative $3,440,024 portfolio adjustment which serves as an offset to the decrease in unearned premiums recognized in connection with this change in pool participation.
Underwriting results of the Company are significantly influenced by the estimates of loss and settlement expense reserves. Changes in reserve estimates are reflected in operating results in the year such changes are recorded. Both the property and casualty insurance and reinsurance segments experienced favorable development on prior years’ reserves in all three years presented.
For the property and casualty insurance segment, the December 31, 2008 estimate of loss and settlement expense reserves for accident years 2007 and prior decreased $21,564,256 from the estimate at December 31, 2007. This decrease represents 5.3 percent of the December 31, 2007 gross carried reserves and is primarily attributed to lower than expected emergence during 2008 of losses estimated to have been incurred but not reported (IBNR) at December 31, 2007, as well as favorable development in settlement costs and continued favorable development from the final settlement of closed claims.
For the reinsurance segment, the December 31, 2008 estimate of loss and settlement expense reserves for accident years 2007 and prior decreased $13,743,764 from the estimate at December 31, 2007. This decrease represents 9.7 percent of the December 31, 2007 gross carried reserves and is largely attributed to the 2005, 2006 and 2007 accident years in the HORAD book of business.
Prior to 2008, actual losses paid for asbestos-related claims had been minimal due to the plaintiffs’ failure to identify an exposure to any asbestos-containing product associated with the pool participants’ current and former policyholders. However, paid losses increased significantly during 2008 as a result of claims attributed to two former policyholders. One of these former policyholders, a broker of various products, including asbestos, had a claim settle for approximately $450,000 (the Company’s share). Prior to 2008, the asbestos exposure associated with this former policyholder had been thought to be relatively small. At December 31, 2008, one additional claim associated with this former policyholder remains pending, though similar exposure on that claim is not anticipated. The other former policyholder, a furnace manufacturer, had multiple claims settle for a total of approximately $354,000 (the Company’s share). The asbestos exposure associated with this former policyholder increased during 2008, and this trend may possibly continue into the future with higher per plaintiff settlements. Approximately 125 asbestos exposure claims associated with this former policyholder remain open. Defense costs for asbestos-related claims continue to be rather significant due to the large number of parties involved in the litigation proceedings and the length of time required to obtain judgments. Whenever possible, the pool participants have participated in cost sharing agreements with other insurance companies to reduce overall asbestos claim expenses. The Company believes its settlement expense reserve adequately provides for these projected expenses.
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 2008, 2007 and 2006.
The NAIC utilizes a risk-based capital model to help state regulators assess the capital adequacy of insurance companies and identify insurers that are in, or are perceived as approaching, financial difficulty. This model establishes 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. At December 31, 2008, the Company’s insurance subsidiaries had total adjusted statutory capital of $284,492,170, which is well in excess of the minimum risk-based capital requirement of $53,674,121.
The following table displays the net premiums earned of the property and casualty insurance segment and the reinsurance segment for the three years ended December 31, 2008, by line of insurance.
The estimated fair value of fixed maturity securities, equity securities, short-term investments, securities lending collateral and securities lending obligation is based on quoted market prices, where available. In cases where quoted market prices are not available, fair values are based on a variety of valuation techniques depending on the type of security.
The Company’s fixed maturity and equity securities available-for-sale, as well as short-term investments, are measured at fair value on a recurring basis. No assets or liabilities are currently measured at fair value on a non-recurring basis. Presented in the table below are the Company’s assets that are measured at fair value on a recurring basis, as of December 31, 2008.
The large decline in U.S. government-sponsored agency securities is due to a significant amount of call activity that occurred during 2008 as a result of the declining interest rate environment. The proceeds from these called securities were initially invested in short-term securities, until suitable long-term investment opportunities could be identified.
The following table sets forth the estimated fair value and gross unrealized losses associated with investment securities that were in an unrealized loss position as of December 31, 2008 and 2007, listed by length of time the securities have been in an unrealized loss position.
All of the Company’s preferred stock holdings are perpetual preferred stocks. The Company evaluates perpetual preferred stocks for “other-than-temporary” impairment similar to fixed maturity securities since they have debt-like characteristics such as periodic cash flows in the form of dividends and call features, are rated similar to debt securities and are priced like other long-term callable fixed maturity securities. There was no evidence of any credit deterioration in the issuers of the preferred stocks and the Company has both the ability and intent to hold these preferred stocks until recovery; therefore, it was determined that the carrying value of these securities was not “other-than-temporarily” impaired at December 31, 2008.
A summary of realized investment gains and losses is as follows:
The amounts reported as “other-than-temporary” impairments on equity securities available-for-sale reflect the impairment of 40 equity securities for the year ended December 31, 2008, compared to 14 equity securities for the year ended December 31, 2007 and 12 equity securities for the year ended December 31, 2006. The large amount of impairment losses recognized during 2008 is a result of the severe and prolonged turmoil in the financial markets, and includes $14,904,000 of losses recognized on the perpetual preferred stocks of Freddie Mac and Fannie Mae when these companies were placed under conservatorship by the U.S. government.
The actual income tax expense (benefit) for the years ended December 31, 2008, 2007 and 2006 differed from the “expected” income tax expense (benefit) for those years (computed by applying the United States federal corporate tax rate of 35 percent to income (loss) before income tax expense (benefit)) as follows:
The Company had no provision for uncertain tax positions at December 31, 2008 or 2007. During 2007, the Company recognized a $34,736 underpayment penalty relating to its December 31, 2006 U.S. federal tax return. The Company did not recognize any interest or other penalties related to U.S. federal or state income taxes during 2008 or 2007. It is the Company’s accounting policy to reflect income tax penalties as other expense, and interest as interest expense.
The Company files U.S. federal tax returns, along with various states income tax returns. The Company is no longer subject to U.S. federal and state income tax examinations by tax authorities for years before 2005.
The Company’s property and casualty insurance subsidiaries have $25,000,000 of surplus notes issued to Employers Mutual. Effective February 1, 2008, the interest rate on these surplus notes was increased from 3.09 percent to 3.60 percent. Future reviews of the interest rate will be conducted by the Inter-Company Committees of the Boards of Directors of the Company and Employers Mutual every five years. Payment of interest and repayment of principal can only be made out of the applicable subsidiary’s statutory surplus and is subject to prior approval by the insurance commissioner of the respective state of domicile. The surplus notes are subordinate and junior in right of payment to all obligations or liabilities of the applicable insurance subsidiaries. Prior to December 31, 2007, the Company’s reinsurance subsidiary had $11,000,000 of surplus notes issued to Employers Mutual. These surplus notes were redeemed in the fourth quarter of 2007, along with accrued interest. Total interest expense incurred on these surplus notes was $889,375, $1,111,469 and $1,112,400 in 2008, 2007 and 2006, respectively. At December 31, 2008, EMCASCO Insurance Company and Illinois EMCASCO Insurance Company had received approval for the payment of interest accrued on the surplus notes during 2008, while Dakota Fire Insurance Company had not received the necessary approval.
Employers Mutual’s supplemental retirement plan provides retirement benefits for a select group of management and highly-compensated employees. This plan enables select employees to receive retirement benefits without the limit on compensation imposed on qualified defined benefit pension plans by the Internal Revenue Service (IRS) and to recognize compensation that has been deferred in the determination of retirement benefits. The plan is unfunded and benefits generally vest after three years of service (five years of service prior to January 1, 2008).
The following table sets forth the funded status of Employers Mutual’s pension and postretirement benefit plans as of December 31, 2008 and 2007, based upon measurement dates of December 31, 2008 and November 1, 2007, respectively. Effective January 1, 2008, the Company adopted the measurement date provision of SFAS 158 and elected to apply the approach under which the Company’s previous November 1, 2007 measurement date was used to obtain the adjustment for the two month transition period. As a result, the 2008 balances reflect fourteen months of activity, whereas the 2007 balances reflect twelve months of activity.
During 2009, the Company will amortize $1,937,214 of net actuarial loss and $139,023 of prior service cost associated with the pension plans into net periodic benefit cost. In addition, the Company will amortize $619,217 of prior service credit and $27,205 of net actuarial loss associated with the postretirement benefit plans into net periodic postretirement benefit cost in 2009.
The weighted-average asset allocation of Employers Mutual’s defined benefit retirement plan as of the measurement dates of December 31, 2008 and November 1, 2007 are as follows:
Effective October 31, 2008, Employers Mutual changed its defined benefit retirement plan administrator from Principal Financial Group to Prudential Financial. In connection with this change in administrator, Employers Mutual retained Global Portfolio Strategies, Inc. to advise on the defined benefit retirement plan asset allocation strategy for 2009.
The weighted-average asset allocation of Employers Mutual’s VEBA trust that is used to fund the postretirement benefit plans as of the measurement dates of December 31, 2008 and November 1, 2007 are as follows:
Employers Mutual plans to contribute approximately $25,000,000 to the pension plan and $2,800,000 to the VEBA trust in 2009.
The Company participates in other retirement plans sponsored by Employers Mutual, including its 401(k) Plan and Board and Executive Non-Qualified Excess Plan. The Company’s share of expenses for these plans amounted to $1,649,624, $2,015,481 and $1,409,914 in 2008, 2007 and 2006, respectively.
In accordance with IRS regulations, Employers Mutual’s incentive stock option plans include a restriction that the aggregate fair value of common stock with respect to which stock options are exercisable for the first time by an option holder may not exceed $100,000 during any calendar year. This restriction, in effect, places a limitation on the number of incentive stock options that can be granted to a participant during any given year. During 2006, Employers Mutual determined that there had been an oversight in the record-keeping for the incentive stock option plans which (1) resulted in the issuance of “invalid” incentive stock options to three of the Company’s executive officers in prior years, and (2) precluded the issuance of 2006 incentive stock option grants to these executive officers that had previously been authorized as part of their 2006 compensation arrangements. To rectify the “invalid” stock option issue, Employers Mutual entered into agreements with the three executive officers in 2006 whereby they surrendered a total of 15,647 “invalid” incentive stock options that were still outstanding for a negotiated cash settlement. In addition, Employers Mutual purchased 10,553 shares of the Company’s common stock from one of the executive officers who had previously exercised the same number of “invalid” incentive stock options and returned the common stock to the Company for cancellation. The Company reimbursed Employers Mutual for the original issuance price of the cancelled common stock. Additional arrangements were made to compensate the executive officers for the 2006 option grants they did not receive.
During 2008, 221,875 options were granted under the 2007 Plan to eligible participants at a price of $23.467 and 93,415 options were exercised under the plans at prices ranging from $9.25 to $25.455. The 2008 grant includes 42,000 non-qualified options, up to 50 percent of which can be exercised as stock appreciation rights. A summary of the activity under Employers Mutual’s stock option plans for 2008, 2007 and 2006 is as follows:
The expected volatility in the price of the underlying shares for the 2008 option grant was computed by using the historical average high and low monthly prices of the Company’s common stock for a period covering 6.25 years, which approximates the average term of the options and produced an expected volatility of 23.2 percent. The expected volatility of options granted to individuals who are, or will be, eligible to retire prior to the completion of the normal vesting period was computed by using the historical average high and low daily, weekly, or monthly prices for the period approximating the expected term of those options. This produced expected volatility ranging from 21.0 percent to 30.1 percent.
During 2008, a total of 19,782 options were exercised at prices ranging from $21.05 to $24.49. Activity under the plan was as follows:
A total of 200,000 shares of the Company’s common stock have been reserved for issuance under the 2003 Employers Mutual Casualty Company Non-Employee Director Stock Option Plan. All non-employee directors of Employers Mutual and its subsidiaries and affiliates who are not serving on the “Disinterested Director Committee” of the Board of Employers Mutual as of the beginning of an option period are eligible to participate in the plan. Each eligible director can purchase shares of common stock at 75 percent of the fair value of the stock on the option exercise date in an amount equal to a minimum of 25 percent and a maximum of 100 percent of their annual cash retainer. The plan will continue through the option period for options granted at the 2012 annual meetings. The plan is administered by the Disinterested Director Committee of the Board. The Board may amend or terminate the plan at any time; however, no such amendment or termination shall adversely affect the rights and privileges of participants with unexercised options. Expenses allocated to the Company in connection with these plans totaled $27,121, $18,173 and $9,495 in 2008, 2007 and 2006, respectively.
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, and may sell shares of common stock through the plan. Employers Mutual did not participate in this plan in 2008, 2007 or 2006. Activity under the plan was as follows:
On October 19, 2006, Employers Mutual entered into a stock appreciation rights (SAR) agreement with the Company’s Executive Vice President and Chief Operating Officer (Mr. Murray). This SAR agreement is a substitute for an incentive stock option grant Mr. Murray was initially authorized to receive as part of his 2006 compensation arrangement, but was not issued to him due to certain limitations contained in Employers Mutual’s incentive stock option plan. The grant-date fair value of this award was $546,300. Because the SAR agreement will be settled in cash, it is considered to be a liability-classified award under SFAS 123(R). As a result, the value of this agreement must be re-measured at fair value at each financial statement reporting date, subject to a minimum fair value of $318,825 contained in the SAR agreement. The fair value of this agreement at December 31, 2008 and 2007 was $318,825 ($95,648 as the Company’s portion from the pool) and $662,850 ($198,855 as the Company’s portion from the pool) at December 31, 2006. The full value of this agreement was expensed in 2006 because Mr. Murray is currently eligible for retirement and is entitled to keep the award at retirement. As a result, the award does not have any subsequent service requirements. Subsequent changes in the fair value of this agreement will be reflected as compensation expense until the agreement is ultimately settled in 2016. During 2008, the Company did not recognize any compensation expense related to this award as the fair value of the award did not change. During 2007, the Company recognized negative compensation expense of $103,207 ($67,085 net of tax) related to this award.
In our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Note 1 to the consolidated financial statements, in response to new accounting standards, the Company changed its methods of accounting for its pension and other post-retirement benefits effective December 31, 2006 and January 1, 2008, and for the treatment of income tax contingencies effective January 1, 2007.