Our headquarters are located in a four story, 110,000 square foot building that we own in Blue Bell, Pennsylvania. Through various wholly-owned subsidiaries, we also own and occupy an office facility in one other location and rent additional office space for our insurance operations in 14 other locations. All of these facilities are shared by The PMA Insurance Group with PMA Management Corp. and/or PMA Management Corp. of New England, Inc. We also rent additional office space for Midlands at five other locations in Oklahoma, Texas, California, and New York, and for PMA Management Corp. of New England, Inc. at a location in New York.
The following is a discussion of the financial condition of PMA Capital Corporation and its consolidated subsidiaries (“PMA Capital” or the “Company,” which also may be referred to as “we” or “us”) as of December 31, 2008, compared with December 31, 2007, and the results of operations of PMA Capital for 2008 and 2007, compared with the immediately preceding year. The balance sheet information is as of December 31 for each respective year. The statement of operations and cash flow information is for the year ended December 31 for each respective year.
Losses and LAE are the most significant payment items affecting our insurance business and represent the most significant accounting estimates in our consolidated financial statements. We establish reserves representing estimates of future amounts needed to pay claims with respect to insured events that have occurred, including events that have not been reported to us. We also establish reserves for LAE, which represent the estimated expenses of settling claims, including legal and other fees, and general expenses of administering the claims adjustment process. Changes in reserve estimates may be caused by a wide range of factors, including inflation, changes in claims and litigation trends and legislative or regulatory changes. We incur a charge to earnings in the period the reserves are increased. In 2008 and 2007, we recorded charges to increase loss reserves for prior years at our discontinued operations, as discussed under “Discontinued Operations” beginning on page 41 of this MD&A.
Our Fee-based Business earns revenues by providing claims adjusting, managed care and risk control services to customers and by placing insurance business with other third party insurance and reinsurance companies. Payments made at this segment primarily consist of operating expenses, which include internal expenses to operate the business and commissions paid to sub-producers. The Fee-based Business segment was created for reporting purposes in 2007 following our acquisition of Midlands Management Corporation. In 2008, we acquired PMA Management Corp. of New England, Inc. Revenues and income increased in 2008 primarily as a result of these acquisitions.
financial presentation to conform to these changes. In 2008, we recorded an after-tax charge of $8.5 million as a result of a $13.0 million capital contribution made to our Run-off Operations in order to comply with a commitment made to an independent rating agency. We continue to work with the buyer and the Pennsylvania Insurance Department to complete this sale.
We recorded net income of $5.7 million in 2008, compared to a net loss of $42.5 million in 2007 and net income of $4.1 million in 2006. Operating income, which we define as net income (loss) excluding realized gains (losses) and the results from discontinued operations, increased to $21.5 million for 2008, compared to $14.4 million in 2007 and $4.5 million in 2006.
In 2008, net income included an after-tax loss of $12.8 million from discontinued operations, which resulted from a $13.0 million capital contribution to increase the statutory capital of our Run-off Operations in addition to prior year adverse loss development that we expect will reduce the amount of cash we will receive at the closing of the sale of our Run-off Operations.
The net loss in 2007 included an after-tax loss of $57.3 million from discontinued operations. The loss from discontinued operations included an after-tax impairment charge of $40.0 million related to the anticipated sale of our Run-off Operations. It also included an after-tax reserve charge of $14.3 million for prior year adverse loss development at our Run-off Operations.
Summarized financial results of The PMA Insurance Group were as follows:
The PMA Insurance Group recorded pre-tax operating income of $46.7 million in 2008, compared to $38.0 million in 2007 and $26.1 million in 2006. The increases for both 2008 and 2007, compared to the immediately preceding year, were due primarily to improved underwriting results, as reflected in our lower combined ratios. The increase in 2008, compared to 2007, was also impacted by a pre-tax gain of $2.1 million on the sale of a property that housed one of our branch offices, which moved to a new, more modern, leased facility.
Direct premium production increased in 2008 and 2007, compared to the immediately preceding year. We define direct premium production as direct premiums written, excluding fronting premiums and premium adjustments. The increase in direct premium production for 2008, compared to 2007, primarily reflected increases in renewal premiums and increases in larger account business. The increase in direct premium production for 2007, compared to 2006, was mainly due to increases in renewal business.
The following is a reconciliation of our direct premium production to direct premiums written:
Under our agreement with Midwest, it underwrote and serviced workers’ compensation policies in California using our approved forms and guidelines. During the term of the agreement, we retained between 0% and 10% of the underwriting results on this business. We also earned an administrative fee based upon the actual amount of premiums earned pursuant to the agreement. Total direct premiums written under this agreement were $10.4 million in 2008, compared to $59.8 million in 2007 and $14.8 million in 2006.
In 2008, pricing on our rate-sensitive workers’ compensation business, which represents approximately 59% of our total workers’ compensation business, decreased by 6%, compared to declines of 4% in 2007 and 2% in 2006. For workers’ compensation coverages, the premium charged on fixed-cost policies is primarily based upon the manual rates filed with state insurance departments. In 2008, workers’ compensation manual rates for business in our principal marketing territories decreased by 7%, compared to declines of 4% in 2007 and 3% in 2006. These changes in manual rates generally reflect the effects of average medical and indemnity cost fluctuations in recent years. Manual rate changes directly affect the prices that we can charge for our rate-sensitive workers’ compensation products.
In total, net premiums written increased 5% in 2008, compared to 2007. The increase in net premiums written for 2008 primarily reflected the increase in direct premium production, which was partially offset by the return premium adjustments. Net premiums written increased 6% in 2007, compared to 2006. The increase in net premiums written for 2007 was mainly due to the increase in direct premium production, which was partially offset by the decrease in premiums assumed.
The loss and LAE ratio improved 0.2 points in 2008, compared to 2007. The improved loss and LAE ratio primarily benefited from favorable development in our loss-sensitive business, which resulted in the retrospective premium adjustments recorded in 2008. Although pricing changes coupled with payroll inflation for rate-sensitive workers’ compensation business were below overall estimated loss trends, our current accident year loss and LAE ratio continued to benefit from changes in the type of workers’ compensation products selected by our insureds. We estimate our medical cost inflation to be 6.5% during 2008, compared to our estimate of 7% in 2007. This decline reflects a decrease in utilization as well as our enhanced network and managed care initiatives. However, we expect that medical cost inflation will continue to be a significant component of our overall loss experience.
The policyholders’ dividend ratio decreased 0.5 points in 2008, compared to 2007. The 2008 ratio reflected slightly higher loss experience on captive accounts, which resulted in lower dividends on captive products where the policyholders may receive a dividend based, to a large extent, on their loss experience. The policyholders’ dividend ratio increased 1.1 points in 2007, compared to 2006. The full year 2007 reflected better loss experience, which resulted in larger dividends on participating products.
Net investment income decreased by $2.5 million in 2008 and increased by $3.1 million in 2007, compared to the immediately preceding year. The decrease in 2008 was due primarily to a lower yield of approximately 40 basis points. The improvement in 2007 was primarily due to a higher yield on an increased average invested asset base.
Other revenues in 2008 reflected a pre-tax gain of $2.1 million for the sale of a property that previously housed one of our branch offices. We are leasing a new, more modern facility for the branch office.
On June 30, 2008, we acquired all of the stock of PMA Management Corp. of New England, Inc. for $7.3 million. We expect to continue to grow the business, which generated $6 million in annual revenues at the time of our acquisition. Our operating results for 2008 include the operating results of PMA Management Corp. of New England, Inc. only from the date of acquisition.
Operating expenses increased to $64.4 million in 2008, up from $34.4 million in 2007. The increase in operating expenses primarily reflected the inclusion of Midlands’ operating expenses for full year 2008, which included $5.8 million in commission expense and $669,000 related to the amortization of intangible assets. Midlands’ operating expenses were $19.6 million higher for full year 2008, compared to the fourth quarter of 2007. The increase in operating expenses for
2008, compared to 2007, also reflected an increase in direct costs of $8.0 million associated with the additional claims and managed care services provided to self-insured clients.
The Corporate and Other segment primarily includes corporate expenses and debt service. Corporate and Other recorded net expenses of $20.7 million, $19.6 million and $21.6 million in 2008, 2007 and 2006, respectively. The increase in net expenses in 2008, compared to 2007, relates primarily to certain intercompany transactions, which are eliminated in the Corporate and Other segment. The reduction in 2007, compared to 2006, was primarily due to lower interest expense. The lower interest expense in 2007 resulted from a lower average level of debt outstanding.
Under the Agreement, we can receive up to $10.0 million in cash and a $10.0 million promissory note, subject to certain adjustments at closing. The promissory note is also subject to certain downward adjustments based on the future development of the business’ loss reserves over the next five years. As a result of adverse loss development in 2008, the cash to be received and the value of the promissory note at closing have each been reduced by $7.5 million. Only the $2.5 million expected cash amount is reflected in our financial statements.
Discontinued operations recorded after-tax losses of $12.8 million in 2008, $57.3 million in 2007 and $1.3 million in 2006. The results for 2008 included an after-tax charge of $8.5 million, which resulted from a $13.0 million capital contribution to increase the statutory capital of our Run-off Operations. The results for 2007 included an after-tax impairment loss of $40.0 million related to the expected sale of these operations and an after-tax reserve charge of $14.3 million for prior year adverse loss development.
Premiums earned in 2008, 2007 and 2006 were primarily attributable to retrospective adjustments of policies written prior to our exit from the reinsurance business. Premiums are earned principally on a pro rata basis over the coverage periods of the underlying policies. However, with respect to policies that provide for premium adjustments, such as experience or exposure-based adjustments, such premium adjustment may be made subsequent to the end of the policy’s coverage period and will be recorded as earned premiums in the period in which the adjustment is made, as was the case in 2008, 2007 and 2006.
During 2008, we recorded unfavorable prior year loss development of $20.8 million at our discontinued operations. Based on the reserve reviews performed by our actuaries in 2008, increased loss development was observed on our pro rata general liability reinsurance business, and to a lesser degree, excess of loss reinsurance business. This increase in 2008 loss trends caused management to determine that reserve levels, primarily for accident years 2001 to 2004, needed to be increased by $20.8 million.
In 2007, we recognized an after-tax impairment loss of $40.0 million related to the expected sale of the Run-off Operations. The components of the loss were as follows:
At December 31, 2007, we recorded an income tax benefit on the impairment loss, as we believe we will be able to use the loss to offset future operating earnings.
During the fourth quarter of 2008, we recorded an $8.5 million after-tax charge at our discontinued operations related to a $13.0 million capital contribution received from the holding company in order to comply with a commitment made to an independent rating agency. The capital contribution, which included $5.0 million of cash and a promissory note of $8.0 million, increased the statutory capital of PMA Capital Insurance Company. We wrote-off the capital contribution as we believe that the additional capital will not result in an increase to the cash we expect to receive at the closing of the sale.
The decrease in net investment income for 2007, compared to 2006, was mainly due to a reduction in the average invested asset base of approximately $155 million, or 52%. This reduction was largely impacted by continued loss payments, as well as the extraordinary dividends of $37.5 million and $73.5 million paid by PMACIC to the holding company in April 2007 and May 2006, respectively. During 2007, the discontinued operations’ insurance liabilities decreased by $143 million, or 30% from December 31, 2006, despite the $22.0 million increase to prior year reserves during the third quarter of 2007. Included in the 2007 reduction was $30.6 million paid in connection with commutations with ceding companies.
The following table represents the reserve levels as of December 31, 2008 for The PMA Insurance Group and the significant lines of business within this segment:
We believe that our unpaid losses and LAE are fairly stated at December 31, 2008. However, estimating the ultimate claims liability is necessarily a complex and judgmental process inasmuch as the amounts are based on management’s informed estimates, assumptions and judgments using data currently available. As additional experience and data become available regarding claims payment and reporting patterns, legal and legislative developments, judicial theories of liability, the impact of regulatory trends on benefit levels for both medical and indemnity payments, changes in social attitudes and economic conditions, the estimates are revised accordingly. If our ultimate losses, net of reinsurance, prove to differ substantially from the amounts recorded at December 31, 2008, then the related adjustments could have a material adverse impact on our financial condition, results of operations and liquidity. See “Critical Accounting Estimates - Unpaid Losses and Loss Adjustment Expenses” beginning on page 58 for additional information. In addition, see the “Cautionary Note Regarding Forward-Looking Statements” on page 65 and “Item 1A - Risk Factors” for a discussion of factors that may adversely impact our losses and LAE in the future.
At December 31, 2008 and 2007, we had amounts receivable from our reinsurers and retrocessionaires for our continuing operations totaling $826.1 million and $795.9 million, respectively. As of December 31, 2008, $21.2 million, or 3%, of these amounts were due to us on losses we have already paid, compared to $29.9 million, or 4%, at December 31, 2007. The remainder of the reinsurance receivables related to unpaid claims.
At December 31, 2008, we had reinsurance receivables for our continuing operations due from the following unaffiliated reinsurers in excess of 5% of our shareholders’ equity:
(3) Includes Munich Reinsurance America, Inc. ($17.8 million) and American Alternative Insurance Company ($172,000).
At December 31, 2008, our reinsurance and retrocessional protection for major lines of business that we write was as follows:
The PMA Insurance Group retains an aggregate $13.8 million deductible on the first layer of its workers’ compensation reinsurance, which is $750,000 excess of $250,000. Effective January 1, 2009, the aggregate deductible decreased to $12.9 million.
Midwest underwrites and services workers’ compensation policies in California, which is exposed to earthquake peril. Upon inception, 100% of this business was ceded to non-affiliated reinsurers. Effective April 1, 2007 and September 1, 2007, we retained 5% and 10% quota share participation, respectively, of the first $500,000 of loss per occurrence on this business. Included as part of our reinsurance program for this business, but not included in our table above, is workers’ compensation catastrophe protection up to a limit of $100.0 million.
Although we believe that we have adequate reinsurance to protect against the estimated probable maximum gross loss from a catastrophe, an especially severe catastrophe or series of catastrophes, or a terrorist event, could exceed our reinsurance and/or retrocessional protection and may have a material adverse impact on our financial condition, results of operations and liquidity. In 2008, 2007 and 2006, our loss and LAE ratios were not significantly impacted by catastrophes.
The following table represents the reserve levels as of December 31, 2008 for our discontinued operations and the significant types of business within these operations:
In the ordinary course of the claims review process, we independently verify that reported claims are covered under the terms of the reinsurance policy or treaty purchased by the ceding company. In the event that we do not believe coverage has been provided, we will deny payment for such claims. Most contracts contain a dispute resolution process that relies on arbitration to resolve any contractual differences. At December 31, 2008, our discontinued operations did not have any material claims that were in the process of arbitration that have not been recorded as liabilities on the accompanying consolidated financial statements.
For our discontinued operations during 2008, 2007 and 2006, we ceded earned premiums totaling $157,000, ($582,000) and ($157,000), and we ceded losses and LAE of $5.8 million, ($3.6) million and $9.2 million to reinsurers and retrocessionaires.
At December 31, 2008, our assets of discontinued operations included reinsurance receivables due from the following unaffiliated reinsurers in excess of 5% of our shareholders’ equity:
At December 31, 2008 and 2007, the reinsurance receivables, recorded in our assets of discontinued operations, were supported by $21.8 million and $56.7 million of collateral, respectively. Of the uncollateralized reinsurance receivables at December 31, 2008, approximately 95% was due from reinsurers rated “A-” or better by A.M. Best and is broken down as follows: “A++” - 9%; “A+” - 22%; “A” - 63% and “A-” - 1%. We believe that our assets of discontinued operations with respect to reinsurance receivables, net of the valuation allowance, are fully collectible. The timing of payments and the collectibility of reinsurance receivables have not had a material adverse effect on our liquidity.
We expect that the cash flows generated from the operating activities of The PMA Insurance Group and our Fee-based Business will be positive for the foreseeable future as we anticipate premium and other service revenue collections to exceed losses and LAE and operating expense payments. We intend to invest these positive cash flows and earn investment income. The positive operating cash flows at our continuing operations in 2007 were reduced by $22.7 million for retroactive reinsurance purchased by The PMA Insurance Group to cover substantially all of the unpaid losses and LAE related to its integrated disability business.
At the holding company level, our primary sources of liquidity are dividends, tax payments received from subsidiaries and capital raising activities. We utilize cash to pay debt obligations, including interest costs, taxes to the federal government, corporate expenses and dividends to shareholders. At December 31, 2008, we had $26.4 million of cash and short-term investments at our holding company and non-regulated subsidiaries, which we believe combined with our other capital sources, will continue to provide us with sufficient funds to meet our foreseeable ongoing expenses and interest payments. We do not currently pay dividends on our Class A Common Stock.
Our principal insurance subsidiaries which comprise The PMA Insurance Group are not subject to the Department’s 2004 Order. However, the amount of dividends the Pooled Companies can pay is restricted by Pennsylvania laws and regulations, which, among other things, limit the amount of dividends that can be paid without prior approval from the Department. For additional information regarding these restrictions, see “Item 1 - Business - Regulatory Matters, Restrictions on Subsidiaries’ Dividends and Other Payments.” The Pooled Companies paid dividends of $4.0 million to the holding company in 2008. The Pooled Companies did not pay dividends to the holding company in 2007 or 2006. As of December 31, 2008, the Pooled Companies can pay up to $31.8 million in dividends to the holding company during 2009 without the prior approval of the Department. In considering their future dividend policy, the Pooled Companies will consider, among other things, the impact of paying dividends on their financial strength ratings. The Pooled Companies had statutory surplus of $332.9 million as of December 31, 2008, including $10.0 million relating to surplus notes.
(5) Our unpaid losses and LAE do not have contractual maturity dates and the exact timing of payments cannot be predicted with certainty. However, based on historical payment patterns, we have included an estimate, gross of discount of $126.1 million, of
Unpaid losses and LAE of our discontinued operations are presented with the gross liabilities of discontinued operations in a separate line on the balance sheet. Based on historical payment patterns, we have included an estimate, gross of discount of $17.4 million, of when we expect these unpaid losses and LAE (without the benefit of reinsurance recoveries) to be paid.
As of December 31, 2008, our total outstanding debt was $129.4 million, compared to $131.3 million at December 31, 2007. During 2008, we retired the remaining $1.3 million principal amount of our 6.50% Convertible Debt for which we paid $1.5 million, exclusive of accrued interest. The lien and restrictive covenants associated with this debt have since been released. As the derivative component of the debt was already reflected in the debt balance, the purchase activity did not result in any significant realized gain or loss. During 2008, we also retired $410,000 principal amount of our 4.25% Senior Convertible Debt due 2022, $20,000 of which was put to us on September 30, 2008. We paid par for these bond purchases, exclusive of accrued interest.
In 2007, we issued $20.6 million of 30-year floating rate junior subordinated securities to a wholly-owned statutory trust subsidiary. The junior subordinated debt matures in 2037 and is redeemable, in whole or in part, any time prior to 2012 at 107.5% of par, or beginning in 2012 at par, plus accrued and unpaid interest. The interest rate on the junior subordinated debt equals the three-month London InterBank Offered Rate (“LIBOR”) plus 3.55%, and interest on this debt is payable on a quarterly basis.
We had previously entered into interest rate swaps with an aggregated notional amount of $52.5 million that we had designated as cash flow hedges to manage interest costs and cash flows associated with the variable interest rates on our junior subordinated debt and our Surplus Notes. During 2007, we settled these interest rate swaps and received net proceeds of $578,000.
In September 2007, we entered into a new interest rate swap that we designated as a cash flow hedge to manage interest costs and cash flows associated with the variable interest rates on a portion of our junior subordinated debt. There was no consideration paid or received for this swap. The swap effectively converts $20.0 million of the junior subordinated debt to fixed rate debt with an interest rate of 8.29%. This swap matures in June 2012.
We made a voluntary contribution of $2.0 million to our qualified pension plan in 2008. We did not make a contribution to our qualified pension plan in 2007 or 2006. Our accumulated benefit obligation was greater than the fair value of plan
Investment grade fixed income securities, substantially all of which are publicly traded, constitute substantially all of our invested assets. The fair values of these investments are subject to fluctuations in interest rates.
Our investment portfolio includes only fixed maturities and short-term investments. We believe the portfolio is sufficiently diversified because it does not contain any significant concentrations in single issuers other than U.S. Treasury and agency obligations. Our largest exposure to a single corporate issuer is $19.7 million, or 3% of total invested assets. In addition, we do not have a significant concentration of our investments in any single industry segment other than finance companies, which comprised 17% of invested assets at December 31, 2008. Included in this industry segment are diverse financial institutions, including banks and insurance companies, with no single issuer exceeding 3% of the total investment portfolio. All of our investments as of December 31, 2008 are dollar denominated.
Also included in structured securities were $175.7 million, or 45% of our structured securities, of residential mortgage-backed pools and CMOs issued by either U.S. Government Agencies or U.S. Government Sponsored Enterprises (“GSE”).
Our structured securities holdings also include $15.1 million, or 4% of our structured securities, in residential mortgage-backed securities whose underlying collateral was either a sub-prime or alternative A mortgage. The $15.1 million, which includes $13.6 million of alternative A collateral and $1.5 million of sub-prime collateral, had an estimated weighted average life of 2.8 years, with $4.3 million of that balance expected to pay off within one year, and an average credit quality of AAA-. Based upon the quality of the collateral and short average life of these securities, we do not expect to incur material losses of principal from these securities.
In addition to issuer-specific financial information and general economic data, we also consider our ability and intent to hold a particular security to maturity or until the fair value of the security recovers to a level at least equal to the amortized cost. Our ability and intent to hold securities to such time is evidenced by our strategy and process to match the cash flow characteristics of the invested asset portfolio, both interest income and principal repayment, to the actuarially determined estimated liability payout patterns of each insurance company’s claims liabilities. Where we determine that a security’s unrealized loss is other than temporary, a realized loss is recognized in the period in which the decline in value is determined to be other than temporary.
In 2008, we recorded other than temporary impairments of $9.2 million. These impairments were the result of writing down our investments in three corporate senior debt securities that were issued by Lehman Brothers Holdings, Inc. and perpetual preferred stock issued by the Federal National Mortgage Association (“Fannie Mae”). Our write-down of the Lehman Brothers senior debt was for $8.2 million and our write-down of the Fannie Mae preferred stock was for $967,000. In 2007, we recorded a pre-tax impairment loss of $209,000 on a security issued by a national provider of higher education loans. The write-downs were measured based on public market prices.
The contractual maturities of securities in an unrealized loss position at December 31, 2008 were as follows:
We had pre-tax net realized investment losses of $4.7 million in 2008, compared to pre-tax net realized investment gains of $563,000 in 2007 and $1.2 million in 2006. During 2008, we had gross realized investment gains and losses of $6.0 million and $1.5 million, respectively, on sales from our invested asset portfolio. The other than temporary impairments of $9.2 million related to write-downs of our investments in the Lehman Brothers securities and Fannie Mae preferred stock, as previously discussed. During 2007, we had gross realized investment gains and losses of $2.0 million and $3.7 million, respectively, on sales from our invested asset portfolio. The change in fair value of trading securities related to a security that was previously held at our discontinued operations and transferred to our holding company as part of the $37.5 million dividend in April 2007. The gross realized gains and losses during both 2008 and 2007 primarily related to general duration management trades, which focused on maintaining our bias towards shorter duration and higher credit quality securities in the investment portfolio.
Effective January 1, 2007, we reclassified securities, which are currently reported as part of our assets of discontinued operations on the balance sheet, from fixed maturities available for sale to the trading category in conjunction with our adoption of Statement of Financial Accounting Standards No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities.” The securities selected had gross unrealized gains of $530,000 and gross unrealized losses of $6.6 million at the time of our adoption.
Effective January 1, 2007, we early adopted Statement of Financial Accounting Standards No. 157, “Fair Value Measurements” (“SFAS 157”), and Statement of Financial Accounting Standards No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities.” See Notes 5 and 14 to our Consolidated Financial Statements for the impact of our adoption of these Statements.
In December 2007, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 141 (revised 2007), “Business Combinations” (“SFAS 141R”). SFAS 141R replaces Statement of Financial Accounting Standards No. 141, “Business Combinations” (“SFAS 141”), although it retains the fundamental requirement in SFAS 141 that the purchase method of accounting be used for all business combinations. SFAS 141R establishes principles and requirements for how the acquirer in a business combination (a) recognizes and measures the assets acquired, liabilities assumed and any non-controlling interest in the acquiree, (b) recognizes and measures the goodwill acquired in a business combination or a gain from a bargain purchase and (c) determines what information to disclose regarding the business combination. SFAS 141R applies prospectively to business combinations for which the acquisition date is on or after the beginning of our 2009 fiscal year, and therefore, had no impact on the accounting for our 2007 acquisition of Midlands, nor our 2008 acquisition of PMA Management Corp. of New England, Inc.
Our Consolidated Financial Statements have been prepared in accordance with GAAP. Some of the accounting policies permitted by GAAP require us to make estimates of the amounts of assets and liabilities to be reported in our Consolidated Financial Statements. We have provided a summary of our significant accounting policies in Note 2 to our Consolidated Financial Statements. We recommend that you read all of these policies.
In estimating our reserves for unpaid losses and LAE, our actuaries also consider the fact that each of our businesses has a different potential for reserve development. We believe that the potential for adverse reserve development is increased at our reinsurance business because of the nature of the reinsurance business itself and because of the fact that it is in run-off. Reinsurers rely on their ceding companies to provide them with information regarding incurred losses. Therefore, it takes longer for reinsurers to find out about reported claims than for primary insurers and those claims are more subject to unforeseen development and uncertainty. Additionally, the potential for adverse reserve development in our reinsurance operation has increased because we have ceased ongoing business relationships with most of our ceding companies. As a result, to the extent that there are disputes with our ceding companies over claims coverage or other issues, we believe that it is more likely that we will be required to arbitrate these disputes.
With respect to The PMA Insurance Group, our actuaries separately review the reserves for our workers’ compensation and integrated disability, commercial automobile and commercial multi-peril/general liability lines of business. The PMA Insurance Group’s loss reserves are comprised primarily of reserves for our workers’ compensation and integrated disability business (87% of the segment loss reserves). Commercial multi-peril/general liability reserves comprise 11% of this segment’s carried reserves, with 29% of such commercial multi-peril/general liability reserves being asbestos and environmental reserves (see page 44 of this Report on Form 10-K for more detail regarding asbestos and environmental loss reserves).
Our discontinued operations’ loss reserves are comprised primarily of excess of loss and pro rata reinsurance reserves (86% of the loss reserves). The excess of loss and pro rata reinsurance reserves are primarily casualty reserves, as only 7% of such reserves are for property business at December 31, 2008. The discontinued operations’ pro rata business is mainly quota share reinsurance of ceding companies’ excess or umbrella insurance. Therefore, our actuarial analysis of our excess of loss and pro rata reinsurance business is generally based upon similar assumptions and loss development patterns.
For additional factors that could impact our reserve estimates please see the risk factor entitled “Reserves are estimates and do not and cannot represent an exact measure of liability. If our actual losses exceed our reserves, we may need to increase our reserves, which would adversely affect our financial results.” on page 21 of this Report on Form 10-K.
If our future estimate of ultimate unpaid losses is greater than the recorded amounts, we would have to increase our reserves in subsequent periods. Any increase in our net reserves would result in a charge to earnings in the period recorded. For example, during the third quarter of 2007, we increased net reserves for our discontinued operations by $22.0 million and took an earnings charge as a result. Accordingly, any reserve adjustment could have a material adverse effect on our financial condition, results of operations and liquidity.
At our continuing operations, the components of our favorable development of reserves for losses and LAE for prior accident years by accident year, excluding accretion of discount, were as follows:
During 2008, The PMA Insurance Group recorded favorable prior year loss development of $7.8 million. In 2008, the Company’s actuaries noticed lower than expected claims frequency and severity in workers’ compensation business written for accident years 2006 and 2007, primarily from loss-sensitive business. As a result, The PMA Insurance Group reduced loss reserves for prior years. Under The PMA Insurance Group’s loss-sensitive plans, the amount of the insured’s premiums is adjusted after the policy period expires based, to a large extent, upon the insured’s actual losses incurred during the policy period. Under policies that are subject to dividend plans, the ultimate amount of the dividend that the insured may receive is also based, to a large extent, upon loss experience during the policy period. Accordingly, offsetting the effects of this favorable prior year loss development were premium adjustments of $8.9 million under loss-sensitive plans and increased policyholder dividends of $1.0 million.
During 2007, the discontinued operations recorded unfavorable prior year loss development of $21.6 million, which included a $22.0 million charge taken in the third quarter. In the third quarter of 2007, our actuaries conducted their periodic comprehensive reserve review. Based on the actuarial work performed, our actuaries observed increased loss development from a limited number of ceding companies on our claims-made general liability business, primarily related to professional liability claims. Specifically, we experienced higher than expected severity on general liability claims-made losses at our discontinued operations during the third quarter causing our actuaries to increase the average expected size of future loss payments on these types of claims. This increase in 2007 loss trends caused management to determine that reserve levels, primarily for accident years 2001 to 2003, needed to be increased by $22.0 million.
During 2006, the discontinued operations recorded $5.3 million in favorable development, largely due to commutations of structured reinsurance treaties with some of our ceding companies. The discontinued operations do not typically record favorable prior year loss development on commutations unless the treaties are structured reinsurance, where IBNR reserves are directly attributable to a treaty.
For additional information about our liability for unpaid losses and loss adjustment expenses, see Notes 5 and 7 to the Consolidated Financial Statements as well as “Item 1 - Business - Loss Reserves.”
All investments in our fixed income portfolio are carried at fair value. For all but three of our securities, we determined the fair value of fixed income securities from prices obtained in the public markets. Prices obtained in the public market include quoted prices that are readily and regularly available in an active market, market values generated by external pricing models that vary by asset class and incorporate available trade, bid and other market information, as well as price quotes from other well-established independent market sources.
Based on our evaluation of securities with an unrealized loss at December 31, 2008, we do not believe that any additional other-than-temporary impairment losses, other than those already reflected in the consolidated financial statements, are necessary at the balance sheet date. However, if we had determined that all securities that were in an unrealized loss position at December 31, 2008 should have been written-down to their fair value, then we would have recorded an additional other-than-temporary impairment loss of $46.6 million pre-tax at our continuing operations.
We follow the customary insurance industry practice of reinsuring with other insurance and reinsurance companies a portion of the risks under the policies written by our insurance subsidiaries. Our reinsurance receivables total $826.1 million at December 31, 2008. We have estimated that $4.6 million of our reinsurance receivables will be uncollectible, and we have provided a valuation allowance for that amount. Our assets of discontinued operations include $95.0 million for reinsurance receivables at December 31, 2008, and these receivables are recorded net of a valuation allowance of $3.2 million.
The valuation allowance of $60.5 million is a reserve against $50.4 million of gross deferred tax assets related to the NOL carryforward and all of the projected deferred tax asset related to the AMT credit carryforward because we believe it is more likely than not that this portion of the benefit will not be realized. We will continue to periodically assess the realizability of our net deferred tax asset. If our estimates of future income were to be revised downward and we determined that it was then more likely than not that we would not be able to realize the value of our net deferred tax asset, then this could have a material adverse effect on our results of operations and financial condition. For additional information, see Note 15 to our Consolidated Financial Statements.
On June 30, 2008, we acquired all of the stock of PMA Management Corp. of New England, Inc. As a result of this acquisition, we recorded $2.2 million of identifiable intangible assets and $5.4 million of goodwill. The identifiable intangible assets consist of non-contractual customer relationships. Goodwill represents the excess of the purchase price over the fair value of the net identifiable assets acquired.
On October 1, 2007, we acquired all of the stock of Midlands Holding Corporation. As a result of this acquisition, we initially recorded $11.0 million of identifiable intangible assets and $11.1 million of goodwill. The identifiable intangible assets consist of non-contractual customer relationships, licenses and a trade name. We have since increased goodwill by an additional $1.5 million for contractual earn-out payments to the former shareholders of Midlands, as well as other adjustments.
Goodwill and indefinite-lived intangible assets will remain on the balance sheet and will be tested for impairment on an annual basis, or when there is a reason to suspect that their values may have been diminished or impaired. Other intangible assets that are not deemed to have an indefinite useful life will be amortized over their estimated useful lives. Annual impairment testing was performed during the second quarter of 2008 on the intangible assets that relate to the acquisition of Midlands. Based upon this review, the assets were not impaired. For additional information about our intangible assets, see Notes 2-K, 3 and 4 to our Consolidated Financial Statements.
As a result of the expected sale of our Run-off Operations, we began reporting the results of this business as discontinued operations in 2007. In conjunction with this change and in accordance with SFAS 144, we recorded a pre-tax impairment loss of $61.5 million in 2007 to reduce the net assets of this business to estimated fair value less costs to sell. In 2008, we recorded adverse loss development at the discontinued operations, which contractually reduces the amount of cash and contingent consideration that we will receive at closing. The estimated fair value of the business was based on our stock purchase agreement with Armour Re. Our estimate reflected amounts anticipated at closing, which are subject to adjustments following Armour Re’s review of the final purchase price calculation, but excluded future contingent payments that may be received from Armour Re.
the success with which our independent agents and brokers sell our products and our ability to collect payments from them;
uncertainties related to possible terrorist activities or international hostilities and whether the Terrorism Risk Insurance Program Reauthorization Act of 2007 is extended beyond its December 31, 2014 termination date;
our ability to consummate the sale of our Run-off Operations in a timely and efficient manner;
restrictions on our operations contained in any document governing our indebtedness;
provisions in our charter documents that can inhibit a change in control of our company; and
You should not place undue reliance on any forward-looking statements that we make. All forward-looking statements made in this annual report reflect our views on the date of this annual report. Forward-looking statements are not generally required to be publicly revised as circumstances change and we do not intend to update the forward-looking statements in this annual report to reflect circumstances after the date of this annual report or to reflect the occurrence of unanticipated events.
Consolidated Statements of Cash Flows for the years ended December 31, 2008, 2007 and
Consolidated Statements of Shareholders’ Equity for the years ended December 31, 2008, 2007 and 2006
Consolidated Statements of Comprehensive Income (Loss) for the years ended December 31, 2008, 2007 and 2006
Premiums receivable (net of valuation allowance: 2008 - $9,011; 2007 - $9,341)
Treasury stock, at cost (2008 - 2,252,139 shares; 2007 - 2,456,839 shares)
Includes cash from discontinued operations of $1.4 million, $5.7 million and $4.6 million as of December 31, 2008, 2007 and 2006, respectively.
Cumulative effect of adjustment to initially apply SFAS 159, net of tax
The PMA Insurance Group - The PMA Insurance Group writes workers’ compensation and other commercial property and casualty lines of insurance, which are marketed primarily in the eastern part of the United States. The PMA Insurance Group primarily consists of the results of the Company’s principal insurance subsidiaries, which are commonly referred to as the “Pooled Companies” because they share results under an intercompany pooling arrangement. Approximately 92% of The PMA Insurance Group’s business for 2008 was produced through independent agents and brokers.
Fee-based Business - Fee-based Business consists of the results of PMA Management Corp., Midlands Management Corporation (“Midlands”), and PMA Management Corp. of New England, Inc. PMA Management Corp. is a TPA that provides various claims administration, risk management, loss prevention and related services, primarily to self-insured clients under fee for service arrangements. Midlands is an Oklahoma City-based managing general agent, program administrator and provider of TPA services, which the Company acquired on October 1, 2007. On June 30, 2008, the Company acquired PMA Management Corp. of New England, Inc. (formerly Webster Risk Services), a Connecticut-based provider of risk management and TPA services.
Discontinued operations - Discontinued operations, formerly the Company’s Run-off Operations segment, consist of the results of the Company’s reinsurance and excess and surplus lines businesses. The Company’s reinsurance operations offered excess of loss and pro rata property and casualty reinsurance protection mainly through reinsurance brokers. The Company withdrew from the reinsurance business in November 2003 and from the excess and surplus lines business in May 2002. On March 28, 2008, the Company entered into a stock purchase agreement to sell this business. The closing of the sale and transfer of ownership are subject to regulatory approval by the Pennsylvania Insurance Department (the “Department”). As of March 9, 2009, the Department’s financial examination of PMA Capital Insurance Company, which includes its review of the loss reserves, was still in process.
In 2007, the Company determined that the results of its Run-off Operations should be reported as discontinued operations. In accordance with Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-lived Assets” (“SFAS 144”), the balance sheets have been presented with the gross assets and liabilities of discontinued operations in separate lines and the statements of operations have been presented with the net results from discontinued operations, shown after the results from continuing operations. See Note 5 for additional information regarding the Company’s discontinued operations.
B. Investments - All fixed maturities in the Company’s investment portfolio are carried at fair value. Changes in fair value of fixed maturities classified as available for sale, net of income tax effects, are reflected in accumulated other comprehensive income (loss). Changes in fair value of fixed maturities classified as trading are reported in the loss from discontinued operations as realized investment gains (losses). All short-term, highly liquid investments, which have original maturities of one year or less from acquisition date, are treated as short-term investments and are carried at amortized cost, which approximates fair value. Effective January 1, 2007, the Company reclassified securities, which are currently reported as part of discontinued operations, from fixed maturities available for sale to the trading category in
conjunction with its adoption of Statement of Financial Accounting Standards No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities.”
D. Unpaid Losses and Loss Adjustment Expenses - Unpaid losses and loss adjustment expenses (“LAE”), which are stated net of estimated salvage and subrogation, are estimates of losses and LAE on known claims and estimates of losses and LAE incurred but not reported (“IBNR”). IBNR reserves are calculated utilizing various actuarial methods. Unpaid losses on certain workers’ compensation claims are discounted to present value using the Company’s payment experience and mortality and interest assumptions in accordance with statutory accounting practices prescribed by the Pennsylvania Insurance Department. The Company also discounts unpaid losses and LAE for certain other claims at rates permitted by domiciliary regulators or if the timing and amount of such claims are fixed and determinable. The methods of making such estimates and establishing the resulting reserves are continually reviewed and updated and any adjustments resulting there from are reflected in earnings in the period identified. See Note 7 for additional information.
I. Claims Service Revenues - Claims service revenues primarily include revenues related to claims administration, risk management and related services provided by the Company’s Fee-based Business, primarily to self-insured clients under fee for service arrangements, as well as to insurance carriers on an unbundled basis. These revenues are earned over the term of the related contracts in proportion to the actual services rendered. Claims service revenues also include managed care services, which include medical bill review services and access to the Company’s preferred provider network partnerships.
J. Commission Income - Commission income primarily includes income related to managing general agency and program administrator services provided by the Company’s Fee-based Business. Commission income, which is generally reported gross of sub-producer fees, is recognized at the later of the date billed or the effective date of the related insurance policy. Adjustments due to payroll, audits, cancellations, and endorsements are recorded in the period in which they occur.
K. Intangible Assets - Identifiable intangible assets consist of non-contractual customer relationships, licenses and a trade name from business acquisitions. Goodwill represents the excess of the purchase price over the fair value of the net identifiable assets acquired. Goodwill and indefinite-lived intangible assets remain on the balance sheet and are tested for impairment on an annual basis, or when there is a reason to suspect that their values may have been diminished or impaired. Other identifiable intangible assets that are not deemed to have an indefinite useful life are amortized over their estimated useful lives. The identifiable intangible assets and goodwill are reported as intangible assets on the balance sheet.
L. Recent Accounting Pronouncements - Effective January 1, 2007, the Company early adopted Statement of Financial Accounting Standards No. 157, “Fair Value Measurements” (“SFAS 157”), and Statement of Financial Accounting Standards No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS 159”). See Notes 5 and 14 for the impact of the Company’s adoption of these Statements.
In October 2008, the FASB issued FSP FAS 157-3, “Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active” (“FSP FAS 157-3”). The purpose of FSP FAS 157-3 was to clarify the application of SFAS 157, for a market that is not active. It also allows for the use of management’s internal assumptions about future cash flows with appropriately risk-adjusted discount rates when relevant observable market data does not exist. FSP FAS 157-3 did not change the objective of SFAS 157, which is the determination of the price that would be received in an orderly transaction that is not a forced liquidation or distressed sale at the measurement date. FSP FAS 157-3 was effective upon issuance, including prior periods for which financial statements had not been issued. The Company’s adoption of FSP FAS 157-3 for the year ended December 31, 2008 did not have a material effect on its financial position, results of operations or liquidity.
The purchase price has been allocated to the estimated fair values of the acquired assets and liabilities as follows:
Identifiable intangible assets consist of non-contractual customer relationships, which were calculated using a 10% annual attrition rate. The non-contractual customer relationships are being amortized on a straight-line basis over 15 years. In 2008, the Company recognized $73,000 of expenses related to the amortization of non-contractual customer relationships. The Company expects to recognize $147,000 of amortization expense per year over the next five years and $1.4 million thereafter.
On October 1, 2007, the Company acquired all of the stock of Midlands Holding Corporation for $19.8 million. The ultimate purchase price for the stock could range from $22.8 million to $44.5 million based on the future earnings growth of Midlands, the operating subsidiary of Midlands Holding Corporation, during the four years following the date of acquisition. On April 1, 2008, the Company paid $817,000 to the former shareholders of Midlands for contractual earn-out payments related to the fourth quarter of 2007. On October 1, 2008, the Company paid $1.7 million to the former shareholders of Midlands for contractual guaranteed payments.
In accordance with the Company’s exit plan, 111 employees have been terminated and 18 positions, primarily claims and financial personnel, remain at December 31, 2008. The Company has established an employee retention arrangement for the remaining employees. Under this arrangement, the Company has recorded operating expenses of $787,000, $838,000 and $1.0 million, which included retention bonuses and severance, in 2008, 2007 and 2006, respectively.
As a result of adverse loss development recorded in 2008, the Company has estimated that the cash to be received, or the estimated sales proceeds, and the value of the promissory note at closing will each be reduced by $7.5 million. As only the expected cash amount is reflected in the Company’s financial statements, the $7.5 million related to the reduction in the value of the promissory note was reflected as a valuation adjustment. The valuation adjustment reflects operating activity at the discontinued operations which is not expected to affect the sale proceeds at closing.
During the fourth quarter of 2008, the Company recorded an $8.5 million after-tax charge at its discontinued operations related to a $13.0 million capital contribution received from PMA Capital Corporation in order to comply with a commitment made to an independent rating agency. The capital contribution, which included $5.0 million of cash and a promissory note of $8.0 million, $4.0 million payable in each of March 2009 and March 2010, increased the statutory capital of PMACIC. The Company wrote-off the capital contribution as it believes that the additional capital will not result in an increase to the cash it expects to receive at the closing of the sale. This write-off was reflected in the Company’s financial statements as an impairment charge.
The following table provides the fair value measurements of the discontinued operations’ fixed maturities by level within the fair value hierarchy as of December 31, 2008. These assets are measured on a recurring basis.
See Note 14 for information regarding the Company’s categorization of the fair value of its fixed maturities.
During 2007, the discontinued operations recorded unfavorable prior year loss development of $21.6 million, which included a $22.0 million charge taken in the third quarter. In the third quarter of 2007, the Company’s actuaries conducted their periodic comprehensive reserve review. Based on the actuarial work performed, the Company’s actuaries observed increased loss development from a limited number of ceding companies on its claims-made general liability business, primarily related to professional liability claims. This increase in 2007 loss trends caused management to determine that reserve levels, primarily for accident years 2001 to 2003, needed to be increased by $22.0 million. The claims-made book of business represented approximately 25% of the discontinued operations’ gross reserves at December 31, 2007.
At December 31, 2008, the assets of discontinued operations included reinsurance receivables due from the following unaffiliated reinsurers in excess of 5% of shareholders’ equity:
On December 31, 2008, the Company had securities with a total amortized cost and fair value of $41.2 million and $46.5 million, respectively, on deposit with various governmental authorities, as required by law. The securities held on deposit are included in total investments on the balance sheet.
Activity in the liability for unpaid losses and LAE is summarized as follows:
Unpaid losses and LAE reflect management’s best estimate of future amounts needed to pay claims and related settlement costs with respect to insured events which have occurred, including events that have not been reported to the Company. Due to the “long-tail” nature of a significant portion of the Company’s business, in many cases, significant periods of time, ranging up to several years or more, may elapse between the occurrence of an insured loss, the reporting of the loss to the Company and the Company’s payment of that loss. The Company defines long-tail business as those lines of business in which a majority of coverage involves average loss payment lags of several years beyond the expiration of the policy. The Company’s primary long-tail line is its workers’ compensation business. As part of the process for determining the Company’s unpaid losses and LAE, various actuarial models are used that analyze historical data and consider the impact of current developments and trends, such as trends in claims severity and frequency and claims settlement trends. Also considered are legal developments, regulatory trends, legislative developments, changes in social attitudes and economic conditions.
The PMA Insurance Group recorded favorable prior year loss development of $1.7 million in 2007 and $2.3 million in 2006, primarily reflecting better than expected loss experience from rent-a-captive workers’ compensation business. Dividends to policyholders offset this favorable development. Rent-a-captives are used by customers as an alternative method to manage their loss exposure without establishing and capitalizing their own captive insurance company.
Unpaid losses and LAE for the Company’s workers’ compensation claims, net of reinsurance, at December 31, 2008 and 2007 were $382.1 million and $379.5 million, net of discount of $27.4 million and $21.4 million, respectively. The discount rate used was approximately 5% at December 31, 2008 and 2007.
At December 31, 2008, 2007 and 2006, gross reserves for asbestos-related losses were $29.5 million, $25.7 million and $17.3 million, respectively ($11.4 million, $10.8 million and $9.8 million, net of reinsurance, respectively). Of the net asbestos reserves, $2.0 million, $2.2 million and $6.6 million related to IBNR losses at December 31, 2008, 2007 and 2006, respectively.
Management believes that its unpaid losses and LAE are fairly stated at December 31, 2008. However, estimating the ultimate claims liability is necessarily a complex and judgmental process inasmuch as the amounts are based on management’s informed estimates, assumptions and judgments using data currently available. As additional experience and data become available regarding claims payment and reporting patterns, legal and legislative developments, judicial theories of liability, the impact of regulatory trends on benefit levels for both medical and indemnity payments, changes in social attitudes and economic conditions, the estimates are revised accordingly. If the Company’s ultimate losses, net of reinsurance, prove to differ substantially from the amounts recorded at December 31, 2008, then the related adjustments could have a material adverse impact on the Company’s financial condition, results of operations and liquidity.
In August 2008, the Company entered into two fronting arrangements. The workers’ compensation business produced under these arrangements is primarily located in the southeastern part of the United States and California. The Company is retaining approximately 10% of the underwriting results on one of the arrangements and approximately 20% of the underwriting results on the other. The Company also earns an administrative fee based upon the direct premiums earned under each agreement as well as fees for providing claims services on the business placed under one of the arrangements. All of the participating reinsurers have current A.M. Best Company, Inc. (“A.M. Best”) financial strength ratings of “A-” (Excellent) or higher. Total direct premiums written under these arrangements were $22.5 million in 2008.
In the first quarter of 2006, the Company stopped writing integrated disability business. Effective August 1, 2007, the Company purchased reinsurance covering substantially all unpaid losses and LAE related to its integrated disability business. Under the agreement, the reinsurer also handles the servicing and benefit payments related to this business. Upon entering into this agreement, the Company ceded $25.7 million in carried loss and LAE reserves and paid $22.7 million in cash.
At December 31, 2008, the Company had reinsurance receivables due from the following unaffiliated reinsurers in excess of 5% of shareholders’ equity:
The Company performs credit reviews of its reinsurers focusing on, among other things, financial capacity, stability, trends and commitment to the reinsurance business. Reinsurers failing to meet the Company’s standards are excluded from the Company’s reinsurance programs. In addition, the Company requires collateral, typically assets in trust, letters of credit or funds withheld, to support balances due from certain reinsurers, generally those not authorized to transact business in the applicable jurisdictions. At December 31, 2008 and 2007, the Company’s reinsurance receivables of $826.1 million and $795.9 million were supported by $367.4 million and $351.4 million of collateral. Of the uncollateralized reinsurance receivables as of December 31, 2008, approximately 88% was recoverable from reinsurers rated “A-” or better by A.M. Best.
In 2002, the Company supplemented its in-force reinsurance programs for The PMA Insurance Group and its former reinsurance business with retroactive reinsurance contracts with Trabaja that provide coverage for adverse loss development on certain lines of business for accident years prior to 2002. These contracts provide coverage of up to $125 million in losses in return for $55 million of funding, which included $50 million of assets and $5 million in ceded premiums. Under the terms of the contracts, losses and LAE ceded to Trabaja by the Company’s former reinsurance business for accident years 1996 through 2001 are recoverable as they are incurred by the Company. Any future cession of losses under these contracts may require the Company to cede additional premiums ranging from 40% to 50% of ceded losses depending on the level of such losses.
In January 2008, the Company retired the remaining $1.3 million principal amount of its 6.50% Senior Secured Convertible Debt due 2022 (“6.50% Convertible Debt”). The Company paid $1.5 million for these bond purchases, exclusive of accrued interest, and the lien and restrictive covenants associated with this debt have since been released. As the derivative component of the debt was already reflected in the debt balance, the purchase activity did not result in any significant realized gain or loss.
In June 2007, the Company issued $20.6 million of 30-year floating rate junior subordinated securities to a wholly-owned statutory trust subsidiary. The junior subordinated debt matures in 2037 and is redeemable, in whole or in part, any time prior to 2012 at 107.5% of par, or beginning in 2012 at par, plus accrued and unpaid interest. The interest rate on the junior subordinated debt equals the three-month London InterBank Offered Rate (“LIBOR”) plus 3.55%, and interest on this debt is payable on a quarterly basis.
The put premium and conversion features of the 6.50% Convertible Debt constituted a derivative which required bifurcation. Any change in the fair value of the derivative component of the 6.50% Convertible Debt was recognized in net realized investment gains (losses). The Company recorded realized investment losses of $483,000 in 2007 and gains of $466,000 in 2006, resulting from changes in the fair value of the derivative component of its 6.50% Convertible Debt.
The Company had previously entered into interest rate swaps with an aggregated notional amount of $52.5 million that it had designated as cash flow hedges to manage interest costs and cash flows associated with the variable interest rates on its junior subordinated debt and its Floating Rate Surplus Notes due 2035 (“Surplus Notes”). During 2007, the Company settled these interest rate swaps and received net proceeds of $578,000.
In June 2007, the Company entered into new interest rate swaps that it designated as cash flow hedges to manage interest costs and cash flows associated with the variable interest rates on a portion of its junior subordinated debt and its Surplus Notes. There was no consideration paid or received for these swaps. The swaps effectively convert $10.0 million of the junior subordinated debt and $10.0 million of Surplus Notes to fixed rate debt with interest rates of 9.40% and 9.93%,
The Company has the right to call its 8.50% Monthly Income Senior Notes due 2018 (“Senior Notes”) at any time at 100% of the face amount of the notes, plus accrued interest.
Net of sublease rentals of $1.6 million in 2009 and 2010, $1.7 million in 2011, 2012 and 2013 and $1.1 million in 2014. Also includes discontinued operations’ obligations of $480,000 in 2009, $475,000 in 2010 and $474,000 in 2011.
Total expenses incurred under operating leases were $7.8 million, $6.3 million and $6.2 million for 2008, 2007 and 2006, respectively.
In the event a property and casualty insurer operating in a jurisdiction where the Company’s insurance subsidiaries also operate becomes or is declared insolvent, state insurance regulations provide for the assessment of other insurers to fund any capital deficiency of the insolvent insurer. Generally, this assessment is based upon the ratio of an insurer’s voluntary premiums written to the total premiums written for all insurers in that particular jurisdiction. As of December 31, 2008 and 2007, the Company had recorded liabilities of $7.7 million and $6.7 million for these assessments, which are included in accounts payable, accrued expenses and other liabilities on the balance sheet.
In 2006, the Company completed the redemption of $35.0 million principal amount of its 6.50% Convertible Debt. The mandatory redemption was triggered by the extraordinary dividend the Company received from PMA Capital Insurance Company, the Company’s wholly-owned run-off subsidiary which is reported as discontinued operations. Under the original terms of this debt, the Company was required to pay a premium to the holders of the debt. The premium was due in cash, or at the election of the holder, in shares of the Company’s Class A Common Stock. As a result of this redemption, the Company issued 307,990 shares of Class A Common Stock. This issuance of shares in lieu of cash resulted in an increase in Shareholders’ equity of $3.1 million.
The Company does not pay dividends on its Class A Common Stock.
The Company has 2,000,000 shares of undesignated Preferred Stock, $0.01 par value per share authorized. There are no shares of Preferred Stock issued or outstanding.
The Pooled Companies, which are not subject to the Department’s 2004 Order, paid dividends of $4.0 million to PMA Capital Corporation in 2008. The Pooled Companies did not pay dividends to PMA Capital Corporation in 2007 or 2006.
As of December 31, 2008, the Pooled Companies can pay up to $31.8 million in dividends to PMA Capital Corporation during 2009 without the prior approval of the Department. The Pooled Companies had statutory surplus of $332.9 million as of December 31, 2008.
Information regarding the Company’s stock option plans for the year ended December 31, 2008 was as follows:
The total intrinsic value of stock options exercised was $335,000 in 2008, $241,000 in 2007 and $843,000 in 2006. The Company reissued shares from its treasury for options exercised during 2008, 2007 and 2006.
Stock options outstanding and options exercisable at December 31, 2008 were as follows:
In 2008, the Company issued 12,500 shares of restricted Class A Common Stock to employees under the Company’s 2007 Omnibus Incentive Compensation Plan and 36,000 shares of restricted Class A Common Stock to its Directors under the 2004 Directors Plan. In 2007, the Company issued 5,000 shares of restricted Class A Common Stock to employees under the Company’s 2007 Omnibus Incentive Compensation Plan, 3,000 shares of restricted Class A Common Stock to employees under the Company’s 2002 Equity Incentive Plan and 48,533 shares of restricted Class A Common Stock to its Directors under the 2004 Directors Plan. In 2006, the Company issued 101,013 shares of restricted Class A Common Stock to employees under the Company’s 2002 Equity Incentive Plan and 56,100 shares of restricted Class A Common Stock to its Directors under the 2004 Directors Plan. Restricted stock issued to the Company’s Directors under the 2004 Directors
Plan includes shares granted to new Directors and shares awarded to all Directors in lieu of a portion of their retainer. The restricted stock vests (restrictions lapse) between one and three years.
Upon vesting of a restricted stock award, employees may remit cash or shares of Class A Common Stock to satisfy their tax obligations relating to the award. During 2008, 2007 and 2006, employees remitted 1,241 shares, 31,525 shares and 8,831 shares, respectively, to the Company to satisfy their payment of withholding taxes for vested awards.
The Company recognizes compensation expense for restricted stock awards over the vested period of the award. Compensation expense recognized for restricted stock was $512,000 in 2008, $771,000 in 2007 and $1.3 million in 2006. At December 31, 2008, unrecognized compensation expense for non-vested restricted stock was $206,000, which is expected to be recognized over a weighted average period of 6 months.
Diluted shares used in the computations of diluted earnings per share for 2008, 2007 and 2006 also do not assume the effects of the potential conversion of the Company’s convertible debt into 2,000, 736,000 and 2.8 million shares of Class A Common Stock, respectively, because they were anti-dilutive.
As of December 31, 2008 and 2007, the carrying amounts for the Company’s financial instruments, except for its Senior Notes at December 31, 2008, approximated their estimated fair value. The Company measures the fair value of fixed maturities, the convertible debt and the Senior Notes based upon quoted market prices or by obtaining quotes from dealers. Certain financial instruments, specifically amounts relating to insurance and reinsurance contracts, are excluded from this disclosure.
The following is a description of the Company’s categorization of the fair value of its fixed maturities:
Level 1 - Fair value measures are based on unadjusted quoted market prices in active markets for identical securities. The fair value of fixed maturities included in the Level 1 category were based on quoted prices that are readily and regularly available in an active market. The Company includes U.S. Treasury securities in the Level 1 category.
Level 2 - Fair value measures are based on observable inputs, such as quoted prices for similar assets at the measurement date; quoted prices in markets that are not active; or other inputs that are observable, either directly or indirectly. The fair value of fixed maturities included in the Level 2 category were based on market values generated by external pricing models that vary by asset class and incorporate available trade, bid and other market information, as well as price quotes from other well-established independent market sources. The Company includes U.S. Government-sponsored agency obligations, states, political subdivisions and foreign government securities, corporate debt securities, and mortgage-backed and other asset-backed securities in the Level 2 category.
Level 3 - Fair value measures are based on inputs that are unobservable and significant to the overall fair value measurement, and may involve management judgment. The Company included private placement securities for which there was no active secondary market in the Level 3 category.
The following table provides the fair value measurements of applicable Company assets by level within the fair value hierarchy as of December 31, 2008. These assets are measured on a recurring basis.
Fair Value Measurements at Reporting Date Using Significant Unobservable Inputs (Level 3)
For the Level 3 securities whose prices were not obtained from the public markets, which were privately placed 18-month construction bridge loans with no secondary market, the Company utilized a discounted cash flow valuation model to approximate their current fair value.
Reconciliations between the total income tax expense and the amounts computed at the statutory federal income tax rate of 35% were as follows:
At December 31, 2008, the Company had a net operating loss (“NOL”) carryforward of $222.0 million, which will expire in years 2018 through 2028, and a $10.1 million tax credit carryforward primarily related to alternative minimum tax (“AMT”) credits, which do not expire. The NOL carryforward, which produces a gross deferred tax asset of $77.7 million, will be applied to reduce taxable income of the Company.
Prior to 2006, the Company had established a valuation allowance in the amount of $60.5 million. This was based upon management’s assessment that it was more likely than not that a portion of the gross deferred tax assets related to the NOL carryforward and all of the deferred tax asset related to the AMT credit carryforward would not be realized. Factors
The valuation allowance of $60.5 million is a reserve against $50.4 million of gross deferred tax assets related to the NOL carryforward and all of the projected deferred tax asset related to the AMT credit carryforward because it is more likely than not that this portion of the benefit will not be realized. The Company will continue to periodically assess the realizability of its net deferred tax asset.
The Company adopted the provisions of FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109 (“SFAS 109”)” (“FIN 48”), effective January 1, 2007. FIN 48 clarifies the accounting for uncertainty in income taxes recognized in a company’s financial statements in accordance with SFAS 109. FIN 48 requires that an uncertain tax position should be recognized only if it is “more likely than not” that the position is sustainable based on its technical merits. Recognizable tax positions should then be measured to determine the amount of benefit recognized in the financial statements. The Company’s adoption of FIN 48 did not have a material impact on its financial condition or results of operations.
The Company also maintains non-qualified unfunded supplemental defined benefit pension plans (the “Non-qualified Pension Plans”) which, prior to January 1, 2006, covered certain key employees. The projected benefit obligation and accumulated benefit obligation for the Non-qualified Pension Plans were $6.9 million and $6.9 million, respectively, as of December 31, 2008.
The following tables set forth the amounts recognized in the Company’s consolidated financial statements with respect to pension benefits and other postretirement benefits:
The asset allocation for the Company’s Qualified Pension Plan at the end of 2008 and 2007, and the target allocation for 2009, by asset category, are as follows:
The Company’s total revenues, substantially all of which are generated within the U.S., and pre-tax operating income (loss) by principal business segment are presented in the table below. In 2007, the Company began reporting the results of its Run-off Operations as discontinued operations. In 2008, the Fee-based Business segment included the operating results of PMA Management Corp. of New England, Inc., which was acquired by the Company in June 2008.
Operating income, which the Company defines as GAAP net income (loss) excluding net realized investment gains (losses) and results from discontinued operations, is the financial performance measure used by the Company’s management and Board of Directors to evaluate and assess the results of its businesses. Net realized investment activity is excluded because (i) net realized investment gains and losses are unpredictable and not necessarily indicative of current operating fundamentals or future performance of the business segments and (ii) in many instances, decisions to buy and sell securities are made at the holding company level, and such decisions result in net realized gains and losses that do not relate to the operations of the individual segments. Operating income does not replace net income (loss) as the GAAP measure of the Company’s consolidated results of operations.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of PMA Capital Corporation and subsidiaries as of December 31, 2008 and 2007, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2008 in conformity with accounting principles generally accepted in the United States of America.
As discussed in Note 5 to the consolidated financial statements, the Company reclassified as trading, certain marketable securities previously designated as available-for-sale and changed the manner in which changes in unrealized gains and losses on these securities get recognized in 2007.
We have audited PMA Capital Corporation and subsidiaries’ (the Company) internal control over financial reporting as of December 31, 2008, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.