We own three buildings in Cedar Rapids, Iowa, that we use as our corporate headquarters including: a five-story office building, a two-story office building and an eight-story office building in which a portion of the first floor (approximately 6.0 percent of the building’s square footage) is leased to tenants, and related parking facilities. All three buildings are connected by a skywalk system. We also own a 250-space parking ramp for use by our employees. The parking ramp is located adjacent to our corporate headquarters upon one parcel of real estate that we own and another parcel that we lease with an option to purchase.
In addition, three of our regional locations in Lock Haven, Pennsylvania, Pennington, New Jersey, and Rocklin, California, conduct operations in office space that we own. A portion of the Lock Haven (approximately 20.0 percent) and Pennington (approximately 4.0 percent) office space is leased to tenants. We also own a tract of land adjacent to the Pennington office and a townhouse located near the Rocklin office that is used for corporate purposes.
The following table sets forth certain selected financial data derived from the Consolidated Financial Statements of United Fire & Casualty Company and its subsidiaries and affiliates. The data should be read in conjunction with Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Part II, Item 8, “Financial Statements and Supplementary Data.”
Net unrealized gains, after tax, were impacted in 2008 by the volatility in the financial markets. The severe downturn in the financial
For further information on this line, please refer to the Results of Operations and Measurement of Results sections in Part II,
This report may contain forward-looking statements about our operations, anticipated performance and other similar matters. The Private Securities Litigation Reform Act of 1995 provides a safe harbor under the Securities Act of 1933 and the Securities Exchange Act of 1934 for forward-looking statements. The forward-looking statements are not historical facts and involve risks and uncertainties that could cause actual results to differ materially from those expected and/or projected. Such forward-looking statements are based on current expectations, estimates, forecasts and projections about the Company, the industry in which we operate, and beliefs and assumptions made by management. Words such as “expect(s),” “anticipate(s),” “intend(s),” “plan(s),” “believe(s),” “continue(s),”
“seek(s),” “estimate(s),” “goal(s),” “target(s),” “forecast(s),” “project(s),” “predict(s),” “should,” “could,” “may,” “will continue,” “might,” “hope,” “can” and other words and terms of similar meaning or expression in connection with a discussion of future operations, financial performance or financial condition, are intended to identify forward-looking statements. These statements are not guarantees of future performance and involve risks, uncertainties and assumptions that are difficult to predict. Therefore, actual outcomes and results may differ materially from what is expressed in such forward-looking statements. Information concerning factors that could cause actual results to differ materially from those in the forward-looking statements is contained in Part II Item 1A, “Risk Factors” of this document. Among the factors that could cause our actual outcomes and results to differ are:
Developments in the domestic and global financial markets that could affect our investment portfolio.
Governmental actions, policies and regulations, including, but not limited to, domestic health care reform, financial services regulatory reform, corporate governance, new laws or regulations or court decisions interpreting existing laws and regulations or policy provisions.
These are representative of the risks, uncertainties, and assumptions that could cause actual outcomes and results to differ materially from what is expressed in forward-looking statements. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date of this report or as of the date they are made. Except as required under the federal securities laws and the rules and regulations of the Securities and Exchange Commission, we do not have any intention or obligation to update publicly any forward-looking statements, whether as a result of new information, future events, or otherwise.
The purpose of the Management’s Discussion and Analysis is to provide an understanding of our results of operations and consolidated financial position. Our Management’s Discussion and Analysis should be read in conjunction with Part II, Item 6, “Selected Financial Data” and Part II, Item 8, “Financial Statements and Supplementary Data.” When we provide information on a statutory basis, we label it as such; otherwise, all other data is presented in accordance with U.S. generally accepted accounting principles (“GAAP”).
property and casualty insurance, which includes commercial insurance, personal insurance, and assumed insurance; and
These business segments are managed separately, as they generally do not share the same customer base, and they each have different products, pricing, and expense structures.
All of our property and casualty insurance subsidiaries, with the exception of Texas General Indemnity Company, are members of an intercompany reinsurance pooling arrangement. The insurance entities of Mercer Insurance
The profitability of the Company is influenced by many factors, including price, competition, economic conditions, interest rates, catastrophic events and other natural disasters, man-made disasters, state regulations, court decisions, and changes in the law. Unless a connection to increased extreme weather events related to climate change is ultimately proven true, management believes that climate change considerations will not have a material impact on our profitability.
When prepared in accordance with statutory accounting principles, the net loss ratio is calculated by dividing the sum of losses and loss settlement expenses by net premiums earned; the expense ratio is calculated by dividing underwriting expenses by net premiums written.
Catastrophe losses is a commonly used non-GAAP financial measure, which utilize the designations of the Insurance Services Office (ISO) and are reported with loss and loss settlement expense amounts net of reinsurance recoverables, unless specified otherwise. According to the ISO, a catastrophe loss is defined as a single
unpredictable incident or series of closely related incidents that result in $25.0 million or more in U.S. industry-wide direct insured losses to property and that affect a significant number of insureds and insurers (“ISO catastrophe”). In addition to ISO catastrophes, we also include as catastrophes those events (“non-ISO catastrophes”), which may include U.S. or international losses, that we believe are, or will be, material to our operations, either in amount or in number of claims made. Management, at times, may determine for comparison purposes that it is more meaningful to exclude extraordinary catastrophe losses and resulting litigation, such as Hurricane Katrina. The frequency and severity of catastrophic losses we experience in any year affect our results of operations and financial position. In analyzing the underwriting performance of our property and casualty insurance segment, we evaluate performance both including and excluding catastrophe losses. Portions of our catastrophe losses may be recoverable under our catastrophe reinsurance agreements. We include a discussion of the impact of catastrophes because we believe it is meaningful for investors to understand the variability in periodic earnings.
(1) This number does not include loss and loss settlement expenses incurred for Hurricane Katrina claims and related litigation.
The year 2011 will be remembered for its devastating catastrophes, both domestic and abroad. According to various reports, 2011 was the costliest catastrophe year on record for the property and casualty insurance industry globally. We experienced losses in our direct and assumed books of business that negatively impacted our full-year results. However, premium rates increased across all lines of business, and there were some positive signs in the overall economy. Additionally, we have taken steps to improve and strengthen our underwriting guidelines based on our catastrophe experiences of the past year. Internal analyses of our catastrophe exposures, utilizing various approaches including the results of the updated RMS Model Version 11, supported the underwriting changes.
During 2011 we began the process of integrating Mercer Insurance Group into our operations. Mercer Insurance Group agents have represented our new combined companies and as a group have increased their production over the past year. We began integrating Mercer Insurance Group's policy renewals into our processing systems, and we
Our property and casualty insurance segment reported pre-tax losses of $24.2 million and $39.9 million in 2011 and 2009, respectively, compared to pre-tax income of $38.8 million in 2010. The deterioration in our 2011 results is due to an increase in loss and loss settlement expenses primarily from catastrophe losses and one-time acquisition-related costs and other expenses associated with our acquisition of Mercer Insurance Group, as explained in more detail throughout this section.
In 2010, our loss and loss settlement expenses decreased by 20.9 percent or $76.3 million from 2009 due in large part to the adverse reserve development experienced in 2009. A decrease in non-catastrophe claims severity, accompanied by a slight decrease in frequency in 2010, also contributed to the reduction in losses and loss settlement expenses. Other underwriting expenses decreased 0.7 percent in 2010, primarily as the result of a higher level of deferrable underwriting expenses in 2010 as compared to 2009. However, included in this line were transaction costs totaling $1.2 million that were incurred in 2010 related to our acquisition of Mercer Insurance Group.
Our 2009 results were negatively impacted by the weak economy. Additionally, in 2009, we incurred OTTI charges of $9.8 million and $38.0 million in adverse development from Hurricane Katrina, which impacted our pre-tax earnings.
Direct premiums written increased $145.2 million in 2011, of which $115.3 million resulted from our acquisition of Mercer Insurance Group. The remaining $29.9 million reflects low-to mid-single-digit rate increases across all lines, along with growth from internal initiatives we implemented at the beginning of 2011.
In our commercial lines, competitive market conditions eased during 2011, although not equally among all regions. New business increased by $15.7 million over 2010. All regions continued to see commercial lines policy cancellations, though at a declining rate, due to insureds going out of business. In our personal lines, pricing continued to improve during 2011, continuing a trend that began over two years ago. In both our commercial and personal lines, policy retention rates remained strong with approximately 82.0 percent of our policies renewing.
In 2009, direct premiums written were negatively impacted by continued competition and the weak economy along with the nonrenewal of accounts that no longer met our underwriting or pricing guidelines. Our policy retention rate in both the personal and commercial lines of business was approximately 80.0 percent in 2009, as our underwriters continued to focus on writing good business at an adequate price, preferring quality to volume.
2011 and 2010. For 2012, using the results of our catastrophe expense analysis we renewed our participation levels in all of our active assumed programs, with the exception of one contract for which we decreased our participation level.
Direct and assumed premiums written are reduced by the ceded premiums that we pay to reinsurers. For 2011, the increase in ceded premiums written is primarily related to our acquisition of Mercer Insurance Group. The reduction in ceded premiums written in 2010 as compared to 2009 was due to the lower level of direct premiums written, which also affected the premiums we pay for our property catastrophe reinsurance program.
We consolidated both Mercer Insurance Group's non-catastrophe and catastrophe reinsurance programs into our programs, effective January 1, 2012, resulting in increased coverage for Mercer Insurance Group and an expected cost savings of $1.5 million because of synergies. The change in programs increased Mercer Insurance Group's catastrophe protection from $55.0 million to $200.0 million and increased their catastrophe retention from $5.0 million to $20.0 million. Mercer Insurance Group's non-catastrophe retention was increased from $1.0 million to $2.0 million. We had no other significant changes to coverage, limits, or retentions for our catastrophe or non-catastrophe programs.
In comparison, the renewal pricing for our 2011 non-catastrophe reinsurance program increased approximately 4.0 percent due to losses in 2010, in the first and second layers of our casualty program. Our catastrophe reinsurance program pricing decreased approximately 8.0 percent because of the soft market conditions and because we had no losses to the program during 2010.
Catastrophe losses are inherent risks of the property and casualty insurance business. Catastrophic events and natural disasters include, without limitation, hurricanes, tornadoes, earthquakes, hailstorms, wildfires, high winds, winter storms and other natural disasters. We also face man-made exposures to losses resulting from, without limitation, acts of war, acts of terrorism and political instability. Such events result in insured losses that can be, and may continue to be, a material factor in our results of operations and financial position, as the extent of losses from a catastrophe is a function of both the total amount of insured exposure in an area affected by the event and the severity of the event. Because the level of insured losses that may occur in any one year cannot be accurately predicted, these losses contribute to fluctuations in our year-to-year results of operations and financial position. Some types of catastrophes are more likely to occur at certain times within the year than others, which adds an element of seasonality to our property and casualty insurance claims. The frequency and severity of catastrophic events are difficult to accurately predict in any year. However, some geographic locations are more susceptible to these events than others.
We control our direct insurance exposures in regions that are prone to naturally occurring catastrophic events through a combination of geographic diversification, restrictions on the amount and location of new business production in such regions, and reinsurance. We regularly assess our concentration of risk exposures in natural catastrophe exposed areas; we have strategies and underwriting standards to manage these exposures through individual risk selection, subject to regulatory constraints, and through the purchase of catastrophe reinsurance coverage. We use catastrophe modeling and a risk concentration management tool to monitor and control our accumulations of potential losses in natural catastrophe exposed areas of the United States, such as California and the Gulf and East Coasts, as well as in natural catastrophe exposed areas of other countries. The information provided by the catastrophe modeling and the risk concentration management tool has resulted in our nonrenewal of
In 2011, our pre-tax catastrophe losses, not including adverse development from Hurricane Katrina claims litigation, were $80.8 million. In comparison, our 2010 and 2009 pre-tax catastrophe losses were $19.8 million and $22.4 million, respectively. Our 2011 losses were the result of several large natural disasters in both our direct business and assumed reinsurance business. The losses in our direct business totaled $59.7 million and resulted from a string of devastating tornadoes that tore through the southern states in April 2011, followed by storms that included a multiple-vortex tornado that destroyed Joplin, Missouri in May 2011. In July 2011, a powerful, long-lasting straightline windstorm known as a derecho hit Iowa, and in August 2011, Hurricane Irene impacted our East Coast policyholders. Our assumed reinsurance business contributed $21.1 million of catastrophe losses from prior year development and current year losses as a result of natural disasters (i.e., earthquakes and tsunamis) in New Zealand and Japan.
In 2011, only Mercer Insurance Group exceeded their $5.0 million catastrophe retention due to losses incurred from Hurricane Irene. In both 2010 and 2009, we did not exceed our catastrophe retention of $20.0 million. Effective January 1, 2012, Mercer Insurance Group is included in our catastrophe reinsurance program.
Workers’ compensation insurance and other liability insurance are considered to be long-tail lines of business due to the length of time that may elapse before claims are finally settled. Therefore, we may not know our final development on individual claims for many years. Our estimates for losses, particularly in these long-tail lines, are dependent upon many factors, such as the legal environment, inflation and medical costs. We consider all of these
factors, as well as others, in estimating our loss reserves. As conditions or trends with respect to these factors change, we change our estimate for loss reserves accordingly. Refer to “Critical Accounting Estimates” in this section for a more detailed discussion of our property and casualty insurance segment’s loss and loss settlement expenses reserves.
In 2011, our loss and loss settlement expenses were affected by significant catastrophe activity in both our direct business and assumed reinsurance business. However, our non-catastrophe results improved, which is reflected in our favorable development of reserves established for claims that occurred in prior years of $61.1 million. This level of development is consistent with our historical experience, excluding the impact of Hurricane Katrina. The favorable development included $6.5 million in adverse development from Hurricane Katrina as a result of our continuing resolution of outstanding claims litigation.
We experienced favorable development in all lines of business with the exception of assumed reinsurance, which experienced a $4.6 million incurred loss as a result of development on 2010 catastrophe activity, and direct commercial multi peril, which experienced a slight deficiency. Our other liability and products liability lines had significant decreases in losses as a result of a lower level of required reserves for incurred but not reported ("IBNR") losses in 2011; a reduction in our legal expenses is a result of an initiative we implemented in 2009; and an overall improvement in our underwriting results.
In 2010, we saw an improvement in our loss and loss settlement expenses due to favorable reserve development of $45.9 million. This level of development is consistent with our historical experience, excluding the impact of Hurricane Katrina. The favorable development included $8.6 million in adverse development from Hurricane Katrina as a result of our continuing resolution of outstanding claims litigation.
Overall, we experienced a net deficiency in our prior year reserves of $26.2 million for 2009. The major components of this deficiency were the deterioration in our other liability lines of business, which resulted in a deficiency in these lines of $21.8 million, and adverse development from Hurricane Katrina claims and litigation totaling $38.0 million, which resulted in a deficiency in the fire and allied lines of business of $16.9 million.
The net loss ratio in our commercial lines of business, excluding assumed reinsurance, improved to 71.3 percent in 2011 from 73.2 percent in 2010 and 85.8 percent in 2009. Our acquisition of Mercer Insurance Group added 1.5 points to this ratio. For 2011, commercial lines without Mercer Insurance Group experienced a slight improvement, primarily in the other liability lines of business, that was somewhat offset by the fire and allied lines, as these lines were affected by a significant amount of catastrophe losses during the year.
The significant decrease in our net loss ratio in 2010 as compared to 2009 was the result of a decrease in our loss and loss settlement expenses, in spite of the lower level of premiums earned during the year. The decrease occurred in our largest lines of business, other liability, fire and allied, automobile, and workers’ compensation, as a result of favorable reserve development, consistent with our historical level of development, excluding the impact of Hurricane Katrina.
In 2009, our other liability lines experienced unfavorable reserve development from the re-estimation of certain of our recorded reserves and a slight increase in severity as a result of larger jury awards and continuing construction defect claims and loss settlement expenses.
The other liability line experienced a slight increase in premiums earned in 2011 as compared to 2010, which were similar to the premiums earned in 2009. The decline in premiums earned in 2010 was due to the effect competition and the weak economy had on residential and commercial construction. Our other liability losses and loss settlement expenses incurred were $75.6 million in 2011, compared to $94.6 million in 2010 and $119.2 million in 2009. The improvement in this line is the result of a lower level of required reserves for IBNR losses in 2011; a reduction in our legal expenses as a result of an initiative we implemented in 2009; and an overall improvement in our underwriting results.
Insurance Group contributed $24.9 million in construction defect loss and loss settlement expense reserves at December 31, 2011, representing 1,535 claims. In comparison, at December 31, 2010 and 2009, we had reserves of $21.1 million and $15.2 million, excluding IBNR reserves, consisting of 326 claims and 234 claims, respectively.
As a result of our acquisition of Mercer Insurance Group, we have construction defect exposure in the states of California, Nevada and Arizona. Mercer Insurance Group has been writing in these states for more than 20 years. We expect to leverage recent improvements in Mercer Insurance Group's program that focus on targeted risk selection, tailored policy forms and the utilization of an in-house legal department staffed by ten attorneys.
Within our other liability lines of business (other than construction defect), frequency decreased in 2011 as compared to 2010, with losses incurred on 3,962 claims in 2011 as compared to 6,134 in 2010 and 4,936 in 2009. In 2011, our average direct losses incurred per other liability claim (other than construction defect) were $15,952 per claim compared to $15,930 per claim in 2010 and $23,699 per claim in 2009.
Because of the long-tail nature of liability claims, significant periods of time, ranging up to several years, may elapse between the occurrence of the loss, the reporting of the loss to us and the settlement of the claim. In 2009, over 37.0 percent of our other liability losses incurred (other than construction defect) resulted from losses that occurred in prior years.
In recent years, we began to use our loss control department more extensively in an attempt to return this line of business to a higher level of profitability. For example, our loss control department has representatives make multiple visits each year to businesses and job sites to ensure safety. We also non-renew accounts that no longer meet our underwriting or pricing guidelines. As pricing in the industry continues to decrease, we continue to avoid accounts that have become too underpriced for the risk.
In 2011, our commercial automobile premium writings increased as a result of our acquisition of Mercer Insurance Group, whereas without this acquisition our premium writings would have remained flat. Our premium writings in 2010 continued to be affected by the slow recovery in the economy, which resulted in a lower level of premiums earned as compared to 2009. Losses and loss settlement expenses were $84.2 million in 2011, of which Mercer Insurance Group contributed $13.8 million, compared to $66.9 million and $75.1 million in 2010 and 2009, respectively. The deterioration in 2011 is primarily attributable to including Mercer Insurance Group's loss and loss settlement expenses in our results; otherwise the line remained relatively flat year-over-year. We attribute the improvement in 2010 to a decrease in claims severity.
The challenges faced by workers’ compensation insurance providers to attain profitability include the regulatory climates in some states that make it difficult to obtain appropriate premium rate increases and inflationary medical costs. Despite these pricing issues, we continue to believe that we can improve the results of this line of business. Consequently, we have increased the utilization of our loss control unit in the analysis of current risks, with the intent of increasing the quality of our workers’ compensation book of business. In 2011, we introduced predictive modeling analytics into our workers’ compensation underwriting process. We are currently using this model to assist us in risk selection, and we will continue to evaluate the model results.
There were no new claims that exceeded our $1.5 million reinsurance retention level in 2011, 2010 and 2009.
The favorable loss ratio in 2010 resulted from our process to evaluate the overall adequacy of our property and casualty insurance reserves. We re-estimated our reserve requirement for this line of business as our largest assumed contract has been in run-off for many years and we believe any new claims on this contract will be minimal. In addition, our current participation level in assumed business is much lower than our historical participation level through selective renewal of the number and type of assumed contracts we have elected to continue writing.
In both 2011 and 2010, we increased our participation in assumed business, which led to the increase in assumed premium writings for these years. In 2009 we terminated one of our assumed reinsurance contracts and reduced our participation level on another contract. We also concluded some of our assumed business in early 2009 that had been in run-off since late 2006.
In 2011, losses and loss settlement expenses were $24.8 million compared to $(7.3) million in 2010. In 2009, we incurred $4.0 million of losses and loss settlement expenses, of which $0.9 million of the losses were attributable to Hurricanes Gustav and Ike. We continue to have exposure, primarily with respect to environmental and asbestos coverage related to the runoff of some business, as well as exposure to catastrophe losses for the small number of assumed reinsurance contracts that we have continued to underwrite.
Our underwriting expense ratios, which are a percentage of other underwriting expenses over premiums earned, were 35.7 percent, 31.0 percent and 31.3 percent for 2011, 2010 and 2009, respectively. In 2011, our other underwriting expenses were higher than our historical experience as a result of increased amortization of deferred policy acquisition costs and the impact of amortization of the value of business acquired ("VOBA") asset recorded in connection with the acquisition of Mercer Insurance Group. The VOBA asset is being amortized in the first 12 months of operations subsequent to the acquisition in correlation to the remaining term of Mercer Insurance Group policies that were acquired. As of December 31, 2011, the VOBA asset was $1.7 million, which will be fully
amortized in the first quarter of 2012. In addition, we incurred one-time acquisition-related costs in connection with this transaction totaling $8.3 million, which included change in control payments, legal expenses and other acquisition related expenses.
United Life Insurance Company underwrites all of our life insurance business. Our principal life insurance products are deferred and immediate annuities, universal life products and traditional life (primarily single premium whole life insurance) products. We also underwrite and market other traditional products, including term life insurance and whole life insurance. Deferred and immediate annuities (71.7 percent), traditional life products (18.9 percent), universal life products (8.3 percent), and other life products (1.1 percent) comprised our 2011 life insurance premium revenues, as determined on the basis of statutory accounting practices. We do not write variable annuities or variable insurance products.
Our life insurance segment recorded pre-tax income of $11.5 million in 2011, compared to $19.5 million in 2010 and $11.2 million in 2009. The deterioration in our 2011 results is primarily due to historically low investment yields, but it was also affected by an increase in future policy benefits and an increase in death benefits due to our preliminary review of available Social Security records that identified deceased policy holders whose beneficiaries had not submitted claims.
impairment ("OTTI") charges, which are reported as realized investment losses, as compared to the level experienced in 2009. In 2011, 2010 and 2009, OTTI charges recorded totaled $0.4 million, $0.3 million and $8.5 million, respectively.
Net premiums earned increased 8.0 percent in 2011 as compared to 2010, and 14.7 percent in 2010 compared to 2009, due to an increase in sales of our single premium whole life product and sales of single premium immediate annuities, which are attractive to consumers seeking a consistent rate of return. Also contributing to increased sales was our strategy to emphasize the marketing of our traditional life insurance products to our independent life insurance agents in order to achieve a more balanced mix of traditional life insurance products to annuities.
Our deferred annuity deposits increased 33.7 percent in 2011 compared to 2010, and decreased 57.3 percent in 2010 compared to 2009. Annuity deposit levels increased from 2010 to 2011 as some consumers continued to seek products with a consistent rate of return as the equity markets remained volatile and interest rates remained low.
Although interest on policyholders’ accounts remained flat in 2011, we experienced an increase in interest on policyholders' accounts due to the higher average deferred annuity balance in 2010 as compared to 2009. In 2009, annuity deposits increased during the year and we experienced the lowest level of surrenders and withdrawals since 2005.
We reported a federal income tax benefit of $12.7 million in 2011 and $18.3 million in 2009, respectively, compared to a federal income tax expense of 10.9 million in 2010. The benefit in 2011 and 2009 resulted from a taxable loss in our property and casualty insurance operations. Our effective federal tax rate varied from the statutory federal income tax expense rate of 35.0 percent, due primarily to our portfolio of tax-exempt securities.
Our invested assets at December 31, 2011, totaled $2.9 billion, compared to $2.5 billion at December 31, 2010. At December 31, 2011, fixed maturity securities and equity securities comprised 93.4 percent and 5.5 percent of our investment portfolio, respectively. Because the primary purpose of the investment portfolio is to fund future claims payments, we utilize a conservative investment philosophy, investing in a diversified portfolio of high quality, intermediate-term taxable corporate bonds, taxable U.S. government bonds and tax-exempt U.S. municipal bonds.
At December 31, 2011, $2.7 billion, or 99.4 percent, of our fixed maturities were classified as available-for-sale, compared with $2.3 billion, or 99.2 percent, at December 31, 2010, due to the addition of Mercer Insurance Group's investment portfolio. We classify our remaining fixed maturities as held-to-maturity or trading. We record held-to-maturity securities at amortized cost. We record trading securities, primarily convertible redeemable preferred debt securities, at fair value, with any changes in fair value recognized in earnings.
Changes in the credit ratings of our fixed maturity securities at December 31, 2011, as compared to December 31, 2010, are primarily due to the inclusion of Mercer Insurance Group's invested assets in our portfolio. In addition during the fourth quarter of 2011, we began taking advantage of the decreasing spread between AAA- and A-rated fixed maturity securities to improve the quality of our fixed maturity purchases.
The weighted average effective duration of our holdings of fixed maturity securities, at December 31, 2011, is 3.6 years compared to 3.7 years at December 31, 2010.
The amortized cost and fair value of held-to-maturity, available-for-sale and trading securities at December 31, 2011, by contractual maturity, are shown in the following table. Actual maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Asset-backed securities, mortgage-backed securities and collateralized mortgage obligations may be subject to prepayment risk and are therefore not categorized by contractual maturity.
In 2010, our investment income, net of investment expenses, increased $5.6 million to $111.7 million as compared to 2009. The growth in our annuity sales in 2009 contributed to an increase in our invested assets and our investment income generated in 2010, despite historically low interest rates.
The following table details our yield on average invested assets for 2011, 2010 and 2009, which is based on our invested assets (including money market accounts) at the beginning and end of the year divided by net investment income:
The improvement in our realized investment gains in 2011 and 2010, as compared to the losses incurred in 2009, was primarily due to a significant reduction in pre-tax realized losses from OTTI charges on our fixed maturity securities and equity securities. We incurred substantial OTTI charges in 2009 as a result of the credit crisis that impacted the financial markets.
We recorded the following pre-tax OTTI charges in 2011, in 2010 and 2009, respectively:
As of December 31, 2011, net unrealized gains, after tax, totaled $124.4 million, compared to $102.6 million and $82.5 million as of December 31, 2010 and 2009, respectively. In 2011, our acquisition of Mercer Insurance Group increased our holdings of fixed maturity securities that, in connection with a decrease in market interest rates, led to an increase in our net unrealized gains. In 2010, the improvement in the equity markets and a decrease in market
interest rates led to an increase in our net unrealized gains. We have and will continue to closely monitor market conditions and evaluate the long-term impact of the market volatility experienced in recent years on all of our investment holdings.
Changes in unrealized gains on available-for-sale securities do not affect net income and earnings per share, but do impact comprehensive income, stockholders’ equity and book value per share. Based upon both our current analysis of the issuers of the securities that we hold and on current market conditions, we believe that our unrealized losses on available-for-sale securities at December 31, 2011, are temporary. If future events and information cause us to determine that a decline in value is other-than-temporary, it is possible that we could recognize impairment write-downs in future periods on securities that we own at December 31, 2011. However, we endeavor to invest in high quality assets to provide protection from future credit quality issues and corresponding impairment write-downs. The following table summarizes the change in our net unrealized gains:
Interest rate risk is the price sensitivity of a fixed maturity security or portfolio of securities to changes in interest rates. We invest in fixed maturity and other interest rate sensitive securities. While it is generally our intent to hold our investments in fixed maturity securities to maturity, we have classified a majority of our fixed maturity portfolio as available-for-sale. Available-for-sale fixed maturity securities are carried at fair value on the balance sheet with unrealized gains or losses reported net of tax in accumulated other comprehensive income.
Duration relates primarily to our life insurance segment because the long-term nature of these reserve liabilities increases the importance of projecting estimated cash flows over an extended time frame. At December 31, 2011, our life insurance segment had $999.5 million in deferred annuity liabilities that were specifically allocated to investments in fixed maturity securities.
The selection of a 100-basis-point increase in interest rates should not be construed as a prediction by our management of future market events, but rather as an illustration of the potential impact of an event.
Equity price risk is the potential loss arising from changes in the fair value of equity securities held in our portfolio. The carrying values of our equity securities are based on quoted market prices as of the balance sheet date. Market prices of equity securities, in general, are subject to fluctuations that could cause the amount to be realized upon the future sale of the securities to differ significantly from the current reported value. The fluctuations may result from perceived changes in the underlying economic characteristics of the issuer of securities, the relative price of alternative investments, general market conditions, and supply and demand imbalances for a particular security.
We have no direct exposure in any of the guarantors that guarantee our investments. Our largest indirect exposure with a single guarantor totaled $133.8 million or 28.8 percent of our insured municipal securities at December 31, 2011, as compared to $134.4 million or 31.2 percent at December 31, 2010. Our five largest indirect exposures to financial guarantors accounted for 77.6 percent and 79.6 percent of our insured municipal securities at December 31, 2011 and 2010, respectively.
The following table displays a summary of cash sources and uses in 2011, 2010 and 2009:
We invest funds required for short-term cash needs primarily in money market accounts, which are classified as cash equivalents. At December 31, 2011, our cash and cash equivalents included $62.9 million related to these money market accounts, compared with $34.4 million at December 31, 2010.
Net cash flows provided by financing activities totaled $65.2 million, $12.7 million, and $111.0 million in 2011, 2010, and 2009, respectively. Net cash from financing activities increased in 2011 because our life insurance segment's annuity and universal life contract deposits exceeded withdrawals. Also affecting 2011 cash flows were borrowed funds totaling $124.9 million related to our acquisition of Mercer Insurance Group, of which $82.9 million was repaid in 2011. For further discussion of our outstanding debt, refer to Part II, Item 8, Note 17 “Debt.”
Net cash inflows from our life insurance segment's annuity and universal life deposits totaled $51.0 million, in 2011, compared to $34.6 million and $128.4 million for the same period in 2010 and 2009, respectively.
Dividends paid to stockholders totaled $15.5 million, $15.8 million and $16.0 million in 2011, 2010 and 2009, respectively. Our practice has been to pay quarterly cash dividends, which we have paid every quarter since March 1968.
State laws permit United Fire & Casualty Company to pay dividends to United Fire Group, Inc. for distribution to stockholders only from earned surplus arising from business operations. Furthermore, under Iowa law United Fire & Casualty Company may pay dividends only if after giving effect to the payment either that the company is able to pay our debts as they become due in the normal course of business or our total assets would be equal to or more than the sum of our total liabilities. Based on these restrictions, in 2012, United Fire & Casualty will be allowed to make a maximum of $56.6 million in dividend distributions without prior approval. Dividend payments by the other insurance subsidiaries in the holding company system are subject to similar restrictions in the states in which they are domiciled. These restrictions will not have a material impact in meeting our cash obligations.
Stockholders' equity decreased from $716.4 million at December 31, 2010, to $696.1 million at December 31, 2011, a decrease of 2.8 percent. The decline was attributable to stockholder dividends of $15.5 million, stock repurchases of $12.4 million, and an increase in the underfunded status of our employee benefit plans of $16.1 million, net of tax. The decrease was somewhat offset by net unrealized investment appreciation of $21.7 million, net of tax. This increase is due to an appreciation in the market value of our holdings of fixed maturity securities, which was somewhat offset by a decline in the market value of our holdings of equity securities. The book value per share of our common stock was $27.29 at December 31, 2011, compared with $27.35 at December 31, 2010.
The National Association of Insurance Commissioner’s (“NAIC”) adopted risk-based capital requirements, which requires us to calculate a minimum capital requirement for each of our insurance companies based on individual company insurance risk factors. These “risk-based capital” results are used by state insurance regulators to identify companies that require regulatory attention or the initiation of regulatory action. At December 31, 2011, all of our insurance companies had capital well in excess of required levels.
The following table shows our contractual obligations and commitments, including our estimated payments due by period, at December 31, 2011:
Future payments to be made to policyholders and beneficiaries must be actuarially estimated and are not determinable from the contract. The projected payments are based on our current assumptions for mortality, morbidity and policy lapse, but are not discounted with respect to interest. Additionally, the projected payments are based on the assumption that the holders of our annuities and life insurance policies will withdraw their account balances upon the expiration of their contracts. Policies must remain in force for the policyholder or beneficiary to receive the benefit under the policy. Depending on the terms of a particular policy, future premiums from the policyholder may be required for the policy to remain in force. The future policy benefit reserves for our life insurance segment presented on the Consolidated Balance Sheets are generally based on historical assumptions for mortality and policy lapse rates and are on a discounted basis. Accordingly, the amounts presented above for future policy benefit reserves significantly exceeds the amount of future policy benefit reserves reported on our Consolidated Balance Sheets at December 31, 2011.
The amounts presented above are estimates of the dollar amounts and time periods in which we expect to pay out our gross loss and loss settlement expense reserves. Because the timing of future payments may vary from the stated contractual obligation, these amounts are estimates based upon historical payment patterns and may not represent actual future payments. Refer to “Critical Accounting Estimates: Loss and Loss Settlement Expenses - Property and Casualty Insurance Segment” in this section for further discussion.
We are obligated under three statutory trusts to repay $15.5 million in trust preferred securities upon their maturities, with the first maturity in December of 2032 and the last maturity in September of 2033. We have the ability to prepay this commitment and are exercising that right. All three statutory trusts will be retired by April 2, 2012. For a discussion of our trust preferred securities, refer to Part II, Item 8, Note 18 “Trust Preferred Securities.”
We offer our agents a profit-sharing plan as an incentive for them to place high-quality property and casualty insurance business with us. Based on business produced by the agencies in 2011, we estimate property and casualty agencies will receive profit-sharing payments of $9.7 million in 2012.
We estimated the pension contribution for 2012 in accordance with the Pension Protection Act of 2006 (“the Act”). Contributions for future years are dependent on a number of factors, including actual performance versus assumptions made at the time of the actuarial valuations and maintaining certain funding levels relative to regulatory requirements. Contributions in 2012, and in future years, are expected to be at least equal to the IRS minimum required contribution in accordance with the Act.
We value our available-for-sale fixed maturity and trading securities, equity securities, short-term investments and money market accounts at fair value in accordance with the current accounting guidance on fair value measurements. We exclude unrealized appreciation or depreciation on investments carried at fair value, with the exception of trading securities, from net income, and report it, net of applicable deferred income taxes, as a component of accumulated other comprehensive income in stockholders’ equity.
We validate the prices obtained from pricing services and brokers prior to their use for reporting purposes by evaluating their reasonableness on a monthly basis. Our validation process includes a review for unusual fluctuations. In our opinion, the pricing obtained at December 31, 2011, was reasonable.
We review our fair value hierarchy categorizations on a quarterly basis at which time the classification of certain financial instruments may change if the input observations have changed.
The following table presents the categorization for our financial instruments measured at fair value on a recurring
The fair value of our Level 3 private placement securities is determined by management relying on pricing received from our independent pricing services and brokers consistent with the process to estimate fair value for Level 2 securities. If pricing could not be obtained from these sources, management performs an analysis of the contractual cash flows of the underlying security to estimate fair value.
The fair value of our Level 3 impaired securities was determined primarily based upon management’s assumptions regarding the timing and amount of future cash inflows. If a security has been written down or the issuer is in bankruptcy, management relies in part on outside opinions from rating agencies, our lien position on the security, general economic conditions and management’s expertise to determine fair value. We have the ability and the positive intent to hold securities until such time that we are able to recover all or a portion of our original investment. If a security does not have a market at the balance sheet date, management will estimate the security’s fair value based on other securities in the market. Management will continue to monitor securities after the balance sheet date to confirm that their estimated fair value is reasonable.
Realized gains are recorded as a component of current operations whereas unrealized gains (losses) are recorded as a component of comprehensive income.
The equity securities reported as “purchases” primarily relate to our acquisition of Mercer Insurance Group. We purchased securities in the Federal Home Loan Bank of Des Moines, as a requirement to obtain membership and secure a loan used as part of the acquisition financing. These securities were classified as Level 3 because we had no observable market price at December 31, 2011. The reported “disposals” relate to the receipt of principal on calls or sinking fund bonds, in accordance with the indentures.
The securities reported as “transfers in” relate to securities transferred from either level 1 or 2 to level 3 because an updated market value was not available. The securities reported as “transfers out” relate to securities transferred from Level 3 to either Level 1 or 2 because an updated market value was available.
The following table presents the composition of our Level 3 securities at December 31, 2011:
The following table summarizes the activity related to our DAC asset for December 31, 2011 and 2010:
This asset is amortized over the life of the policies written, generally one year. We assess the recoverability of DAC on a quarterly basis by line of business. This assessment is performed by comparing recorded unearned premium to the sum of unamortized DAC and estimates of expected losses and loss settlement expenses. If the sum of these costs exceeds the amount of recorded unearned premium (i.e., the line of business is expected to generate an operating loss), the excess is recognized as an offset against the established DAC asset. We refer to this offset as a premium deficiency charge.
Costs that vary with and relate to the acquisition of life insurance and annuity business are deferred. Such costs consist principally of commissions and related underwriting, agency and policy issue expenses.
The following table summarizes the activity related to our DAC asset for 2011 and 2010. The majority of the DAC asset relates to our universal life and annuity contracts, hereafter referred to as non-traditional business.
Reserves for losses and loss settlement expenses are reported using our best estimate of ultimate liability for claims that occurred prior to the end of any given reporting period, but have not yet been paid. Before credit for reinsurance recoverables, these reserves were $945.1 million and $603.1 million at December 31, 2011 and 2010, respectively. We purchase reinsurance to mitigate the impact of large losses and catastrophic events. Loss and loss settlement expense reserves ceded to reinsurers were $120.4 million for 2011 and $39.0 million for 2010. Our reserves, before credit for reinsurance recoverables, by line of business as of December 31, 2011, were as follows:
historical analysis of Company experience as to what level of IBNR reserve should be established to achieve an adequate IBNR reserve relative to our existing loss exposure base. Unique circumstances or trends, which are evident as of the end of a given period, may require us to refine our IBNR reserve calculation. This methodology for establishing our IBNR reserve has consistently resulted in aggregate reserve levels that management believes are reasonable in comparison to the reserve estimates prepared by our independent actuary, Regnier Consulting Group, Inc. (“Regnier”).
For our short-tail lines of business, IBNR reserves constitute a small portion of the overall reserves. As these claims are generally reported and settled shortly after the loss occurs. In our long-tail lines of business, IBNR reserves constitute a relatively higher proportion of total reserves, because, for many liability claims, significant periods of time may elapse between the initial occurrence of the loss, the reporting of the loss to us and the ultimate settlement of the claim.
Generally, the loss settlement expense reserves for long-tail lines of business are a greater portion of the overall reserves, as there are often substantial legal fees and other costs associated with the complex liability claims that are associated with long-tail coverages. Because short-tail lines of business settle much more quickly and the costs are easier to determine, loss settlement expense reserves for such claims constitute a smaller portion of the total reserves.
To the best of our knowledge, there are no new latent trends that would impact our case-basis reserves;
Our key assumptions are subject to change as actual claims occur and as we gain additional information about the variables that underlie our assumptions. Accordingly, management reviews and updates these assumptions periodically to ensure that the assumptions continue to be valid. If necessary, management makes changes not only
In 2011, we did not change the key assumptions on which we based our reserving calculations. In estimating our 2011 loss and loss settlement expense reserves, we did not anticipate future events or conditions that were inconsistent with past development patterns.
Our reserve for other liability claims at December 31, 2011, is $506.0 million and consists of 5,358 claims, compared with $282.7 million, consisting of 3,419 claims at December 31, 2010. Of the $506.0 million total reserve for other liability claims, $79.0 million is identified as defense costs and $15.5 million is identified as general overhead required in the settlement of claims.
Included in the other liability line of business are gross reserves for construction defect losses and loss settlement expenses. Construction defect is a liability allegation relating to defective work performed in the construction of structures such as commercial buildings, apartments, condominiums, single family dwellings or other housing, as well as the sale of defective building materials. These claims seek recovery due to damage caused by alleged deficient construction techniques or workmanship. At December 31, 2011, we had $42.3 million in construction defect loss and loss settlement expense reserves, excluding IBNR reserves, which consisted of 1,861 claims. The acquisition of Mercer Insurance Group contributed $24.9 million in construction defect loss and loss settlement expense reserves at December 31, 2011, representing 1,535 claims. At December 31, 2010, our reserves, excluding IBNR reserves, totaled $21.1 million, which consisted of 326 claims. The reporting of such claims can be delayed, as the statute of limitations can be up to 10 years. Also, court decisions in recent years have expanded insurers’ exposure to construction defect claims. As a result, claims may be reported more than 10 years after a project has been completed, as litigation can proceed for several years before an insurance company is identified as a potential contributor. Claims have also emerged from parties claiming additional insured status on policies issued to other parties, such as contractors seeking coverage from a subcontractor’s policy.
that we anticipate will mitigate the amount of construction defect losses experienced. These initiatives include increased care regarding additional insured endorsements and stricter underwriting guidelines on the writing of residential contractors and an increased utilization of loss control.
Included in the other liability and assumed reinsurance lines of business are reserves for asbestos and other environmental losses and loss settlement expenses. At December 31, 2011 and 2010, we had $1.8 million and $3.4 million in direct and assumed asbestos and environmental loss reserves. In addition, we had ceded asbestos and environmental loss reserves of $0.3 million and $0.5 million at December 31, 2011 and 2010, respectively. The estimation of loss reserves for environmental claims and claims related to long-term exposure to asbestos and other substances is one of the most difficult aspects of establishing reserves, especially given the inherent uncertainties surrounding such claims. Although we record our best estimate of loss and loss settlement expense reserves, the ultimate amounts paid upon settlement of such claims may be more or less than the amount of the reserves, because of the significant uncertainties involved and the likelihood that these uncertainties will not be resolved for many years.
In establishing reserves, management’s goal is to ensure that our net reserves for losses and loss settlement expenses are adequate to cover all costs, while sustaining minimal variation from the time such reserves are initially estimated until the underlying claims are concluded. Changes in our reserve estimates over time, also referred to as “development,” will occur and may be material. Favorable development is recognized and reported in the Consolidated Financial Statements when we decrease our previous estimate of ultimate losses and loss settlement expenses, which results in an increase to net income in the period recognized. Adverse development is recognized and reported in the Consolidated Financial Statements when we increase our previous estimate of ultimate losses and loss settlement expenses, which results in a decrease to net income.
The following table details the pre-tax impact on our property and casualty insurance segment’s financial results and financial condition of reasonably likely reserve development. Our lines of business that have historically been most susceptible to significant volatility in reserve development have been shown separately and utilize hypothetical levels of volatility of 5.0 percent and 10.0 percent. Our other, less volatile, lines of business have been aggregated and utilize hypothetical levels of volatility of 3.0 percent and 5.0 percent.
It is management’s policy to utilize staff adjusters to develop our estimate of case-basis loss reserves. IBNR and loss settlement expense reserves are established through various formulae that utilize pertinent, recent Company historical data. The calculations are supplemented with knowledge of current trends and events that could result in adjustments to the level of IBNR and loss settlement expense reserves. In addition, management consults with Regnier throughout the year as deemed necessary. On an annual basis, we compare our estimate of total reserves to
Regnier uses four projection methods in their actuarial analysis of our loss reserves and uses the paid-to-paid projection method in their analysis of our loss settlement expense reserves. Based on the results of the projection methods, the actuaries select an actuarial central estimate of the reserves, which is compared to our carried reserves to evaluate the reasonableness of the carried reserves. The four methods utilized by Regnier are: paid loss development; reported loss development; expected loss emergence based on paid losses; and expected loss emergence based on reported losses.
We periodically review the adequacy of these reserves and recoverability of DAC for these contracts on an aggregate basis using actual experience. In the event that actual experience is significantly adverse compared to the original assumptions, any remaining unamortized DAC asset must be expensed to the extent not recoverable and the establishment of a premium deficiency reserve may be required. The effects of changes in reserve estimates are reported in the results of operations in the period in which the changes are determined. We have not made any changes in our methods or assumptions for estimating reserves in the past three years. However, we anticipate that changes in mortality, investment and reinvestment yields, and policy termination assumptions are the factors that would most likely require an adjustment to these reserves or related DAC asset.
Liabilities for future policy benefits for disability claims are estimated using the present value of benefits method and experience assumptions as to claim terminations, expenses and interest.
Estimated rate used to discount the ultimate estimated liability to a present value.
In addition, for the postretirement benefit plan, a 100 basis point increase in the medical trend rate would increase the postretirement benefit obligation at December 31, 2011, by $7.1 million, while a 100 basis point decrease in the medical trend rate would decrease the benefit obligation at December 31, 2011, by $5.6 million.
For the postretirement benefit plan, an increase in our estimated medical trend rate would increase the postretirement benefit expense for the year ended December 31, 2011, by $0.8 million, while a 100 basis point decrease in the rate would decrease benefit expense by $0.6 million, for the same period.
United Fire Group, Inc. (“United Fire”) and its consolidated subsidiaries and affiliates is engaged in the business of writing property and casualty insurance and life insurance and selling annuities through a network of independent agencies. We report our operations in two business segments: property and casualty insurance and life insurance. At December 31, 2011, we were licensed as a property and casualty insurer in 43 states plus the District of Columbia and as a life insurer in 33 states.
On March 28, 2011, we acquired 100 percent of the outstanding common stock of Mercer Insurance Group, Inc. for $191,475,000. The acquisition was funded through a combination of cash and $79,900,000 of short-term debt. Accordingly, the results of operations for Mercer Insurance Group, Inc. have been included in the accompanying consolidated financial statements from that date forward. After the acquisition, we market our products through over 1,300 independent property and casualty agencies. In addition, the acquisition allows us to diversify our exposure to weather and other catastrophe risks across our geographic markets. In connection with this acquisition, we incurred $8,318,000 of transaction costs, which included $5,540,000 of expense related to change in control payments made to the former executive officers of Mercer Insurance Group, Inc.. Refer to Note 16 "Business Combinations" for additional information on this acquisition.
On February 1, 2012, United Fire & Casualty Company completed a corporate reorganization that resulted in the creation of United Fire Group, Inc., an Iowa corporation, as the holding company and sole owner of United Fire & Casualty Company. In connection with the reorganization transaction, each share of United Fire & Casualty Company common stock (par value $3.33 1/3 per share) that was issued and outstanding immediately prior to the effective date was automatically converted into a share of United Fire Group, Inc. common stock (par value $0.001 per share). In addition, each outstanding option to purchase or other right to acquire shares of United Fire & Casualty Company common stock was automatically converted into an option to purchase or right to acquire, upon the same terms and conditions, an identical number of shares of United Fire Group, Inc. common stock. United Fire Group, Inc. became the publicly held corporation upon completion of the reorganization.
We have accounted for the reorganization as a merger of entities under common control, which is similar to the former "pooling of interests method" to account for business combinations. Accordingly, the accompanying Consolidated Financial Statements include the consolidated financial position and results of operations of United Fire & Casualty Company on the same basis as was historically presented, except that the amount reported for common stock at par value has been retrospectively restated to report the par value of United Fire Group, Inc. common stock. The resulting difference has been recorded in additional paid-in capital for all periods presented.
Company, its corporate attorney-in-fact, pursuant to three types of agreements: trust agreements between United Fire & Indemnity Company and certain individuals who agree to serve as trustees; articles of agreement among the trustees who agree to act as underwriters to establish how the Lloyds plan will be operated; and powers of attorney from each of the underwriters appointing a corporate attorney-in-fact, who is authorized to operate the Lloyds plan. Because United Fire & Indemnity Company can name the trustees, the Lloyds plan is perpetual, subject only to United Fire & Indemnity Company’s desire to terminate it.
In the preparation of the accompanying Consolidated Financial Statements, we have evaluated all material subsequent events or transactions that occurred after the balance sheet date through the date on which the financial statements were issued for potential recognition or disclosure therein.
The effect on DAC that results from the assumed realization of unrealized gains (losses) on investments allocated to non-traditional business is recognized with an offset to net unrealized investment appreciation as of the balance sheet dates. The DAC asset increased by $3,402,000 in 2011 and decreased by $2,172,000 and $63,425,000 in 2010 and 2009, respectively, as a result of this adjustment.
Realized gains or losses on disposition of investments are computed using the specific identification method and are included in the computation of net income.
For purposes of reporting cash flows, cash and cash equivalents include cash, money market accounts and non-negotiable certificates of deposit with original maturities of three months or less.
Depreciation expense totaled $3,661,000, $2,812,000 and $3,473,000 for 2011, 2010 and 2009, respectively.
Goodwill and other intangible assets arise as a result of business combinations and consist of the excess of the fair value of consideration paid over the tangible assets acquired and liabilities assumed. We evaluate goodwill and other intangible assets for impairment at least on an annual basis or whenever events or changes in circumstances indicate that it is more likely than not that the carrying amount of goodwill and other intangible assets may exceed the implied fair value. Goodwill is evaluated at the reporting unit level. Any impairment is charged to operations in the period that the impairment was recognized. We did not recognize an impairment charge on our goodwill in 2011.
Our intangible assets, which consist primarily of agency relationships, trade names, licenses, and software, are being amortized by the straight-line method over periods ranging from 2 years to 15 years, with the exception of licenses, which are indefinite-lived and not amortized. We did not recognize an impairment charge on our intangible assets in 2011, 2010 and 2009. Amortization expense, which is allocated to the property and casualty insurance segment, totaled $1,922,000 for 2011, and $60,000 for both 2010 and 2009, respectively.
For our non-qualified stock options, we utilize the Black-Scholes option pricing method to establish the fair value of options granted under our equity compensation plans. Our determination of the fair value of stock options on the date of grant using this option-pricing model is affected by our stock price, as well as assumptions regarding a number of complex and subjective variables, which include the expected volatility in our stock price, the expected term of the award, the expected dividends to be paid over the term of the award and the expected risk-free interest rate. Any changes in these assumptions may materially affect the estimated fair value of the award. For our restricted
and unrestricted stock awards, we utilize the fair value of our common stock on the date of grant to establish the fair value of the award. Refer to Note 9 “Stock Option Plans” for further discussion.
In September 2011, the FASB issued updated accounting guidance that is intended to reduce complexity and costs by allowing an entity to make a qualitative evaluation about the likelihood of goodwill impairment to determine whether it should calculate the fair value of a reporting unit. The updated guidance also improves previous guidance by expanding upon the examples of events and circumstances that an entity should consider between annual impairment tests in determining whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. In addition, the updated guidance improves the examples of events and circumstances that an entity having a reporting unit with a zero or negative carrying amount should consider in determining whether to measure an impairment loss, if any, under the second step of the goodwill impairment test. The updated guidance is effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011, with early adoption permitted. We have elected to early adopt this guidance, which did not impact the amounts reported in our Consolidated Financial Statements.
In October 2010, the FASB issued updated accounting guidance to address the diversity in practice for the accounting for costs associated with acquiring or renewing insurance contracts. This guidance modifies the definition of acquisition costs to specify that a cost must be incremental and directly related to the successful acquisition of a new or renewal insurance contract in order to be deferred. Acquisition costs that are not eligible for deferral are to be charged to expense in the period incurred. If application of this guidance would result in the capitalization of acquisition costs that had not previously been capitalized by a reporting entity, the entity may elect not to capitalize those costs. The updated guidance is effective for interim and annual reporting periods beginning after December 15, 2011. We will adopt this guidance prospectively effective January 1, 2012.The implementation of this guidance will reduce the amount of acquisition costs we can capitalize and report as an asset in the accompanying Consolidated Balance Sheets. We currently estimate that the corresponding reduction in pretax income will be approximately $11,000,000 to $17,000,000 in 2012. However, this estimate is preliminary in nature and the actual amount of the reduction may be above or below the range.
In June 2011, the FASB issued revised accounting guidance that eliminates the option to present the components of other comprehensive income as part of the statement of stockholders' equity. Instead, comprehensive income must be reported in either a single continuous statement of comprehensive income that contains two sections, net income and other comprehensive income, or in two separate but consecutive statements. The revised guidance will be effective for public companies for interim and annual reporting periods beginning after December 15, 2011 with early adoption permitted, and is to be applied retrospectively. We will adopt this guidance effective January 1, 2012, which will not change the items that constitute net income or other comprehensive income as currently reported.
A reconciliation of the amortized cost (cost for equity securities) to fair value of investments in held-to-maturity and available-for-sale fixed maturity and equity securities at December 31, 2011 and 2010, is as follows:
There were no sales of held-to-maturity securities in 2011, 2010 and 2009.
Net investment income for the years ended December 31, 2011, 2010 and 2009, is comprised of the following:
Pursuant to an agreement with one of our limited liability partnership funds, we are contractually committed to make capital contributions up to $15,000,000, upon request by the partnership, through December 31, 2017. Our remaining potential contractual obligation was $9,156,000 at December 31, 2011.
We continually monitor the difference between our cost basis and the estimated fair value of our investments. Our accounting policy for impairment recognition requires OTTI charges to be recorded when we determine that it is more likely than not that we will be unable to collect all amounts due according to the contractual terms of the fixed maturity security or that the anticipated recovery in fair value of the equity security will not occur in a reasonable amount of time. Impairment charges on investments are recorded based on the fair value of the investments at the measurement date. Factors considered in evaluating whether a decline in value is other-than-temporary include: the length of time and the extent to which fair value has been less than cost; the financial condition and near-term prospects of the issuer; our intention to hold the investment; and the likelihood that we will be required to sell the investment.
We believe the unrealized depreciation in value of our fixed maturity portfolio is primarily attributable to changes in market interest rates and not the credit quality of the issuer. We have no intent to sell and it is more likely than not that we will not be required to sell the securities until such time that the fair value recovers or the securities mature.
We have evaluated the unrealized losses reported for all of our equity securities at December 31, 2011, and have concluded that the duration and severity of these losses do not warrant the recognition of an OTTI charge at December 31, 2011. Our largest unrealized loss greater than 12 months on an individual equity security at December 31, 2011, was $122,000. We have no intention to sell any of these securities prior to a recovery in value, but will continue to monitor the fair value reported for these securities as part of our overall process to evaluate investments for OTTI recognition.
A summary of the carrying value and estimated fair value of our financial instruments at December 31, 2011 and 2010, is as follows:
To determine the fair value of the majority of our investments, we utilize prices obtained from independent, nationally recognized pricing services. We obtain one price for each security. When the pricing services cannot provide a determination of fair value for a specific security, we obtain non-binding price quotes from broker-dealers with whom we have had several years experience and who have demonstrated knowledge of the subject security. We
The following tables present the categorization for our financial instruments measured at fair value on a recurring basis in our Consolidated Balance Sheets at December 31, 2011 and 2010:
For the year ended December 31, 2011, the change in our available-for-sale securities categorized as Level 1 and Level 2 is the result of investment purchases and disposals made during the period, which were made from funds held in our money market accounts, and an increase in unrealized gains on both fixed maturities and equity securities. There were no significant transfers of securities in or out of Level 1 or Level 2 during the year.
Realized losses are recorded as a component of current operations whereas unrealized gains (losses) are recorded as a component of comprehensive income.
We account for premiums, written and earned, and losses incurred net of reinsurance ceded. The ceding of insurance does not legally discharge us from primary liability under our policies, and we must pay the loss if the reinsurer fails to meet its obligation. We periodically monitor the financial condition of our reinsurers to confirm that they are financially stable. We believe that all of our reinsurers are in an acceptable financial condition and there were no reinsurance balances at December 31, 2011, for which collection is at risk that would result in a material impact on our Consolidated Financial Statements. The amount of reinsurance recoverable on paid losses totaled $2,590,000 and $2,207,000 at December 31, 2011 and 2010, respectively.
In 2010, we increased our participation in assumed business, which led to the increase in assumed premium writings for the year. The benefit reported for loss and loss settlement expenses incurred from assumed business in 2010 is the result of our process to evaluate the overall reserve adequacy of our property and casualty insurance segment. We re-estimated our reserve requirement for assumed business as our largest assumed reinsurance contract has been in run-off for many years and we believe any new claims on this contract would not be significant. In addition, our participation level in assumed business was much lower than our historical participation level. The re-estimation of reserve estimates specific to the assumed reinsurance line of business was part of an overall review of reserves by line of business and did not have a direct impact on the net income reported for our property and casualty insurance segment in 2010.
We have several programs that provide reinsurance coverage. This reinsurance coverage limits the risk of loss that we retain by reinsuring direct risks in excess of our retention limits. The following table provides a summary of our primary reinsurance programs, for 2011 and 2010. Retention amounts reflect the accumulated retentions and co-participation of all layers within a program.
(1) On August 1, 2011, Mercer Insurance Group's property and casualty reinsurance retention and limits were changed to match the rest of the property and casualty insurance segment.
United Life purchases reinsurance to limit the dollar amount of any one risk of loss. Beginning in 2011, our retention on standard individual life cases is $300,000. Our accidental death benefit rider on an individual policy is reinsured at 100 percent, up to a maximum benefit of $250,000. Our group coverage, both life and accidental death and dismemberment, is reinsured at 50.0 percent. Catastrophe excess reinsurance coverage applies when three or more insureds die in a catastrophic accident. For catastrophe excess claims, we retain the first $1,000,000 of ultimate net loss and the reinsurer agrees to indemnify us for the excess up to a maximum of $5,000,000. We supplement this coverage when appropriate with “known concentration” coverage. Known concentration coverage is typically tied to a specific event and time period, with a threshold of a minimum number of lives involved in the event, minimum event deductible (stated retention limit) and a maximum payout.
Because property and casualty insurance reserves are estimates of the unpaid portions of incurred losses that have been reported to us, as well as losses that have been incurred but not reported ("IBNR"), the establishment of appropriate reserves, including reserves for catastrophes, is an inherently uncertain and complex process. The ultimate cost of losses and related loss settlement expenses may vary materially from recorded amounts, which are based on management’s best estimates. We regularly update our reserve estimates as new information becomes available and as events unfold that may affect the resolution of unsettled claims. Changes in prior year reserve estimates, which may be material, are reported in losses and loss settlement expenses in the accompanying Consolidated Statements of Income in the period such changes are determined.
The following table provides an analysis of changes in our property and casualty loss and loss settlement expense reserves for 2011, 2010 and 2009 (net of reinsurance amounts):
All states require domiciled insurance companies to prepare statutory-basis financial statements in conformity with the National Association of Insurance Commissioner’s (“NAIC”) Accounting Practices and Procedures Manual, subject to any deviations prescribed or permitted by the applicable insurance commissioner and/or director. Statutory accounting practices primarily differ from GAAP in that policy acquisition and certain sales inducement costs are charged to expense as incurred, life insurance reserves are established based on different actuarial assumptions and the values reported for investments, pension obligations and deferred taxes are established on a different basis.
requirements. Retirement benefits under our pension plan are based on the number of years of service and level of compensation. Our policy to fund the pension plan on a current basis to not less than the minimum amounts required by the Employee Retirement Income Security Act of 1974, as amended, and the Internal Revenue Code of 1986, as amended, is to assure that plan assets will be adequate to provide retirement benefits. We estimate that we will contribute approximately $7,000,000 to the pension plan in 2012.
We also offer a health and dental benefit plan (the “postretirement benefit plan") to all of our eligible employees and retirees that consists of two programs: (1) the self-funded retiree health and dental benefit plan and (2) the self-funded employee health and dental benefit plan. The postretirement benefit plan provides health and dental benefits to our employees and retirees (and covered dependents) who have met the service and participation requirements stipulated by the postretirement benefit plan. The third party administrators for the postretirement benefit plan are responsible for making medical and dental care benefit payments. Participants are required to submit claims for reimbursement or payment to the claims administrator within twelve months after the end of the calendar year in which the charges were incurred. An unfunded benefit obligation is reported for the postretirement benefit plan in the accompanying Consolidated Balance Sheets.
Our investment policy and objective for the pension plan is to generate long-term capital growth and income, by way of a diversified investment portfolio along with appropriate employer contributions, which will allow us to provide for the pension plan’s benefit obligation.
The investments held by the pension plan at December 31, 2011, include the following asset categories:
Equity securities, which may include various types of stock, such as large-cap, mid-cap and small-cap stocks, international stocks and our common stock.
We consider historical experience for comparable investments and the target allocations we have established for the various asset categories of the pension plan to determine the expected long-term rate of return, which is an assumption as to the average rate of earnings expected on the pension plan funds invested, or to be invested, by the pension plan, to provide for the settlement of benefits included in the projected pension benefit obligation. Investment securities, in general, are exposed to various risks, such as fluctuating interest rates, credit standing of the issuer of the security and overall market volatility. Annually, we perform an analysis of expected long-term rates of return based on the composition and allocation of our pension plan assets and recent economic conditions. We use
The investment return expectations for the pension plan are used to develop the asset allocation based on the specific needs of the pension plan. Accordingly, equity securities comprise the largest portion of our pension plan assets, as they yield the highest rate of return. The United Life annuity, which is the third largest asset category and was originally written by our life insurance subsidiary in 1976, provides a guaranteed rate of return. The interest rate on the group annuity contract is determined annually.
The pension plan also had a significant investment in United Fire Group, Inc. common stock. We believe that even though market fluctuations impact the fair value of this investment, the target allocation is reasonable and the shares held have historically generated investment income, through dividend payments, for the pension plan. Dividends on shares of United Fire Group, Inc. common stock totaled $121,000 for 2011, 2010 and 2009, respectively.
There were no transfers of assets in or out of Level 1 or Level 2 during the period.
The low interest rate environment has resulted in a significant decline in the discount rates we use to value our respective plan's benefit obligations. As a result, the valuation of the benefit obligations has increased, which has reduced the funded status of those plans. A prolonged low interest rate environment could require a higher level of cash contributions to fund our pension plan.
Our accumulated pension benefit obligation was $93,769,000 and $73,762,000 at December 31, 2011 and 2010, respectively.
We have an employee stock ownership plan (the “ESOP”) for the benefit of eligible employees and their beneficiaries. All employees are eligible to participate in the ESOP upon completion of one year of service, meeting the hourly employment requirements and attaining 21 years of age. Contributions to the ESOP are made at our discretion. When made, these contributions are based upon a percentage of the total payroll and are allocated to participants on the basis of compensation. We can make contributions in stock or cash, which the trustee uses to acquire shares of our stock to allocate to participants’ accounts. As of December 31, 2011, 2010 and 2009, the ESOP owned 226,375, 234,107, and 241,741 shares of United Fire Group, Inc. common stock, respectively. Shares owned by the ESOP are included in shares issued and outstanding for purposes of calculating earnings per share, and dividends paid on the shares are charged to retained earnings. We made contributions to the ESOP of $175,000 in 2011, $100,000 in 2010, and $150,000 in 2009.
The United Fire Group, Inc. 2008 Stock Plan (the “2008 Stock Plan”) authorizes the issuance of restricted and unrestricted stock awards, stock appreciation rights, incentive stock options, and non-qualified stock options for up to 1,900,000 shares of our common stock to employees, with 653,511 authorized shares available for future issuance at December 31, 2011. The 2008 Stock Plan is administered by the Board of Directors, which determines those employees who will receive awards, when awards will be granted, and the terms and conditions of the awards. The Board of Directors may also take any action it deems necessary and appropriate for the administration of the 2008 Stock Plan. Pursuant to the 2008 Stock Plan, the Board of Directors may, at its sole discretion, grant awards to our employees who are in positions of substantial responsibility with United Fire.
The activity in the 2008 Stock Plan is displayed in the following table:
The 2005 Non-qualified Non-Employee Director Stock Option and Restricted Stock Plan (the "Director Plan") authorizes us to grant restricted and unrestricted stock and non-qualified stock options to purchase shares of our common stock to non-employee directors. At our annual stockholders’ meeting on May 18, 2011, our stockholders approved an amendment to the Director Plan to increase from 150,000 to 300,000 the number of shares that may be issued under the Director Plan and to extend the life of the Director Plan from December 31, 2014 to December 31, 2020. At December 31, 2011, we had 160,009 authorized shares available for future issuance.
The Board of Directors has the authority to determine which non-employee directors receive awards, when options and restricted and unrestricted stock shall be granted, the option price, the option expiration date, the date of grant, the vesting schedule of options or whether the options shall be immediately vested, the terms and conditions of options and restricted stock (other than those terms and conditions set forth in the plan) and the number of shares of common stock to be issued pursuant to an option agreement or restricted stock agreement. The Board of Directors may also take any action it deems necessary and appropriate for the administration of the Director Plan.
The analysis below details the award activity for 2011 and the awards outstanding at December 31, 2011, for both of our plans and ad hoc options, which were granted prior to the adoption of the other plans:
Intrinsic value is the difference between our share price on the last day of trading (i.e., December 31, 2011) and the price of the options when granted and represents the value that would have been received by option holders had they exercised their options on that date. These values change based on the fair market value of our shares. The intrinsic value of options exercised totaled $35,000, $27,000 and $4,000 in 2011, 2010 and 2009, respectively.
lines, other liability, automobile, workers’ compensation and surety. Our personal lines consist primarily of automobile and fire and allied lines coverage, including homeowners.
Premiums for our life and health insurance products are based on assumptions with respect to mortality, morbidity, investment yields, expenses, and lapses and are also affected by state laws and regulations, as well as competition. Pricing assumptions are based on our experience, as well as the industry in general, depending upon the factor being considered. The actual profit or loss produced by a product will vary from the anticipated profit if the actual experience differs from the assumptions used in pricing the product.
The sum of the quarterly reported amounts may not equal the full year, as each is computed independently.
The components of basic and diluted earnings (loss) per share were as follows:
Comprehensive income includes changes in stockholders’ equity during a period except those resulting from investments by and dividends to stockholders.
At December 31, 2011, our future minimum rental payments are as follows:
We are named as a defendant in various lawsuits relating to disputes arising from damages that occurred as a result of Hurricane Katrina in 2005. These lawsuits involve, among other claims: disputes as to the amount of reimbursable claims; the scope of insurance coverage under homeowners and commercial property policies due to flooding, civil authority actions, loss of use and business interruption; breach of the duty of good faith or violations of Louisiana insurance claims-handling laws or regulations (which cases involve claims for statutory damages and, in some cases, punitive or exemplary damages); the applicability of Louisiana's so-called “Valued Policy Law,” pursuant to which insurers must pay the total insured value of a structure that is totally destroyed if any portion of such damage was caused by a covered peril, even if the principal cause of the loss was an excluded peril; and the scope or enforceability of the water damage exclusion in the policies. We have established our loss and loss settlement expense reserves on the assumption that the application of the Valued Policy Law will not result in our having to pay damages for perils not otherwise covered. We believe that, in the aggregate, these reserves are adequate.
We consider all of our other litigation pending as of December 31, 2011, to be ordinary, routine, and incidental to our business.
The fair value of available-for-sale fixed maturity securities is primarily based on quoted prices for similar financial instruments in markets that are not active or on inputs that are observable either directly or indirectly for the full term of the financial instrument. The fair value of equity securities is primarily based on unadjusted quoted prices in active markets for identical financial instruments that we have the ability to access.
The fair value of reserves for losses, claims and loss settlement expenses related to incurred claims and reinsurance receivables and recoverables is determined using a valuation model that is based on actuarial estimates of future cash flows for the underwriting liabilities. These future cash flows are adjusted for the time value of money using duration-matched risk-free interest rates that approximate current U.S. Treasury bill rates and a risk margin to compensate the acquirer for the risk associated with these liabilities.
The value of business acquired (“VOBA”) at the acquisition date is an intangible asset relating to the difference between the unearned premium reserves acquired in the transaction and the estimated fair value of the unexpired insurance policies, which consists of two components: (1) a provision for loss and loss settlement expenses that will be incurred as the premium is earned and (2) a provision for policy maintenance costs related to servicing those policies until they expire. Loss and loss settlement expenses are valued in a manner identical to that used for loss reserve valuation. Policy maintenance costs are valued based on estimates of future cash flows that are discounted to present value using duration-matched risk-free interest rates. VOBA is reported as a component of deferred policy acquisition costs in the accompanying Consolidated Balance Sheets and is amortized over a twelve-month period
The fair value of the intangible asset for agency relationships was established using the excess earnings method, which is an income approach based on estimated financial projections developed by management using market participant assumptions. Fair value has been estimated as the present value of the benefits anticipated from our continued relationship with these agencies that are in excess of the return required on the investment in contributory assets necessary to realize those benefits. The rate used to discount the net benefits is based on a risk-adjusted rate that takes into consideration market-based rates of return and is representative of the relative risk of the acquired asset.
The fair value of the intangible asset for software was established using the replacement cost method, which estimates the cost to recreate the utility of the subject asset in consideration of the technological and functional obsolescence of the acquired software.
The fair value of all other tangible assets and liabilities approximates their carrying values at the acquisition date due to their short-term duration.
The unaudited pro forma results above have been prepared for comparative purposes only and do not purport to be indicative of the results of operations that actually would have resulted had the acquisition occurred at January 1, 2010, and they are not necessarily indicative of future operating results. Annualized revenues of Mercer Insurance Group were $145,868,000 for 2011. Total revenues and net loss recorded in the accompanying Consolidated Statements of Income related to Mercer Insurance Group was $109,043,000 and $14,650,000 for the year ended December 31, 2011, respectively.
We were in compliance with all covenants for the credit agreement as of December 31, 2011.
In connection with our acquisition of Mercer Insurance Group, we acquired three statutory business trusts formed by Mercer Insurance Group to issue floating rate capital securities (“Trust Preferred Securities”) and to invest the proceeds in junior subordinated debentures of Mercer Insurance Group. Mercer Insurance Group holds $488,000 of equity securities to capitalize the Trusts. The three trusts issued a total of $15,500,000 Trust Preferred Securities to the public. The following Trust Preferred Securities were outstanding as of December 31, 2011:
Financial Pacific Statutory Trust I (“Trust I”) is a Connecticut statutory business trust. Trust I issued 5,000,000 shares of the Trust Preferred Securities at a price of $1 per share for $5,000,000 and purchased $5,155,000 in junior subordinated debentures from Mercer Insurance Group that mature on December 4, 2032. The annual effective rate of interest at December 31, 2011 is 4.527 percent.
The carrying value of our goodwill was $15,091,000 at December 31, 2011.
We have audited the accompanying consolidated balance sheets of United Fire Group, Inc. (United Fire) as of December 31, 2011 and 2010, and the related consolidated statements of income, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2011. Our audits also included the financial statement schedules listed in Item 15(a)(2). These financial statements and schedules are the responsibility of United Fire’s management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.