(a) Net Realized Investment Gains (Losses) in 2006, 2005, 2004, 2003, 2002 and 2001 include the effect of SFAS 133 adjustments of $1.0 million, $0.4 million, $0.8 million, $0.8 million, $(0.2) million and $1.1 million, respectively.
American Modern has continued to experience significant premium growth in non-manufactured housing product lines, including site built dwelling, mortgage fire, credit life and excess and surplus lines. Collectively, our non-manufactured housing direct and assumed written premiums grew 22.6% in 2006 compared to 2005. Non-manufactured housing products represented 59% and 64% of American Modern’s direct and assumed written premiums and related pre-tax profit, respectively, during 2006.
The following chart shows American Modern’s gross written premium, net written premium and net earned premium by business segment for the years ended December 31, 2006 and 2005 (in millions). Gross written premium, also described as direct and assumed written premium, is the amount of premium charged for policies issued during a fiscal period. Net written premium is the amount of premium that American Modern retains after ceding varying portions of its gross written premium to other insurance companies. Net earned premium is the amount included in our condensed consolidated statements of operations. Premiums for physical damage and other property and casualty related coverages, net of premium ceded to reinsurers, are considered earned and are included in the financial results on a pro-rata basis over the lives of the policies. Credit accident and health and credit life premiums are recognized as income over the lives of the policies in proportion to the amount of insurance protection provided. The portion of written premium applicable to the unexpired terms of the policies is recorded as unearned premium in our condensed consolidated balance sheets.
Gross written premium, net written premium and net earned premium increased 13.2%, 10.7% and 7.0%, respectively, in 2006 compared to 2005. The most significant contributors to the growth in premiums in 2006 were the mortgage fire, site-built dwelling, excess and surplus lines and credit life insurance products.
The following chart is an overview of the results of operations of the company’s residential property segment (in 000’s).
The results from this segment are driven primarily by the manufactured housing and site-built dwelling products. Although the manufactured housing industry continues to be depressed, American Modern’s diverse distribution channels have enabled gross written premiums related to this product to increase to $337.8 million in 2006 compared to $331.5 million in 2005. Site-built dwelling gross written premiums increased 22.2% to $105.6 million in 2006 compared to $86.4 million in 2005.
The following chart is an overview of the results of operations of the company’s recreational casualty segment (in 000’s).
Direct and assumed written premiums for our recreational casualty products decreased due primarily to the decreases of $5.6 million and $2.5 million for our watercraft and motorcycle products, respectively. The decrease in motorcycle direct and assumed written premiums was due primarily to the implementation in recent years of new underwriting modifications such as restrictions on certain types of coverages and implementation of a more sophisticated motorcycle
The following chart is an overview of the results of operations of the company’s other insurance segment (in 000’s).
Overall, American Modern’s losses and loss adjustment expenses increased 7.3% in 2006 to $307.5 million from $286.7 million in 2005. The increase was due primarily to the related 7.0% increase in earned premiums in 2006 compared to 2005 combined with slight increases in loss ratios related to the manufactured housing, collateral protection and excess and surplus lines products. While the overall financial impact of catastrophes in 2006 improved compared to 2005,
due to reinstatement premiums and other catastrophe related items in 2005, loss and loss adjustment expenses due to catastrophes remained relatively constant in 2006 at $34.5 million compared to $34.9 million in 2005.
American Modern’s commissions and other policy acquisition costs increased 5.6% in 2006 to $209.7 million from $198.6 million in 2005. This fluctuation is consistent with the increase in net earned premium. However, the majority of the fluctuation related to the increase in performance-based commission expense, with the up-front commissions increasing only slightly. This change in the mix of commission expense is attributable to American Modern’s “Pay for Performance” commission policy, with agents representing the Company, which reduces the up-front commission paid but rewards favorable underwriting and growth performance with a higher performance-based commission.
M/G Transport, Midland’s transportation subsidiary, contributed $7.8 million of income, before taxes, in 2006 compared to $4.9 million in 2005. In addition, M/G Transport’s revenues increased to $49.8 million in 2006 compared to $42.2 million in 2005. The increases in transportation revenues and pre-tax income are due primarily to an improved freight rate environment that we expect to continue into 2007.
Gross written premium, net written premium and net earned premium decreased 2.7%, 8.4% and 6.7%, respectively, in 2005 compared to 2004. The more significant decrease in net written premium and net earned premium was due partially to a $14.7 million increase in reinstatement premiums in 2005 compared to 2004. Reinstatement premiums, which are netted against net written premium and net earned premium but do not impact gross written premium, related to purchasing additional reinsurance in response to the severe hurricane season experienced in 2005. In addition to the increased reinstatement premiums, the Company experienced growth in several accounts where premium is ceded back to the producing agent.
The combined ratio for the residential property segment was 95.2% in 2005 compared to 94.3% in 2004. The results from this segment are driven primarily by the manufactured housing and site-built dwelling products. Although the manufactured housing industry continues to be depressed, American Modern’s gross written premium related to this product remained relatively constant at $331.5 million in 2005 compared to $334.1 million in 2004. Site-built dwelling gross written premiums decreased 2.3% to $86.4 million in 2005 compared to $88.4 million in 2004.
The decrease in gross written premiums for our financial institutions insurance products was driven by the collateral protection and mortgage fire products which decreased $11.0 million and $7.9 million, respectively, compared to the prior year. The decrease in collateral protection gross written premiums in 2005 compared to 2004 was due to the assumption of a $17.6 million book of business during the second quarter of 2004 which included a one-time assumption of unearned premium totaling $13.6 million. The decrease in mortgage fire gross written premiums resulted primarily from the sale of a mortgage portfolio in 2005 which was serviced by one of our agents within this line.
American Modern’s excess and surplus lines and credit life products were the primary drivers of the increase in gross written premiums in 2005 compared to 2004. A large percentage of the Company’s excess and surplus lines gross written premium is ceded to reinsurers. In addition, a large percentage of credit life gross written premium is ceded to an insurance affiliate of the producing agent. The improvement in profitability in 2005 compared to 2004 is due primarily to the improved underwriting results related to our excess and surplus lines business and our park and dealer business.
During 2005 and 2004 the company experienced favorable loss development, while it experienced unfavorable loss development in 2003. This was attributable to several factors. The company exited a commercial liability product line in 2001 related to manufactured housing park operators and dealers. Original loss reserve estimates in 2001 and 2002 related to this line were not adequate. Loss reserve estimates were increased in 2003 to account for this deficiency. Subsequent settlement of these reserves has been for amounts below the revised loss reserves, resulting in a redundancy in 2004 and 2005. Another factor that contributed to the favorable development was an overestimate of the reserves related to the motorcycle line of business, the excess and surplus lines business and the liability component of our other personal lines products. The liability components associated with these lines are inherently less predictable than the company’s traditional property coverages. The company entered the motorcycle line in 2000 and the excess and surplus lines in 2002. The excess and surplus line has continued to grow at a rapid pace while the motorcycle line contracted in 2004 and 2005.
The Company’s operating and administrative expenses increased 3.5% to $112.3 million in 2005 compared to $108.5 million in 2004. This increase is due primarily to expenses related to modernLINK®, our proprietary information systems and web enablement initiative, and an
The interest rates related to portions of the long-term debt in the above table are variable in nature and the interest payments included in the table have been calculated using the rates in effect at December 31, 2006.
We do not utilize any special-purpose financing vehicles or have any undisclosed off balance sheet arrangements. Similarly, the Company holds no fair-value contracts for which a lack of marketplace quotations would necessitate the use of fair value techniques.
No shares were repurchased in the open market under the Company’s share repurchase program during 2006. On April 27, 2006, the Company’s Board of Directors approved a two-year extension to the share repurchase program that will run through the date of the Board’s second quarterly meeting in 2008. In addition, 500,000 additional shares were authorized for repurchase bringing the total to 1,086,000 shares that remain authorized for repurchase under terms of this program. The resolution does not require the repurchase of shares, but rather gives management discretion to make purchases based on market conditions and the Company’s capital requirements.
The share repurchase program pertains exclusively to shares to be purchased on the open market. This program specifically excludes shares repurchased in connection with stock incentive plans. The Company may periodically repurchase stock awarded to associates in connection with stock incentive programs. Such repurchase transactions essentially accommodate associates funding of the exercise price and any tax liabilities arising from the exercise or receipt of equity based incentive awards. During 2006, the Company repurchased 30,288 shares for approximately $2.1 million in connection with associate stock programs.
We paid dividends to our shareholders of $4.6 million during 2006, $4.2 million in 2005 and $3.7 million in 2004. In 2007, we expect to pay approximately $7.7 million in dividends to our shareholders due to increasing our annual dividend to $0.40 per share in 2007 compared to $0.245 per share in 2006.
On October 21, 2003 Midland filed a shelf registration statement with the Securities and Exchange Commission. This registration statement will allow the Company to offer from time to time up to $150.0 million in various types of securities, including debt, preferred stock and common stock. On February 5, 2004, Midland sold 1,150,000 shares of its common stock authorized by this shelf registration. The net proceeds received of $25.1 million were used to increase the capital base of its insurance subsidiaries to provide for future growth and for other general corporate purposes.
securities. In each of the periods presented, funds generated from the insurance operating activities were used primarily to purchase investment grade marketable securities, accounting for the majority of the cash used in investing activities.
The amounts expended for the development costs capitalized in connection with the development of modernLINK®, our proprietary information systems and web enablement initiative, amounted to $10.0 million in 2006 and a total of $40.3 million from inception in 2000 through December 31, 2006. The initiative is being designed, developed and implemented in periodic phases to ensure its cost effectiveness and functionality. This project may involve future cash expenditures in the range of $40 million to $45 million over the next four years, with additional spending thereafter to expand system compatibility and functionality. A portion of such expenditures will be capitalized and amortized over the useful life. However, actual costs may be more or less than what we estimate. The cost of the development and implementation is expected to be funded out of operating cash flow. Significant changes to the technology interface between American Modern and its distribution channel participants and policyholders, while unlikely, could significantly disrupt or alter its distribution channel relationships. If the new information systems are ultimately deemed ineffective, it could result in an impairment charge to our capitalized costs. The unamortized balance of modernLINK®’s software development costs was $28.3 million at December 31, 2006.
American Modern has a $72.0 million long-term credit facility available on a revolving basis at various rates. As of December 31, 2006, there was $36.0 million outstanding under these facilities.
Accounts receivable is primarily comprised of premium due from both policyholders and agents. In the case of receivables due directly from policyholders, policies are cancelable in the event of non-payment and thus offer minimal credit exposure. Approximately 63% of American Modern’s accounts receivables relate to premium due directly from policyholders as of December 31, 2006. In the case of receivables due from agents, American Modern has extended payment terms that are customary and normal in the insurance industry. Management monitors its credit exposure with its agents and related concentrations on a regular basis. However, as collectibility of such receivables is dependent upon the financial stability of the agent, American Modern cannot assure collections in full. Where management believes appropriate, American Modern has provided a reserve for such exposures. Accounts receivable increased $11.1 million to $148.2 million at December 31, 2006 compared to $137.1 million at year end 2005. The increase is due to the corresponding increase in written premiums in 2006 compared to 2005.
The $50.3 million increase in unearned insurance premiums at December 31, 2006 compared to year end 2005 is related to the $97.3 million increase in the Company’s direct and assumed written premiums.
The decrease of $33.0 million in insurance loss reserves was due primarily to the settlement of losses in 2006 related to hurricanes Katrina, Rita and Wilma. The following table provides additional detail surrounding the Company’s insurance policy loss reserves at December 31, 2006 and 2005 (amounts in 000’s):
Cash flow from the insurance operations is expected to remain sufficiently positive to meet American Modern’s future operating requirements and to provide for reasonable dividends to Midland.
Changes in net unrealized gains on marketable securities result from both market conditions and realized gains recognized in a reporting period. The interest rate swap agreement expired on December 1, 2005. While the interest rate swap agreement was in place, its after-tax fair value varied according to the current interest rate environment relative to the fixed rate of the swap agreement. Changes in the additional minimum pension liability are actuarially determined based on the funded status of the plans and current actuarial assumptions.
Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates, assumptions and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosures of contingent assets and liabilities. We regularly evaluate our critical accounting policies, assumptions and estimates, including those related to insurance revenue and expense recognition, loss reserves and reinsurance. We base our estimates on historical experience and on various assumptions that we believe to be reasonable under the circumstances. This process forms the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.
Case base loss reserves are estimated liabilities set for specifically identified outstanding losses incurred to date to be paid in the future. Case base loss reserves are based on the specific facts and circumstances of reported claims, but still require a significant amount of judgment. Case base reserves are established after notice of loss is received. The initial amount of the case base reserve is based on the policy coverages and limits, loss description, exposure information (i.e., insured product and insured value), cause of loss and historical loss cost information. The claim reserves are subsequently adjusted by claims personnel as more information becomes available in the claim adjustment process, through such procedures as a physical inspection of the loss. In many of our property lines of business, our adjusters utilize specialized claim estimatic software to assist in the claim estimation process. The claim estimatic software utilizes historical information and considers factors such as the region to assist in the estimated value of such items as materials, labor and depreciation, as applicable. Case base loss reserves are subsequently revised based on additional information until the claim is ultimately paid. The case base claims from our property lines of business tend to be reported and settled rather quickly. We estimate that property claims are reported to us, on average, approximately 30 days after the loss incurred date and approximately 90 percent are settled within 30 days from when they are reported to us. Losses for our liability lines of business are generally reported to us much longer after the loss incurred date as compared to our property lines of business. The majority of our liability claims are settled within 90 days of being reported to us. However, it is not unusual to have liability claims that are not reported to us for as much as several years after the actual loss has occurred and for these claims to take an extended period of time to actually settle. This is particularly true in our exited commercial park and dealer liability business and to a lesser extent, in our excess and surplus lines. We estimate that approximately 55 percent of our case base loss reserves relate to property coverages and 45 percent relate to liability coverages. The Company’s philosophy is to adequately reserve our case base claims in a consistent manner.
The objective of the incurred-but-not-reported loss (IBNR) reserve is to establish a reserve for claims that have been incurred by our policyholders but not yet been reported to us and to contemplate any deficiency or redundancy in case base loss reserves as of a particular reporting date. In determining the recorded amount for the incurred-but-not-reported loss reserves for a reporting period management considers the following factors to determine if an adjustment to the incurred-but-not-reported loss reserve is necessary:
Trends or patterns in claim experience. We regularly review the level of loss reserves against actual loss development. This retrospective review is the primary criteria used in refining the levels of loss reserves recorded in the financial statements.
Management and the actuaries also meet periodically with Claims and Product personnel to review ongoing business trends, claim frequency and severity statistics and other relevant developmental trends.
We consider changes in our business, product mix, current events and any changes in case base claims reserving philosophies.
As noted in the table above, case base loss reserves represent the largest component of our loss reserves at approximately 75 percent of our net property and casualty loss reserves. Primarily composed of case base loss reserves, our total loss reserves are relatively short-tailed in nature and less as a percentage of statutory surplus than the property and casualty industry average. In total, our net property and casualty loss reserves represented 32% and 40% of the statutory property and casualty surplus at December 31, 2006 and 2005, respectively. In comparison, statutory loss reserves approximate 120% of statutory surplus for the property and casualty industry. Case base loss reserves tend to be more mechanical in nature and are based on specific facts and circumstances related to reported claims as compared to IBNR loss reserves, which have a higher degree of estimation and uncertainty.
In the loss reserve estimation process, accuracy of the recorded amounts is the primary objective. However, due to the uncertainty inherent in the process, we approach our loss reserves with an implicit degree of caution for adverse deviation although we do not specifically utilize an implicit or explicit provision for uncertainty or adjust any one specific assumption.
At December 31, 2006, the recorded net property and casualty loss reserves were in the upper half of the acceptable actuarial range.
We have consistently applied our approach to loss reserves. Our estimates for loss reserves utilize historical loss development patterns. As new patterns emerge, they are reflected in our assumptions. Due to the significant amount of judgment and estimation that is required to estimate loss reserves, the actual loss development is likely to be different than the amounts recorded. For example, during the last 10 years we have experienced both favorable and unfavorable development in individual calendar years. Looking back at our net property and casualty loss reserves over the last ten years, we have experienced eight years where redundancy has developed and two years where a deficiency developed. The table below outlines the cumulative (deficiency)/redundancy for the net property and casualty loss reserves since 1996, based on re-estimated amounts at December 31, 2006.
We believe the recent favorable IBNR development was caused, in part, by lower non-catastrophe related frequency patterns than we have experienced historically, a higher level of case base redundancies, and favorable loss development in our newer lines of business. The case base redundancy was due in part to our response to the loss reserve deficiencies for the December 31, 2002 loss reserves that were ultimately discovered during 2003. In response to deficient development of reserves, management strengthened the company’s loss reserves to reflect these changing development trends arriving at a best estimate of how these losses would ultimately settle. The higher levels of loss reserves, and their potential redundancy, were not fully contemplated in the incurred-but-not-reported loss reserves, because our experience had not been validated over an appropriate period of time.
The loss reserves from the following lines of business tend to be more difficult to predict as compared to the larger property portion of our business.
The excess and surplus lines are new lines of business to the Company. We began writing excess and surplus in 2002 and we therefore do not have a large amount of historical development data. Additionally, the excess and surplus lines contain a higher degree of liability risks and the reserving methodology is more dependent on longer term development patterns.
Essentially, in each of these lines we experienced more favorable development in 2005 than our historical development and baseline industry data would have indicated. The favorable development in 2005 was the result of a combination of redundant case base reserves, where claims were settled for less than the reserved amount, and lower non-catastrophe related
frequency patterns than we have historically experienced. We estimate that redundant case base reserves accounted for approximately 40% of our favorable development with the remaining redundancy attributed primarily to the re-estimate of incurred-but-not-reported loss reserves, after an additional year of development. As discussed above, we believe this IBNR development was caused, in part, by lower non-catastrophe related frequency patterns than we have experienced historically, a higher level of case base redundancies, and favorable loss development in our newer lines of business. The case base redundancy was due in part to our response to the loss reserve deficiencies for the December 31, 2002 loss reserves that were ultimately discovered during 2003. Both our property and liability lines developed a deficiency in 2003. Collectively, the December 31, 2002 loss reserves developed a deficiency of approximately 10 percent, or $12 million, in 2003. This was due in part to the newer lines of business and the more volatile park and dealer liability lines, which we exited in 2001. In response to deficient development of reserves, management strengthened the company’s loss reserves to reflect these changing development trends arriving at a best estimate of how these losses would ultimately settle. The higher levels of loss reserves, and their potential redundancy, were not fully contemplated in the incurred-but-not-reported loss reserves, because our experience had not been validated over an appropriate period of time.
The table below provides a summary of these actuarial models along with an outline of the model advantages, disadvantages and the primary use of the model and key assumptions used on the models:
Principally used for property lines of business, including the property components of residential property lines. Model is also used for older accident years for liability components.
Historical loss development growth will be consistent from year to year. Often an average growth development factor will be utilized
Estimates of ultimate losses are independent of case reserve adequacy and are unaffected by changes in case reserving practices
Principally used for liability lines of business. It is appropriate for more recent accident years and may also be used if there has been a change in case reserving philosophies.
This method bases the projection of losses on the loss ratio and percent of losses reported to date for an accident year. This model is often used in newer lines of business and may incorporate industry information.
Ignores current information as it assumes similar exposures and loss potential for all accident years, unless specific adjustments are made to account for changes.
The selected initial expected loss ratio is reflective of the actual loss ratio. Reporting and/or payment patterns are consistent.
Other specific operating factors, such as changes in claims reserving philosophies or changes in claims personnel management
used by the actuaries are generally based on our historical patterns, rather than the development from any one year, which balances stability and responsiveness in developing age to age factors. For example, in determining the 2005 loss reserves, the most recent favorable one year development patterns were considered as part of historical averages. However, the impacts of the latest one-year favorable development factors were only partially recognized in the external actuary’s contemplation of loss reserves. As development factors continue to emerge they will be a larger part of the historical three- and five-year averages, and will be more heavily weighted when reflected in the range of our affirming external actuary. For example, we have experienced more favorable development patterns over the last couple of years in our motorcycle coverages than our historical patterns would indicate.
Based on the considerations noted above, and our historical loss reserve development patterns, we believe it is reasonably likely that our December 31, 2006 net property and casualty loss reserves will develop with a redundancy in the range of 5 percent to 15 percent, although it is possible that the actual development will be more or less. A chart outlining the after-tax earnings impact of reasonably likely redundancies is shown below. The potential earnings impact of the 2006 loss reserves redundancy on our 2007 after-tax earnings assumes no development, positive or negative, relative to the December 31, 2007 loss reserves.
American Modern participates in several reinsurance contracts with various reinsurers. The Company’s primary reasons for entering reinsurance contracts are to reduce its exposure on particular risks and classes of risks as well as to protect against large accumulated losses resulting from catastrophes. In order to limit its exposure to certain levels of risks, the Company cedes varying portions of its written premiums to other insurance companies. As such, the Company limits its loss exposure to that portion of the insurable risk it retains. In addition, the
The Company utilizes excess of loss reinsurance programs in order to reduce its exposure on particular risks and classes of risks (excess of loss per risk) as well as to protect against large accumulated losses resulting from catastrophes (excess of loss per occurrence). Under excess reinsurance, the insurer limits its liability to all or a particular portion of a predetermined deductible or retention. Therefore, the reinsurer’s portion of the loss depends on the size of the loss.
Due to the nature of our non-catastrophe related reinsurance programs, the results of operations related to these programs did not significantly fluctuate during the three year period ended December 31, 2006.
However, our operating results were impacted to varying degrees by our catastrophe reinsurance program. Catastrophe reinsurance costs, including reinstatements, totaled $25.8 million, $31.9 million and $16.9 million during 2006, 2005 and 2004, respectively. The Company’s gross catastrophe losses for 2006, 2005 and 2004 were $41.9 million, $232.1 million and $67.1 million, respectively, of which $7.4 million, $179.4 million and $21.1 million, respectively, were recovered through our catastrophe reinsurers.
Based on our estimates as of December 31, 2006, Hurricane Katrina, the costliest storm in U.S history, exceeded the limits of the Company’s 2005 catastrophe reinsurance program by approximately $8.0 million in 2006, which impacted after tax earnings by approximately $5.2 million.
2. Our assessment of a particular issuer’s ability to meet all of its contractual obligations changes based on changes in the facts and circumstances related to the issuer.
3. New information is obtained or facts and circumstances change that cause a change in our ability or intent to hold a security to maturity or until it recovers in value.
When a security is considered other-than-temporarily impaired, we monitor trends or circumstances that may impact other material investments in our portfolio. For example, we review any other securities that are held in the portfolio from the same issuer and also consider any circumstances that may impact other securities of issuers in the same industry. At December 31, 2006, we had no significant concentration of unrealized losses in any one issuer, industry or sector.
the issuer’s ability to continue to make obligated payments to security holders
It is our intent, and thus the intent of our investment managers, to hold securities that have an unrealized gain or loss. For the securities with an unrealized loss, which in our judgment we believe to be temporary, it is our intent to hold the security for a period of time that will allow
the security to recover in value. While the Company has the ultimate authority regarding sales of securities, investment managers may sell certain securities and reinvest the proceeds if they believe returns would be enhanced by doing so, in which case the unrealized gain or loss will be recognized as a realized gain or loss. As part of our comprehensive quarterly review for other than temporary impairment, the Company asks investment managers to identify any securities in which they have the intent to sell in the near term. In the case where investment managers have indicated their intent to sell a security in the near term and there is an unrealized loss, we record an other-than-temporary impairment at the balance sheet date, if such date is prior to the sale of the security. At December 31, 2006, we had no securities with an unrealized loss for which a decision was made to sell in the near term.
For the years ended December 31, 2006, 2005 and 2004, we incurred no losses related to other-than-temporary impairments. Impairment charges, if incurred, would be included in the consolidated financial statements in “net realized investment gains (losses).”
Available-for-sale securities are reviewed quarterly for possible other-than-temporary impairment. The review includes an analysis of the facts and circumstances of each individual investment such as the length of time the fair value has been below cost, the expectation for that security’s performance, the credit worthiness of the issuer and the Company’s intent to sell or its ability to hold the security to maturity. A decline in value that is considered to be other-than-temporary is recorded as a loss within Net Realized Investment Gains in the Consolidated Statements of Income.
Property and Depreciation - Property, plant and equipment are recorded at cost. The Company periodically measures fixed assets for impairment. Depreciation and amortization are generally calculated over the estimated useful lives of the respective properties (buildings and equipment - 15 to 35 years, furniture and equipment - 3 to 7 years, and barges - 23 years).
Goodwill and Other Intangibles - In July 2006, the Company acquired all of the outstanding stock of Southern Pioneer Life Insurance Company, a privately held insurance company located in Trumann, Arkansas. Operating results emanating from this purchase since July 2006 are reported in the “All other insurance” segment.
As a result of this acquisition, the Company recorded $3.2 million in goodwill and $1.7 million in other intangible assets. The other intangible assets will be amortized over periods ranging from five to fifteen years. Future amortization expense will equal (amounts in 000’s): $127 - 2007; $127 - 2008; $127 - 2009; $127 - 2010; $117 in 2011 and $1,056 - thereafter.
In addition to the $3.2 million of goodwill mentioned above, the Company also has $2.1 million of goodwill related to past business combinations. The goodwill balances are recorded in Other Assets on the Company’s Consolidated Balance Sheets. In accordance with SFAS No. 142, “Goodwill and Other Intangible Assets”, the Company accounts for goodwill under the impairment approach. Based on the Company’s impairment review, no impairment charges were necessary for 2006, 2005 or 2004.
The Company files a consolidated federal income tax return which includes all subsidiaries.
Reinsurance - In order to limit its exposure to certain levels of risks, the Company cedes varying portions of its written premiums to other insurance companies. As such, the Company limits its loss exposure to that portion of the insurable risk it retains. In addition, the Company pays a percentage of earned premiums to reinsurers in return for coverage against catastrophic losses. However, if a reinsurer fails to honor its obligations, American Modern could suffer additional losses as the reinsurance contracts do not relieve American Modern of its obligations to policyholders.
The Company also assumes a limited amount of business on certain reinsurance contracts. Related premiums and loss reserves are recorded based on records supplied by the ceding companies.
Statements of Cash Flows - For purposes of the consolidated statements of cash flows, the Company defines cash as cash held in operating accounts at financial institutions. The amounts reported in the consolidated statements of cash flows for the purchase, sale or maturity of marketable securities do not include cash equivalents.
Fair Value of Financial Instruments - The carrying values of cash, receivables, short-term notes payable, trade accounts payable and any financial instruments included in other assets and accrued liabilities approximate their fair values principally because of the short-term maturities of these instruments. Generally, the fair value of investments, including derivatives, is considered to be the market value which is based on quoted market prices. The fair value of long-term debt is estimated using interest rates that are currently available to the Company for issuance of debt with similar terms and maturities.
Derivative Instruments - The Company accounts for its derivatives under Statement of Financial Accounting Standards (“SFAS”) 133, “Accounting for Derivative Instruments and Hedging Activities,” as amended. The standard requires recognition of all derivatives as either assets or liabilities in the balance sheet and requires measurement of those instruments at fair value through adjustments to either accumulated other comprehensive income or current earnings or both, as appropriate. During 2002, the Company entered into a series of interest rate swaps to convert $30 million of floating rate debt to a fixed rate. The interest rate swaps were
Prior to 2005, Midland accounted for stock options using the “intrinsic value” method. Therefore, no compensation cost had been recognized for the stock option plans. Had the Company accounted for all stock based employee compensation under the fair value method (SFAS 123), the Company’s 2004 net income and earnings per share would have been reduced to the pro forma amounts indicated below (amounts in 000’s, except per share data):
In February 2006, the FASB issued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments-an amendment of FASB Statements No. 133 and 140,” which resolves issues addressed in Statement 133 Implementation Issue No. D1, “Application of Statement 133 to Beneficial Interests in Securitized Financial Assets.” SFAS No. 155, among other things, permits the fair value remeasurement of any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation; clarifies which interest-only strips and principal-only strips are not subject to the requirements of Statement 133; and establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation. SFAS No. 155 is effective for all financial instruments acquired or issued in a fiscal year beginning after September 15, 2006. The Company is currently assessing the impact of SFAS No. 155 on its consolidated financial position and results of operations.
Accounts receivable at December 31, 2006 and 2005 are generally due within one year and consist of the following (amounts in 000’s):
Included in Buildings, Improvements, Fixtures, etc. in the above table is $17.4 million and $0.8 million of construction in progress for 2006 and 2005, respectively, related to the expansion of the Company’s headquarters which is scheduled for completion in September 2007. The construction in progress amount includes $0.3 million of capitalized interest for 2006. There was no capitalized interest at the end of 2005.
The aforementioned notes payable, together with outstanding commercial paper, had weighted average interest rates of 5.67% and 4.90% at December 31, 2006 and 2005, respectively.
Long-term debt at December 31, 2006 and 2005 is summarized as follows (amounts in 000’s):
The aggregate amount of repayment requirements on long-term debt for the five years subsequent to 2006 are (amounts in 000’s): 2007 - $15,183; 2008 - $6,125; 2009 - $562; 2010 - $36,593; 2011 - $627; thereafter - $7,418.
At December 31, 2006 and 2005, the carrying value of the Company’s long-term debt approximated its fair value.
Wholly-owned subsidiary trusts of Midland have issued preferred trust securities and, in turn, purchased a like amount of subordinated debt which provides interest and principal payments to fund the trusts’ obligations. The preferred trust securities are mandatorily redeemable upon maturity or redemption of the subordinated debt and are an obligation of Midland. The interest rate related to these securities is based on the 90 day LIBOR rate plus 3.5%, not to exceed 12.5% through the optional redemption dates in April and May 2009, respectively. The interest rates were 8.9% and 7.9% at December 31, 2006 and 2005, respectively. The junior subordinated debentures are due in 2034. They consist of $12 million issued in April 2004 and $12 million issued in May 2004 that are redeemable at the Company’s option any time after April and May 2009, respectively.
For 2006, 2005 and 2004, $1,420, $455 and $1,114, respectively, of income tax benefits applicable to deductible compensation related to stock options exercised and restricted stock issued were credited to shareholders’ equity.
The amounts of recoveries pertaining to property and casualty reinsurance contracts that were deducted from losses incurred during 2006, 2005 and 2004 were (amounts in 000’s): $30,722, $189,407 and $38,295, respectively.
In 2005 and 2004 incurred losses related to prior years benefited from claims settling in 2005 and in 2004 for less than the case base reserve amounts that were estimated at the end of the previous respective years.
Loss reserves, net of reinsurance, for Life and Other totaled $7.4 million, $6.0 million and $6.9 million at December 31, 2006, 2005 and 2004 respectively.
The Company has a qualified 401(k) savings plan, a funded non-qualified savings plan and a funded non-qualified self-directed retirement plan. The Company contributed (amounts in 000’s) $1,412, $1,256 and $1,118 to the qualified 401(k) savings plan and $202, $250 and $228 to the non-qualified savings plan for the years 2006, 2005 and 2004, respectively. The Company also has an unfunded non-qualified defined benefit pension plan.
Plan assets consist primarily of equity and fixed income securities managed by non-affiliated professional investment managers. No plan assets are invested in either real estate or the Company’s stock. The following table reflects the asset allocations at fair value related to plan assets in 2006 and 2005:
The Company’s qualified defined benefit pension plan had projected benefit obligations, accumulated benefit obligations and fair value of plan assets amounting to (in 000’s) $30,726, $25,334 and $21,771 in 2006 and $29,213, $24,869 and $19,741 in 2005, respectively. The Company’s non-qualified defined benefit plan had projected benefit obligations, accumulated benefit obligations and fair value of plan assets amounting to (in 000’s) $1,686, $1,763 and $0 in 2006 and $1,740, $1,614 and $0 in 2005, respectively.
Midland’s equity compensation plans include plans for restricted stock, performance shares and non-qualified stock options.
In 2000, the Company established a performance stock award program. Under this program, shares vest after a three-year performance measurement period and will only be awarded if pre-established performance levels have been achieved. Shares are awarded at no cost and the recipient must have been employed throughout the entire three-year performance period. In 2006, 61,000 shares were issued under this program, 57,000 shares have been earned and are scheduled for distribution in 2007, and a maximum of 60,000 and 82,000 shares could potentially be issued in 2008 and 2009, respectively, related to this program. The expected fair value of these awards is charged to compensation expense over the performance period. Compensation expense for 2006, 2005 and 2004 amounted to (amounts in 000’s) $3,085, $2,215 and $1,852, respectively.
Under the Company’s stock option plans, all of the outstanding stock options at December 31, 2006 were non-qualified options and had an exercise price of not less than 100% of the fair market value of the common stock on the date of grant. Of these stock options, 990,000 were exercisable at December 31, 2006, and 225,000, 171,000, 121,000 and 75,000 options become exercisable in 2007, 2008, 2009 and 2010, respectively. A summary of stock option transactions follows:
At December 31, 2006, options exercisable have exercise prices between $6.32 and $33.21 and an average contractual life of approximately 5.1 years.
At December 31, 2006, 978,000 common shares are authorized for future option award or stock grants.
During the fourth quarter of 2005, the Company elected to early adopt SFAS 123 (Revised 2004), “Share-Based Payment” (“SFAS 123(R)”) under the modified retrospective approach, restating only prior interim periods in fiscal 2005. The Company recognized $2.5 million and $1.9 million of expense in 2006 and 2005, respectively, related to its stock option program.
In January 2001, the Company’s Board of Directors authorized the repurchase of up to 1,000,000 shares of the Company’s common stock and 414,000 of these shares have been repurchased as of December 31, 2006. No shares were repurchased under this program in 2006 or 2005.
The change in accumulated other comprehensive income is due to changes related to the unrealized gains and losses on investments, the fair value of interest rate swap, additional minimum pension liability and the adoption of SFAS 158 as follows (amounts in 000’s):
Net income as reported by the Company’s insurance subsidiaries, determined in accordance with statutory accounting practices, which differ in certain respects from accounting principles generally accepted in the United States of America, for the Company’s insurance subsidiaries was (amounts in 000’s): $64,053, $68,634 and $57,677 for 2006, 2005 and 2004, respectively. Statutory surplus as reported by the Company’s insurance subsidiaries, was (amounts in 000’s): $450,729 and $394,314 at December 31, 2006 and 2005, respectively.
The amounts shown for residential property, recreational casualty, financial institutions, all other insurance and unallocated insurance comprise the consolidated amounts for Midland’s insurance operations subsidiary, American Modern Insurance Group, Inc. Intersegment revenues were not significant for 2006, 2005 or 2004. During 2004 the Midland parent company purchased 492,634 shares of U.S. Bancorp common stock from American Modern Insurance Group, Inc. The effects of this transaction were eliminated from consolidated net realized investment gains, income before taxes and income tax expense.
(a) The sum of quarterly earnings per common share may not equal the year end earnings per common share due to rounding.