Through various wholly owned subsidiaries, we also own and occupy additional office facilities in three other locations and rent additional office space for our insurance operations in 16 other locations. We believe that such owned and leased properties are suitable and adequate for our current business operations.
(4) On November 6, 2003, we announced our decision to withdraw from the reinsurance business previously served by PMA Re. As a result of this decision, the results of PMA Re are reported as Run-off Operations. In May 2002, we exited the excess and surplus lines business and placed this business, formerly known as Caliber One, into run-off.
(7) The operating ratio is equal to the combined ratio less the net investment income ratio, which is computed by dividing net investment income by net premiums earned.
This Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) contains forward-looking statements, which involve inherent risks and uncertainties. Statements that are not historical facts, including statements about our beliefs and expectations, and containing words such as “believe,” “estimate,” “anticipate,” “expect” or similar words, are forward-looking statements. These statements are based upon current estimates, assumptions and projections. Actual results may differ materially from those projected in such forward-looking statements, and therefore, you should not place undue reliance on them. See “Cautionary Statements” beginning on page 59 for a list of factors that could cause our actual results to differ materially from those contained in any forward-looking statement. Also, see “Item 1 - Business - Risk Factors” for a further discussion of risks that could materially affect our business.
We achieved our most important goal for 2004, the restoration of The PMA Insurance Group's A- (Excellent) financial strength rating, on November 15, 2004. We believe the restoration of The PMA Insurance Group’s A-financial strength rating will enable us to achieve measured written premium growth in 2005, compared to 2004.
In June 2004, the Pennsylvania Insurance Department approved our application for our primary insurance subsidiaries that comprise The PMA Insurance Group, or the Pooled Companies, previously subsidiaries of PMACIC, to become direct, wholly owned subsidiaries of PMA Capital Corporation. As a result, the Pooled Companies can pay dividends directly to PMA Capital Corporation. In 2004, the Pooled Companies paid dividends of $12.1 million to PMA Capital and can pay up to $23.5 million in dividends in 2005 without the prior approval of the Pennsylvania Insurance Department.
In its Order approving the transfer of the Pooled Companies from PMACIC to PMA Capital Corporation, the Pennsylvania Insurance Department prohibited PMACIC from any declaration or payment of dividends, return of capital or any other types of distributions in 2004 and 2005 to PMA Capital Corporation. In 2006, PMACIC may declare and pay ordinary dividends or returns of capital without the prior approval of the Pennsylvania Insurance Department if, immediately after giving effect to the dividend or return of capital, PMACIC’s risk-based capital equals or exceeds 225% of Authorized Control Level Capital as defined by the National Association of Insurance Commissioners. In 2007 and beyond, PMACIC may make dividend payments, as long as such dividends are not
The PMA Insurance Group earns revenue and generates cash primarily by writing insurance policies and collecting insurance premiums. The PMA Insurance Group also earns other revenues by providing risk control and claims adjusting services to customers. Because time normally elapses between the receipt of premiums and the payment of claims and certain related expenses, we invest the available premiums and earn investment income. From our revenues are deducted:
Losses and LAE are the most significant expense items affecting our insurance business and represent the most significant accounting estimates in our 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. Reserves are estimates of amounts to be paid in the future for losses and LAE and do not and cannot represent an exact measure of liability. If actual losses and LAE are larger than our loss reserve estimates, or if actual claims reported to us exceed our estimate of the number of claims to be reported to us, we have to increase reserve estimates with respect to prior periods. Changes in reserve estimates may be due to 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.
We recorded net income of $1.8 million in 2004, compared to net losses of $93.6 million in 2003 and $48.0 million in 2002. The exchange and sale of the 6.50% Convertible Debt reduced 2004 results by $6.4 million after-tax ($9.8 million pre-tax), which included a loss on the debt exchange of $3.9 million after-tax ($6.0 million pre-tax) and a loss of $2.5 million after-tax ($3.8 million pre-tax) for the subsequent increase in the fair value of the derivative component of the 6.50% Convertible Debt. The loss associated with the derivative component is included in net realized investment gains and losses.
The net loss for 2003 reflects a third quarter after-tax charge of $97.5 million ($150 million pre-tax), to increase loss reserves for our reinsurance business. On November 6, 2003, we announced our decision to exit the reinsurance business and we are no longer writing new reinsurance business. Additionally, we established a valuation allowance of $49 million on our deferred tax asset in 2003.
Consolidated revenues were $608.0 million, $1,301.2 million and $1,075.1 million in 2004, 2003 and 2002. The lower revenues in 2004 reflect lower net premiums earned due to our fourth quarter 2003 withdrawal from the reinsurance business and, to a lesser extent, the impact of the B++ financial strength rating on The PMA Insurance Group. The increase in revenues in 2003, compared to 2002, primarily reflected higher net premiums earned.
Following is a reconciliation of our segment operating results to GAAP net income (loss). See Note 15 to our Consolidated Financial Statements for additional information.
Pre-tax operating income for The PMA Insurance Group was $13.2 million in 2004, compared to $21.5 million in 2003 and $25.3 million in 2002. The lower pre-tax operating income in 2004, compared to 2003, primarily reflects lower underwriting results and lower net investment income. The lower pre-tax operating income in 2003, compared to 2002, primarily reflects lower underwriting results from accident years 2001 and 2002 in the workers’ compensation lines of business and lower net investment income, partially offset by improved current accident year underwriting results.
Direct writings of commercial lines of business other than workers’ compensation, such as commercial auto, general liability, umbrella, multi-peril and commercial property lines (collectively, “Commercial Lines”), decreased by $60.6 million in 2004, compared to 2003, reflecting the impact of The PMA Insurance Group’s B++ A.M. Best financial strength rating, partially offset by price increases that averaged 19% in 2004. Direct writings increased by $3.5 million in 2003, compared to the immediately preceding year, primarily due to weighted average price increases of approximately 17% in 2003.
Premiums assumed increased $10.0 million and $11.2 million in 2004 and 2003, respectively, compared to the immediately preceding year, primarily due to an increase in the amount of residual market business in The PMA Insurance Group’s principal marketing territories. Companies that write premiums in certain states generally must share in the risk of insuring entities that cannot obtain insurance in the voluntary market. Typically, an insurer’s share of this residual market business is
Net premiums written and earned decreased 37% and 22%, respectively, in 2004, compared to 2003 and increased 33% and 39%, respectively, in 2003, compared to 2002. Generally, trends in net premiums earned follow patterns similar to net premiums written adjusted for the customary lag related to the timing of premium writings within the year. In periods of decreasing premium writings, the decrease in net premiums written will typically be greater than the decrease in net premiums earned, as was the case in 2004. Direct premiums are earned principally on a pro rata basis over the terms of the policies. However, with respect to policies that provide for premium adjustments, such as experience-rated 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 premium in the period in which the adjustment is made. We made such an adjustment in 2003 as described above.
The operating expense ratio equals insurance-related operating expenses divided by net premiums earned. Insurance-related operating expenses were $43.7 million, $52.2 million and $36.7 million for 2004, 2003 and 2002, respectively.
As part of the year end closing process, in the fourth quarter of 2003, our internal actuaries completed a comprehensive year-end actuarial analysis of loss reserves. Based on the actuarial work performed, we noticed higher than expected claims severity in our workers' compensation business written for accident years 2001 and 2002, primarily from loss-sensitive and participating workers' compensation business. As a result, The PMA Insurance Group increased loss reserves for prior years by $50 million. An independent actuarial firm also conducted a comprehensive review of The PMA Insurance Group’s loss reserves as of December 31, 2003 and concluded that such carried loss reserves were reasonable as of December 31, 2003. Under The PMA Insurance Group's loss-sensitive rating plans we adjust the
amount of the insured's premiums 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 unfavorable prior year loss development were premium adjustments of $35 million under loss-sensitive plans and reduced policyholder dividends of $8 million, resulting in a net fourth quarter pre-tax charge of $7 million. This unfavorable prior year loss development and resulting premium and policyholders' dividend adjustments in 2003 increased the loss and LAE ratio by approximately 4 points and decreased the total expense ratio and policyholder's dividend ratio each by approximately 1.5 points. The total impact to the combined ratio was approximately 1 point.
In addition to the 1.5 point impact in the total expense ratio for 2003 discussed above, the total expense ratio increased 2.8 points in 2004, compared to 2003. In 2004, we did not reduce our level of operating expenses as quickly as revenues decreased in order to be in a position to respond to anticipated market demand after the restoration of the A- financial strength rating.
Net investment income was $1.9 million lower in 2004 and $2.7 million lower in 2003, compared to the immediately preceding years. The lower net investment income in 2004, compared to 2003, primarily reflects a reduction in invested asset yields of approximately 50 basis points, partially offset by a higher invested asset base that increased approximately 5%. The decline in 2003, compared to 2002, primarily reflects a reduction in invested asset yields of approximately 90 basis points, partially offset by a higher invested asset base that increased approximately 12%.
The Run-off Operations recorded pre-tax operating income of $5.5 million in 2004, compared to pre-tax operating losses of $80.4 million and $74.2 million for 2003 and 2002, respectively. Net premiums earned, losses and LAE, and acquisition and operating expenses have decreased significantly in 2004, compared to 2003 and 2002, due to our
Losses and LAE incurred decreased significantly for 2004, compared to 2003 and 2002, primarily due to the effects of lower net premiums earned in 2004, compared to 2003 and 2002, and the adverse prior year loss development recorded in 2003 and 2002.
Net unfavorable prior year loss development impacted results by approximately $116 million ($64 million for our reinsurance business and $52 million for excess and surplus lines) in 2002. During 2002, company actuaries conducted reserve reviews to determine the impact of any emerging data on anticipated loss development trends and recorded unpaid losses and LAE reserves. Based on the actuarial work performed, which included analyzing recent trends in the
levels of the reported and paid claims, an updated selection of actuarially determined loss reserve estimates was developed by accident year for each major line of business. Management’s selection of the ultimate losses resulting from their reviews indicated that net loss reserves for the excess and surplus lines business for prior accident years, mainly 1999 and 2000, needed to be increased by $52 million. This unfavorable prior year development reflects the impact of higher than expected claim severity and, to a lesser extent, frequency, that emerged in 2002 on casualty lines of business, primarily professional liability policies for the nursing homes class of business; general liability, including policies covering contractors’ liability for construction defects; and commercial automobile, mainly for accident years 1999 and 2000. For the reinsurance business, during the fourth quarter, our actuaries observed a higher than expected increase in the frequency and, to a lesser extent, severity of reported claims by our ceding companies. Management’s selection of the ultimate losses indicated that net loss and LAE reserves for prior accident years needed to be increased by $64 million in the fourth quarter of 2002, primarily for excess of loss and pro rata general liability occurrence contracts and, to a lesser extent, excess of loss general liability claims-made contracts, from accident years 1998, 1999 and 2000.
Operating expenses for 2004 were reduced by $2.5 million from a gain on the sale of our interest in Cathedral Capital PLC, a Lloyd’s of London managing general agency. Operating expenses for 2003 include exit costs of $2.6 million, mainly employee termination benefits, as a result of the decision to exit from and run off the reinsurance business. The majority of these costs were paid during 2004. Approximately 80 employees were terminated in accordance with our exit plan. Approximately 60 positions, primarily claims and financial personnel, remain after the terminations. We have established an employee retention arrangement for these remaining employees. Under this arrangement, expenses of $1.7 million were recorded in 2004, which includes retention bonuses and severance. We expect to incur an additional $1.3 million of these expenses in 2005.
As a result of our decision to exit from and run off our excess and surplus lines business, results for the Run-off Operations included a pre-tax charge of $43 million in 2002. Components of the pre-tax charge included approximately $16 million to write-down assets to their estimated net realizable value, including non-cash charges of approximately $6 million for leasehold improvements and other fixed assets and $1.3 million for goodwill. In addition, the $43 million pre-tax charge included expenses associated with the recognition of liabilities of approximately $27 million, including reinsurance costs of approximately $19 million, long-term lease costs of approximately $4 million and involuntary employee termination benefits of approximately $3 million. During 2003, the Run-off Operations recognized an additional $2.5 million write-down of assets, made up of approximately $2 million for reinsurance receivables and $500,000 for premiums receivable, reflecting an updated assessment of their estimated net realizable value. The write-down is included in operating expenses in the Statement of Operations for 2003.
Other revenues for 2003 reflected the gain on the sale of the capital stock of Caliber One Indemnity Company. Pursuant to the agreement of sale, we retained all assets and liabilities related to the in-force policies and outstanding claim obligations relating to Caliber One’s business written prior to closing on the sale.
Net investment income was $24.7 million, $34.4 million and $49.8 million in 2004, 2003 and 2002, respectively. The lower net investment income in 2004, compared to 2003, reflects lower yields of approximately 30 basis points on an average invested asset base that decreased approximately 18%, partially offset by lower net interest credited of $1.7 million on funds held. The decline in 2003, compared to 2002, reflected lower yields on the invested asset portfolio of approximately 110 basis points on an average invested asset base that increased approximately 9%, and lower interest earned of $7.5 million on funds held. For 2003, the reduction in interest earned on funds held arrangements was substantially offset by lower losses on the associated assumed Finite Risk and Financial Products contracts. In a funds held arrangement, the ceding company retains the premiums, and losses are offset against these funds in an experience account. Because the reinsurer is not in receipt of the funds, the reinsurer earns interest on the experience fund balance at a predetermined credited interest rate.
Our consolidated unpaid losses and LAE, net of reinsurance, at December 31, 2004 and 2003 were $998.8 million and $1,346.3 million, respectively, net of discount of $70.5 million and $82.3 million, respectively. Included in the consolidated unpaid losses and LAE are amounts related to our workers’ compensation claims of $448.7 million and $433.8 million, net of discount of $48.2 million and $54.6 million at December 31, 2004 and 2003, respectively. The discount rate used was approximately 5% at December 31, 2004 and 2003.
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 us. Due to the Òlong-tailÓ nature of a significant portion of our 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 us and our payment of that loss. We define 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. Our major long-tail lines include our workers’ compensation and casualty reinsurance business. In addition, because reinsurers rely on their ceding companies to provide them with information regarding incurred losses, reported claims for reinsurers become known more slowly than for primary insurers and are subject to more unforeseen development and uncertainty. As part of the process for determining our 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.
Management believes that its unpaid losses and LAE are fairly stated at December 31, 2004. 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, 2004, the related adjustments could have a material adverse effect on our financial condition, results of operations and liquidity. See the discussion under Losses and Expenses beginning on page 40, and Run-off Operations beginning on page 41 for additional information regarding increases in loss reserves for prior years.
At December 31, 2004, 2003 and 2002, our gross reserves for asbestos-related losses were $27.9 million, $37.8 million and $42.1 million, respectively ($14.0 million, $17.8 million and $25.8 million, net of reinsurance, respectively). At December 31, 2004, 2003 and 2002, our gross reserves for environmental-related losses were $16.1 million, $14.2 million and $18.2 million, respectively ($6.4 million, $8.8 million and $14.3 million, net of reinsurance, respectively).
Includes Trabaja Reinsurance Company ($264.1 million) and London Life & General Reinsurance Company ($24.7 million).
Includes United States Fidelity & Guaranty Insurance Company ($68.6 million), Mountain Ridge Insurance Company ($24.6 million) and other affiliated entities ($9.7 million).
We perform credit reviews of our reinsurers focusing on, among other things, financial capacity, stability, trends and commitment to the reinsurance business. Reinsurers failing to meet our standards are excluded from our reinsurance programs. In addition, we require 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, 2004 and 2003, our reinsurance receivables were supported by $507.2 million and $644.1 million of collateral. Of the uncollateralized reinsurance receivables at December 31, 2004, 94% were due from reinsurers rated “A-” or better by A.M. Best and is broken down as follows: “A++” - 5%; “A+” - 43%; “A” - 39% and “A-” - 7%. We believe that our reinsurance receivables, net of the valuation allowance, are fully collectible. In 2003 and 2002, we wrote off reinsurance receivables of $3.0 million and $3.5 million, respectively, all from the Run-off Operations. The timing and collectibility of reinsurance receivables have not had a material adverse effect on our liquidity.
At December 31, 2004, our reinsurance and retrocessional protection for major lines of business that we write was as follows:
The PMA Insurance Group retains an aggregate $18.8 million deductible on the first layer of its workers' compensation reinsurance, which is $1.25 million excess $250,000.
Effective January 1, 2005, the retention was reduced to $1.0 million and the limit was increased to $49.0 million.
The PMA Insurance Group does not write a significant amount of natural catastrophe exposed business. We actively manage our exposure to catastrophes through our underwriting process, where we generally monitor the accumulation of insurable values in catastrophe-prone regions. The PMA Insurance Group maintains property catastrophe reinsurance protection of 95% of $18.0 million excess of $2.0 million per occurrence.
In 2004, 2003 and 2002, our loss and LAE ratios were not significantly impacted by catastrophes.
With respect to the reinsurance and retrocessional protection shown in the table above, our treaties do not cover us for losses sustained from terrorist activities. Therefore, if future terrorist attacks occur, they may result in losses that have a material adverse effect on our financial condition, results of operations and liquidity.
In November 2002, the Terrorism Risk Insurance Act of 2002 (“TRIA”) became effective. TRIA provides federal reinsurance protection for property and casualty losses in the United States or to United States aircraft or vessels arising from certified terrorist acts through the end of 2005. TRIA expires on December 31, 2005 and although legislation has been introduced in Congress to extend TRIA, there is no assurance that it will be re-enacted or extended. For terrorist acts to be
covered under TRIA, they must be certified as such by the United States Government and must be committed by individuals acting on behalf of a foreign person or interest. TRIA contains a “make available” provision, which requires insurers subject to the Act, to offer coverage for acts of terrorism that does not differ materially from the terms (other than price), amounts and other coverage limitations offered to the policyholder for losses from events other than acts of terrorism. The “make available” provision permits exclusions for certain types of losses, if a state permits exclusions for such losses. TRIA requires insurers to retain losses based on a percentage of their commercial lines direct earned premiums for the prior year equal to a 15% deductible for 2005. The federal government covers 90% of the losses above the deductible, while a company retains 10% of the losses. TRIA contains an annual limit of $100 billion of covered industry-wide losses. TRIA applies to commercial lines of property and casualty insurance, including workers’ compensation insurance, offered by The PMA Insurance Group, but does not apply to reinsurance. The PMA Insurance Group would have a deductible of approximately $70 million in 2005 if a covered terrorist act were to occur.
Liquidity is a measure of an entity’s ability to secure sufficient cash to meet its contractual obligations and operating needs. Our insurance operations generate cash by writing insurance policies and collecting premiums. The cash generated is used to pay losses and LAE and operating expenses. Any excess cash is invested and earns investment income.
Operating cash flows declined significantly in 2004, compared to 2003, primarily due to the run-off of our reinsurance business, including the commutation and novation of certain reinsurance and retrocessional contracts of the Run-off Operations occurring in 2004 and the purchase of a reinsurance agreement covering potential adverse development at the Run-off Operations. See Notes 4 and 5 to the Consolidated Financial Statements for additional information regarding commutations and novations by the Run-off Operations and the reinsurance agreement covering potential adverse loss development, respectively. To a lesser extent, the impact of The PMA Insurance Group’s B++ financial strength rating between November 2003 and November 2004 also negatively impacted operating cash flows. Operating cash flows increased significantly in 2003, compared to 2002, reflecting higher revenues.
The Pooled Companies, which are not subject to the Pennsylvania Insurance Department’s Order, paid dividends of $12.1 million to PMA Capital Corporation in 2004. The Pooled Companies can pay up to $23.5 million in dividends in 2005 without the prior approval of the Pennsylvania Insurance Department. In considering its future dividend policy, the Pooled Companies consider, among other things, the impact of paying dividends on its financial strength ratings. PMA Capital received dividends from subsidiaries of $24.0 million and $28.0 million in 2003 and 2002, respectively.
On November 15, 2004, we exchanged $84.1 million aggregate principal amount of 6.50% Convertible Debt for $84.1 million aggregate principal amount of 4.25% Convertible Debt. We did not receive any proceeds as a result of the exchange offer. The exchange allowed us to extend the first put date associated with our convertible debt from September 2006 to June 2009. Additionally, in November 2004, we received net proceeds of $15.2 million from the issuance of $15 million aggregate principal amount of 6.50% Convertible Debt in a private placement to a limited number of qualified institutional buyers. We expect to be able to receive capital distributions from our principal operating subsidiaries sufficient to repurchase the new debt on the put date of June 30, 2009.
On June 30, 2009, holders of the 6.50% Convertible Debt will have the right to require us to repurchase for cash any amounts outstanding for 114% of the principal amount of the debt plus accrued and unpaid interest, if any, to the settlement date. In 2006, in the event we receive any extraordinary dividends from our subsidiaries, we will be required to use 50% of those dividends to redeem up to $35 million principal amount of the debt at 110% of the original principal amount. Holders may elect to receive any premium over the principal amount in either cash or Class A common stock (with the number of shares determined based on a value of $8.00 per share).
The 6.50% Convertible Debt is secured equally and ratably with our $57.5 million 8.50% Monthly Income Senior Notes due 2018 (“Senior Notes”) by a first lien on 20% of the capital stock of our principal operating subsidiaries. We have agreed to make an additional pledge of the remainder of the capital stock of these subsidiaries if the A.M. Best financial strength rating of the Pooled Companies is not A- or higher on December 31, 2005 or is reduced below B++ prior to December 31, 2005. However, execution of any lien by the holders of the 6.50% Convertible Debt is subject to the approval by the Pennsylvania Insurance Department. The 6.50% Convertible Debt is
Assumes holders require us to repurchase all of this debt on June 30, 2009 at 114% of the principal amount. This debt may be converted at any time, at the holder's option, at a current price of $16.368 per share.
Holders of the Convertible Debt, at their option, may require the Company to repurchase all or a portion of their debt on September 30, 2006, 2008, 2010, 2012 and 2017. This debt may be converted at any time, at the holder’s option, at a current price of $16.368 per share.
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 $244.2 million, of when we expect our unpaid losses and LAE (without the benefit of reinsurance recoveries) to be paid. We maintain an investment portfolio with varying maturities that we believe will provide adequate cash for the payment of claims.
In 2004, the Run-off Operations paid a $1.0 million fee to shorten the term of our Philadelphia office lease from fifteen years to seven years and reduce the leased space by approximately 75% effective October 1, 2004, which reduced our contractual obligations under the lease by $661,000 annually from 2005 through 2008, $870,000 in 2009 and $14.6 million thereafter. In addition to the reduced contractual obligations, we estimate that this change will also result in reduced related expenses of approximately $830,000 annually.
statutory trust subsidiaries are guaranteed by PMA Capital with respect to distributions and payments of the trust preferred securities.
In October 2002, we issued $86.25 million of 4.25% Convertible Debt from which we received net proceeds of $83.7 million. We used the proceeds from this offering primarily to increase the capital and surplus of our reinsurance and insurance subsidiaries. As discussed above, we exchanged $84.1 million of this debt in November 2004. During December 2004, we retired $1.2 million of this debt at par through open market purchases. As of December 31, 2004, $925,000 remained outstanding. See Note 6 to our Consolidated Financial Statements for additional information.
At December 31, 2004, we had $214.5 million of long-term debt, compared to $187.6 million at December 31, 2003. During 2004, 2003 and 2002, we incurred $12.4 million, $9.9 million and $3.3 million of interest expense, and paid interest of $11.6 million, $8.4 million and $2.1 million in each respective year.
During 2003 and 2002 we paid dividends to shareholders of $9.9 million and $12.1 million, respectively. We did not declare a dividend in the fourth quarter of 2003 and we have suspended common stock dividends at the current time.
In 2002, we contributed $16.5 million to our qualified pension plan in order to ensure that the plan assets were at least equal to our accumulated benefit obligation at the end of 2002. We did not make a contribution to our qualified pension plan in 2004 or 2003. We made the contribution in 2002 due to a significant decline in the market value of our plan assets, stemming from the broad market declines in the bond and equity markets over the previous three years. Our accumulated benefit obligation was greater than the fair value of plan assets by approximately $8 million and $3 million at December 31, 2004 and December 31, 2003, respectively, largely due to reductions in the discount rate used to measure the benefit obligation. As a result, we recorded a minimum pension liability of $25.3 million and reduced accumulated other comprehensive income by $15.6 million, after-tax in 2003. In 2004, we increased the additional minimum pension liability by $1.2 million and reduced accumulated other comprehensive income by $806,000 after-tax. In 2004 and 2003, the Company was not required to make any contribution to the pension plan under the minimum funding requirements of the Employee Retirement Income Security Act (“ERISA”) of 1974. Our plan assets are composed of 31% fixed maturities and 69% equities at December 31, 2004. We currently estimate that the pension plan’s assets will generate a long-term rate of return of 8.50%, which we believe is a reasonable long-term rate of return, in part, because of the historical performance of the broad financial markets. Pension expense in 2004, 2003 and 2002 was $4.9 million, $4.4 million and $3.0 million, respectively.
(1) Average invested assets throughout the year, at amortized cost, excluding amounts related to securities lending activities.
As of December 31, 2004, our investment asset portfolio had gross unrealized losses of $12.3 million. For securities that were in an unrealized loss position at December 31, 2004, the length of time that such securities have been in an unrealized loss position, as measured by their month-end fair values, is as follows:
Of the securities that have been in an unrealized loss position for more than 12 months, 33 securities have an unrealized loss of less than $1 million each and less than 20% of each security's amortized cost. These 33 securities have a total fair value of 96% of the amortized cost basis at December 31, 2004, and the average unrealized loss per security is approximately $33,000. There is only one security out of the 34 with an unrealized loss in excess of $1 million at December 31, 2004, and it has a market value of $15.7 million and a par value and cost of $20.0 million. The security, which matures in 2011, is a structured security backed by a U.S. Treasury Strip, and is rated AAA. We have both the ability and intent to hold this security until it matures.
During 2004, we determined there were other than temporary declines in the market value of securities issued by two companies, resulting in impairment losses of $334,000 in 2004. The impairment losses for 2004 were related to an asset-backed security and a security issued by an airline company. The write-downs were measured based on public market prices and our expectation of the future realizable value for the securities at the time we determined the decline in value was other than temporary.
Results for 2003 include gross realized gains and losses of $18.7 million and $4.9 million, respectively. Included in the gross realized losses were impairment losses of $2.6 million on fixed income securities, primarily securities issued by airline companies and one asset-backed security and realized losses of $800,000 on sales of securities where we reduced and/or eliminated our positions in certain issuers due to credit concerns. Realized losses also include sales reducing our per issuer exposure and general duration management trades. The net realized investment losses for 2002 primarily reflect impairment losses of $23.8 million on fixed income securities, primarily corporate bonds issued by telecommunications and energy companies.
In general, our businesses are subject to a changing social, economic, legal, legislative and regulatory environment that could affect them. Some of the changes include initiatives to restrict insurance pricing and the application of underwriting standards and reinterpretations of insurance contracts long after the policies were written in an effort to provide coverage unanticipated by us. The eventual effect on us of the changing environment in which we operate remains uncertain.
The Pennsylvania Insurance Department has completed examinations of PMA Capital Insurance Company and the Pooled Companies as of December 31, 2002. The examinations did not result in any material adjustments to our statutory capital in our previously filed statutory financial statements. No material qualitative matters were raised as a result of the examinations.
In December 2004, we adopted Emerging Issues Task Force (“EITF”) Consensus 04-8, “The Effect of Contingently Convertible Debt on Diluted Earnings Per Share,” which requires the inclusion of the dilutive effect of contingently convertible debt instruments in the computation of diluted income (loss) per share regardless of whether the contingency triggering convertibility has been met. Our earnings per share calculation for the first and second quarters of 2003 did not include the effects of potential conversion because the conditions for convertibility had not yet occurred. Adoption of EITF 04-8 resulted in a reduction in our first and second quarter 2003 diluted income per share by three and four cents, respectively, but has no effect for full year 2003, because the effect would have been anti-dilutive. Beginning in the third quarter of 2003, the conversion requirements were met on our convertible debt. See unaudited “Quarterly Financial Information” in Item 8 of this Form 10-K for additional information.
In December 2004, the FASB revised SFAS No. 123, “Share-Based Payment” to require the recognition of expenses relating to share-based payment transactions, including employee stock option grants, based on the fair value of the equity instruments issued. We are required to adopt the revised SFAS No. 123 in the third quarter of 2005. Effective with the third quarter of 2005, we will recognize an expense over the required service period for any stock options granted, modified, cancelled, or repurchased after that date and for the portion of grants for which the requisite service has not yet been rendered, based on the grant-date fair value of those awards. In December 2002, we adopted the disclosure provisions of SFAS No. 148, “Accounting for Stock-Based Compensation - Transition and Disclosure,” which required prominent disclosures in financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. See Note 2-J to the Consolidated Financial Statements for the effect on net income (loss) if the fair value based method had been applied.
It is important to realize and understand that the process of estimating our 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, and changes in social attitudes and economic conditions, we revise our estimates accordingly. Due to the long-tail nature of a significant portion of our 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 us and our payment of that loss. Furthermore, because reinsurers rely on their ceding companies to provide them with information regarding incurred losses, reported claims for reinsurers become known more slowly than for primary insurers and are subject to more unforeseen development and uncertainty. We believe that our liability for unpaid losses and loss adjustment expenses is fairly stated at December 31, 2004. However, if our future estimate of ultimate unpaid losses is larger than the recorded amounts, we would have to increase our reserves. Any increase in reserves would result in a charge to earnings in the period recorded. For example, in 2003 we increased net reserves for our reinsurance business by $169 million and took earnings charges as a result. Accordingly, any reserve adjustment could have a material adverse effect on our financial condition, results of operations and liquidity.
As outlined above, our loss and LAE reserves at December 31, 2004 have been established relying on generally accepted actuarial techniques and are based on numerous critical assumptions and informed judgments about reported and paid claim trends and their implication on our estimate of the ultimate loss for reported and incurred but unreported claims at the balance sheet date. We have established a loss and LAE reserve for unpaid claims at December 31, 2004 that we believe is a reasonable and adequate provision based on the information available to us. If we revised our assessment of loss reporting and claims payment patterns because of changes in those patterns, such that it resulted in a 1% change in our net loss and LAE reserves, then our pre-tax income would change by approximately $10 million.
All investments in our portfolio are carried at market value. For 99% of our investments, we determine the market value using prices obtained in the public markets, both primary and secondary markets. These market prices reflect publicly reported values of recent purchase and sale transactions for each specific, individual security. Therefore, we believe that the reported fair values for our investments at December 31, 2004 reflect the value that we could realize if we sold these investments in the open market at that time.
Based on our evaluation of securities with an unrealized loss at December 31, 2004, we do not believe that any additional other-than-temporary impairment losses, other than those already reflected in the financial statements, are necessary at the balance sheet date. However, if we were to have determined that all securities that were in an unrealized loss position at December 31, 2004 should have been written down to their fair value, we would have recorded an additional other-than-temporary impairment loss of $12.3 million pre-tax.
For additional information about our investments, see Notes 2-B, 3 and 11 of the Consolidated Financial Statements as well as “Investments” beginning on page 51.
Although the contractual obligation of individual reinsurers to pay their reinsurance obligations is determinable from specific contract provisions, the collectibility of such amounts requires significant estimation by management. Many years may pass between the occurrence of a claim, when it is reported to us and when we ultimately settle and pay the claim. As a result, it can be several years before a reinsurer has to actually remit amounts to us. Over this period of time, economic conditions and operational performance of a particular reinsurer may impact their ability to meet these obligations and while they may still acknowledge their contractual obligation to do so, they may not have the financial resources to fully meet their obligation to us. If this occurs, we may have to write down a reinsurance receivable to its then determined net realizable value and reflect that write-down in earnings in the period such determination is made. We attempt to limit any such exposure to uncollectible reinsurance receivables by performing credit reviews of our reinsurers. In addition, we require collateral, such as assets held in trust or letters of credit, for certain reinsurance receivables. However, if our future estimate of uncollectible receivables exceeds our current expectations, we may need to increase our allowance for uncollectible reinsurance receivables. The increase in this allowance would result in a charge to earnings in the period recorded. Accordingly, any related charge could have a material adverse effect on our financial condition, results of operations and liquidity.
The premiums on reinsurance business ceded are recorded as incurred on a pro rata basis over the contract period. Certain ceded reinsurance contracts contain provisions requiring us to pay additional premiums ranging from 20% to 50% of ceded losses or reinstatement premiums in the event that losses of a significant magnitude are ceded under such contracts. Under accounting rules, we are not permitted to establish reserves for potential additional premiums or record such amounts until a loss occurs that would obligate us to pay such additional or reinstatement premiums. As a result, the net benefit to our results from ceding losses to our retrocessionaires in the event of a loss may be reduced by the payment of additional premiums and reinstatement premiums to our retrocessionaires.
the uncertain nature of damage theories and loss amounts and the development of additional facts related to the attack on the World Trade Center;
uncertainties related to possible terrorist activities or international hostilities and whether TRIA is extended beyond its December 31, 2005 termination date; and
Consolidated Statements of Operations for the years ended December 31, 2004, 2003 and 2002
Consolidated Statements of Cash Flows for the years ended December 31, 2004, 2003 and 2002
(2004 - 60,000,000 shares authorized; 34,217,945 shares issued and 31,676,851 outstanding;
Treasury stock, at cost (2004 - 2,541,094 shares; 2003 - 2,883,542 shares)
The accompanying consolidated financial statements include the accounts of PMA Capital Corporation and its subsidiaries (collectively referred to as “PMA Capital” or the “Company”). PMA Capital Corporation is an insurance holding company that owns and operates specialty risk management businesses:
Run-off Operations - Run-off Operations consists of the results of the Company’s former reinsurance and excess and surplus lines businesses. The Company’s former reinsurance operations offered excess of loss and pro rata property and casualty reinsurance protection mainly through reinsurance brokers. In November 2003, the Company decided to withdraw from the reinsurance business. In May 2002, the Company withdrew from its former excess and surplus lines business.
Realized gains and losses, determined by the first-in, first-out method, are reflected in income in the period in which the sale transaction occurs. For all securities that are in an unrealized loss position for an extended period of time and for all securities whose fair value is significantly below amortized cost, the Company performs an evaluation of the specific events attributable to the market decline of the security. The Company considers the length of time and extent to which the security’s market value has been below cost as well as the general market conditions, industry characteristics and the fundamental operating results of the issuer to determine if the decline is other than temporary. The Company also considers as part of the evaluation its intent and ability to hold the security until its market value has recovered to a level at least equal to the amortized cost. When the Company determines 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. The write-downs are measured based on public market prices and the Company’s expectation of the future realizable value for the security at the time the Company determines the decline in value was other than temporary.
The Company participates in a securities lending program through which securities are lent from the Company’s portfolio for short periods of time to qualifying third parties via a lending agent. Borrowers of these securities must provide collateral equal to a minimum of 102% of the market value including accrued interest of the lent securities. Acceptable collateral may be in the form of either cash or securities. Cash received as collateral is invested in short-term investments, and is recorded as such on the Balance Sheet, along with a corresponding liability included in payable under securities loan agreements. All securities received as collateral are of similar quality to those securities lent by the Company. The Company is not permitted by contract to sell or repledge the securities received as collateral. Additionally, the Company limits securities lending to 40% of statutory admitted assets of its insurance subsidiaries, with a 2% limit on statutory admitted assets to any individual borrower. The Company either receives a fee from the borrower or retains a portion of the income earned on the collateral. Under the terms of the securities lending program, the Company is indemnified against borrower default, with the lending
agent responsible to the Company for any deficiency between the cost of replacing a security that was not returned and the amount of collateral held by the Company.
Certain of the Company’s assumed and ceded reinsurance contracts are funds held arrangements. In a funds held arrangement, the ceding company retains the premiums instead of paying them to the reinsurer and losses are offset against these funds in an experience account. Because the reinsurer is not in receipt of the funds, the reinsurer will generally earn interest on the experience fund balance at a predetermined credited rate of interest. The Company generally earns an interest rate of between 6% and 8% on its assumed funds held arrangements and generally pays interest at a rate of between 6% and 7% on its ceded funds held arrangements. The interest earned or credited on funds held arrangements is included in net investment income in the Statement of Operations. In addition, interest on funds held arrangements will continue to be earned or credited until the experience account is fully depleted, which can extend many years beyond the expiration of the coverage period.
F. Deferred Acquisition Costs - Costs that directly relate to and vary with the acquisition of new and renewal business are deferred and amortized over the period during which the related premiums are earned. Such direct costs include commissions or brokerage and premium taxes, as well as other policy issuance costs and underwriting expenses. The Company determines whether acquisition costs are recoverable considering future losses and LAE, maintenance costs and
J. Stock-Based Compensation - The Company accounts for stock-based compensation using the intrinsic value method prescribed in Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees," and related interpretations. Accordingly, compensation cost for stock options is measured as the excess, if any, of the quoted market price of the Company’s Class A Common stock at grant date or other measurement date over the amount an employee must pay to acquire the Class A Common stock. The following table illustrates the effect on net income (loss) if the fair value based method had been applied:
K. Other Revenues - Other revenues include service revenues related to unbundled claims, risk management and related services provided by The PMA Insurance Group, which are earned over the term of the related contracts in proportion to the actual services rendered, and other miscellaneous revenues. During 2004, other revenues included a $6.6 million gain on the sale of a partnership interest.
L. Recent Accounting Pronouncements - In December 2003, the Financial Accounting Standards Board (“FASB”) revised Statement of Financial Accounting Standards (“SFAS”) No. 132, “Employers’ Disclosures About Pensions and Other Postretirement Benefits,” to require additional disclosures regarding defined benefit pension plans and other defined benefit postretirement plans. The Company has applied the disclosure provisions of SFAS No. 132, as revised, to its Consolidated Financial Statements.
As of December 31, 2004, gross unrealized losses on the Company’s investment asset portfolio were $12.3 million. For securities that were in an unrealized loss position at December 31, 2004, the length of time that such securities have been in an unrealized loss position, as measured by their month-end fair values, is as follows:
Included in realized losses for 2004, 2003 and 2002 were impairment losses of $334,000, $2.6 million and $23.8 million, respectively. The impairment losses for 2004 were related to an asset-backed security and a security issued by an airline company. The impairment losses for 2003 primarily related to securities issued by airline companies and an asset-backed security. The impairment losses for 2002 primarily related to corporate bonds issued by telecommunications and energy companies, including $14.2 million for WorldCom. The write-downs were measured based on public market prices and the Company’s expectation of the future realizable value for the security at the time when the Company determined the decline in value was other than temporary.
The realized loss on the change in fair value of derivative related to the increase in the fair value of the derivative component of the 6.50% Convertible Debt from the date of issuance/exchange to December 31, 2004. See Note 6 for additional information.
At December 31, 2003, the Company had $6.3 million of collateral related to securities on loan, substantially all of which was cash received and subsequently reinvested in short-term investments.
On December 31, 2004, the Company had securities with a total amortized cost of $47.9 million and fair value of $48.5 million on deposit with various governmental authorities, as required by law. In addition, the Company had securities with a total amortized cost of $27.8 million and fair value of $28.2 million held in trust for the benefit of certain ceding companies on reinsurance balances assumed by the Run-off Operations. Securities with a total amortized cost and fair value of $7.0 million were held in trust to support the Company’s participation in the underwriting capacity of a Lloyd’s of London syndicate. There were also securities with a total amortized cost and fair value of $4.0 million pledged as collateral for letters of credit issued on behalf of the Company. The securities held in trust, on deposit or pledged as collateral are included in fixed maturities and short-term investments on the Balance Sheet.
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 major long-tail lines include its workers’ compensation and casualty reinsurance business. In addition, because reinsurers rely on their ceding companies to provide them with information regarding incurred losses, reported claims for reinsurers become known more slowly than for primary insurers and are subject to more unforeseen development and uncertainty. 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 components of the Company’s (favorable) unfavorable development of reserves for losses and LAE for prior accident years, excluding accretion of discount, are as follows:
The PMA Insurance Group recorded favorable prior year loss development of $2.1 million in 2004, 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.
During 2003, The PMA Insurance Group recorded unfavorable prior year loss development of $49.7 million. As part of the year end closing process, in the fourth quarter of 2003, the Company’s actuaries completed a comprehensive year-end actuarial analysis of loss reserves. Based on the actuarial work performed, the Company’s actuaries noticed higher than expected claims severity in workers' compensation business written for accident years 2001 and 2002, primarily from loss-sensitive and participating workers' compensation business. As a result, The PMA Insurance Group increased loss reserves for prior years by $50 million. An independent actuarial firm also conducted a comprehensive review of The PMA Insurance Group’s loss reserves as of December 31, 2003 and concluded that such carried loss reserves were reasonable as of December 31, 2003. Under The PMA Insurance Group's loss-sensitive rating 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 unfavorable prior year loss development were premium adjustments of $35 million under loss-sensitive plans and reduced policyholder dividends of $8 million, resulting in a net fourth quarter pre-tax charge of $7 million.
During 2003, the Run-off Operations increased its net loss reserves for prior accident years for reinsurance business by $169.1 million, including $150 million during the third quarter. The third quarter 2003 reserve charge related to higher than expected underwriting losses, primarily from casualty business written in accident years 1997 through 2000. Approximately
75% of the charge was related to general liability business written from 1997 to 2000 with substantially all of the remainder of the charge from the commercial automobile line written during those same years. During the third quarter, the Company’s actuaries conducted their periodic comprehensive reserve review. Based on the actuarial work performed, which included analyzing recent trends in the levels of the reported and paid claims, an updated selection of actuarially determined loss reserve estimates was developed by accident year for each major line of reinsurance business written. The information derived during this review indicated that a large portion of the change in expected loss development was due to increasing loss trends emerging in calendar year 2003 for prior accident years. This increase in 2003 loss trends caused management to determine that the reserve levels, primarily for accident years 1997 to 2000, needed to be increased by $150 million. An independent actuarial firm also conducted a comprehensive review of the Company’s Traditional-Treaty, Specialty-Treaty and Facultative reinsurance loss reserves, and concluded that those carried loss reserves were reasonable at September 30, 2003.
The Company’s analysis was enhanced by an extensive review of specific accounts, comprising about 40% of the carried reserves of the reinsurance business for accident years 1997 to 2000. The Company’s actuaries visited a number of former ceding company clients, which collectively comprised about 25% of the reinsurance business total gross loss and LAE reserves from accident years 1997 to 2000, to discuss reserving and reporting experience with these ceding companies. The Company’s actuaries separately evaluated an additional number of other ceding companies, representing approximately 15% of the reinsurance business total gross loss and LAE reserves from accident years 1997 to 2000, to understand and examine data trends.
During 2002, the Run-off Operations recorded net unfavorable prior year loss development of $159 million ($107 million for reinsurance and $52 million for excess and surplus lines). During 2002, company actuaries conducted reserve reviews to determine the impact of any emerging data on anticipated loss development trends and recorded unpaid losses and LAE reserves. Based on the actuarial work performed, which included analyzing recent trends in the levels of the reported and paid claims, an updated selection of actuarially determined loss reserve estimates was developed by accident year for each major line of business. Management’s selection of the ultimate losses resulting from their reviews indicated that net loss reserves for the excess and surplus lines business for prior accident years, mainly 1999 and 2000, needed to be increased by $52 million. This unfavorable prior year development reflects the impact of higher than expected claim severity and, to a lesser extent, frequency, that emerged in 2002 on casualty lines of business, primarily professional liability policies for the nursing homes class of business; general liability, including policies covering contractors’ liability for construction defects; and commercial automobile, mainly for accident years 1999 and 2000.
Reserves transferred in 2002 reflect the assumption of losses by an unaffiliated third party. Cash and short-term investments of $50 million were transferred to support the payment of the transferred reserves.
Unpaid losses for the Company’s workers’ compensation claims, net of reinsurance, at December 31, 2004 and 2003 were $448.7 million and $433.8 million, net of discount of $48.2 million and $54.6 million, respectively. The discount rate used was approximately 5% at December 31, 2004 and 2003.
The Company’s loss reserves were stated net of salvage and subrogation of $30.8 million and $33.2 million at December 31, 2004 and 2003, respectively.
During 2004, the Company’s actuaries conducted their periodic reserve reviews of The PMA Insurance Group and the Run-off Operations. Based on the actuarial work performed, which included analyzing recent trends in the levels of the reported and paid claims, an updated selection of actuarially determined loss reserve estimates was developed by accident year for each major line of business. The information derived during these reviews indicated that general liability and professional liability lines written by the Run-off Operations continued to exhibit volatility. While the conclusion of the reviews indicated that no adjustments to reserves were necessary and that the Company's carried reserves were resonable, continued volatility could require adjustments in future periods.
On December 6, 2004, the New York jury in the trial regarding the insurance coverage for the World Trade Center rendered a verdict that the September 11, 2001 attack on the World Trade Center constituted two occurrences under the policies issued by certain insurers. The Company considers the jury's verdict to be contrary to the terms of the insurance coverage in force and to the intent of the parties involved. Because the litigation is ongoing and the appraisal and valuation process is pending, the ultimate resolution of this issue cannot be determined at this time. The Company estimates that it could be required to incur a charge of up to $5 million pre-tax at the Run-off Operations if it is ultimately determined that the September 11, 2001 attack on the World Trade Center constituted two occurrences under the policies issued by certain of its ceding companies and if as a result of this determination, additional losses are incurred by its ceding companies.
In 2004, the Company purchased reinsurance covering potential adverse loss development of the loss and LAE reserves of the Run-off Operations. Under the agreement, the Company ceded $100 million in carried loss and LAE reserves and paid $146.5 million in cash. During 2004, the Company incurred $6.0 million in ceded premiums for this agreement. In addition, the contract requires additional premiums of $2.5 million if it is not commuted by December 2007. At December 31, 2004, the Run-off Operations have $105 million of available coverage under this agreement for future adverse loss development.
Any future cession of losses may require the Company to cede additional premiums of up to $35 million on a pro rata basis, at the following contractually determined levels:
The additional premiums have been prepaid and are included in other assets on the Balance Sheet. Because the coverage is retroactive, the Company will not record the benefit of this reinsurance in its Statement of Operations until it receives the related recoveries.
In January 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 of the Run-off Operations ceded to Trabaja for accident years 1996 through 2001 are recoverable as they are incurred by the Company. In 2002, the Run-off Operations recognized a benefit of $25 million for losses ceded to these reinsurance contracts. 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.
The 6.50% Convertible Debt is secured equally and ratably with the Company's $57.5 million 8.50% Monthly Income Senior Notes due 2018 (the “8.50% Senior Notes”) by a first lien on 20% of the capital stock of the Company's principal operating subsidiaries. The Company has agreed to make an additional pledge of the remainder of the capital stock of these subsidiaries if the A.M. Best financial strength rating of the Pooled Companies is not A- or higher on December 31, 2005 or is reduced below B++ prior to December 31, 2005. The 6.50% Convertible Debt is convertible at the rate of 61.0948 shares per $1000 principal amount, equivalent to a conversion price of $16.368 per share of Class A common stock.
The Put Premium and conversion features of the 6.50% Convertible Debt constitute a derivative which requires bifurcation. Any change in the fair value of the derivative component of the 6.50% Convertible Debt is recognized in net realized investment gains (losses). The Company had a net realized loss of $3.8 million in 2004 for the increase in the fair value of the derivative component of the 6.50% Convertible Debt from the date of issuance to December 31, 2004.
In 2003, the Company issued $43.8 million of 30-year floating rate subordinated debentures to three wholly owned statutory trust subsidiaries. The Company used all of the $41.2 million of net proceeds to pay down a portion of its then outstanding bank credit facility and for general corporate purposes. The trust preferred debt matures in 2033 and is redeemable, in whole or in part, in 2008 at the stated liquidation amount plus accrued and unpaid interest. The interest rates on the trust preferred debt equal the three-month London InterBank Offered Rate ("LIBOR") plus 4.10%, 4.20% and 4.05% and is payable on a quarterly basis. At December 31, 2004, the weighted average interest rate on the trust preferred securities was 6.51%.
The Company has the right to defer interest payments on the Trust Preferred securities for up to twenty consecutive quarters but, if so deferred, it may not declare or pay cash dividends or distributions on its Class A common stock. The Company has guaranteed the obligations of these statutory trust subsidiaries with respect to distributions and payments on the trust preferred securities issued by these subsidiaries.
The indenture governing the 6.50% Convertible Debt contains restrictive covenants with respect to limitations on the Company’s ability to incur indebtedness, enter into transactions with affiliates or engage in a merger or sale of all or substantially all of the Company’s assets.
The Company leases certain office space and office equipment such as computers under noncancelable operating leases. Future minimum net operating lease obligations as of December 31, 2004 are as follows:
Net of sublease rentals of $1.5 million in 2005 and 2006, $1.6 million in 2007, 2008 and 2009 and $7.8 million thereafter.
Total rent expense incurred under operating leases was $3.9 million, $4.0 million and $4.1 million for 2004, 2003 and 2002, 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, 2004 and 2003, the Company had recorded liabilities of $6.6 million and $7.5 million for these assessments, which are included in accounts payable, accrued expenses and other liabilities on the Balance Sheet.
Prior to December 2004, the Company had an interest in a real estate partnership for which it had provided a guaranty of $7.0 million related to loans on properties of the partnership. In December 2004, the Company sold the partnership and as such, this guaranty terminated at the time of the sale.
Until December 31, 2003, the Company had an executive loan program, through which a financial institution provided personal demand loans to the Company’s officers. The Company had provided collateral and agreed to purchase any loan in default. In November 2003, the financial institution sold the Company’s collateral partially securing the loans of two former officers of the Company in satisfaction of their loans in the aggregate amount of $2.0 million. The Company received $1.7 million in repayment for the loans of one former officer in 2004, and in consideration of the Company forgiving $166,000 of indebtedness, the former officer executed an agreement, which, among other things, includes a release of the Company and its officers, employees and affiliates from any and all claims as of the date of that agreement. The loan of the other former officer in the outstanding principal amount of $185,000 is fully secured and is due on April 30, 2005. The Company is accruing interest on this loan, which is included in other assets on the Balance Sheet, at a rate of 4.5% as of December 31, 2004.
See Note 4 for information regarding losses related to the September 11, 2001 attack on the World Trade Center and Note 5 for information regarding disputed reinsurance receivables.
The Company and certain of its directors and key executive officers are defendants in several purported class actions that were filed in 2003 in the United States District Court for the Eastern District of Pennsylvania by alleged purchasers of the Company’s Class A Common Stock, 4.25% Convertible Debt and 8.50% Senior Notes. On June 28, 2004, the District Court issued an order consolidating the cases under the caption In Re PMA Capital Corporation Securities Litigation (civil action no. 03-6121) and appointing Sheet Metal Workers Local 9 Pension Trust, Alaska Laborers Employers Retirement Fund and Communications Workers of America for Employees’ Pension and Death Benefits as lead plaintiff. On September 20, 2004, the plaintiffs filed an amended and consolidated complaint on behalf of an alleged class of purchasers of the Company's securities between May 5, 1999 and February 11, 2004. The complaint alleges, among other things, that the defendants violated Section 10(b) of the Exchange Act, and Rule 10b-5 thereunder by making materially false and misleading public statements and material omissions during the class period regarding the Company's underwriting performance, loss reserves and related internal controls. The complaint alleges, among other things, that the defendants violated Sections 11, 12(a) (2) and 15 of the Securities Act by making materially false and misleading statements in registration statements and prospectuses about the Company's financial results, underwriting performance, loss reserves and related internal controls. The complaint seeks unspecified compensatory damages, the right to rescind the purchases of securities in the public offerings, interest, and plaintiffs’ reasonable costs and expenses, including attorneys’ fees and expert fees. The Company intends to vigorously defend against the claims asserted in this consolidated action. The lawsuit is in its earliest stages; therefore, it is not possible at this time to reasonably estimate the impact on the Company. However, the lawsuit may have a material adverse effect on the Company’s financial condition, results of operations and liquidity.
During the vesting period, restricted shares issued are nontransferable and subject to forfeiture, but the shares are entitled to all of the other rights of the outstanding shares. Restricted shares are forfeited if employees terminate employment, or Directors resign from the Board, prior to the lapse of restrictions except upon death or permanent disability. The Company determines the cost of restricted stock awarded, which is recognized as compensation expense over the vesting period, based on the market value of the stock at the time of the award. The Company recorded expenses of $1.3 million during 2004 for restricted stock awards and $112,000 for Class A Common stock issued to Directors in lieu of their retainer. During 2004, 15,900 restricted shares were forfeited.
In 2003, shareholders approved an increase in the authorized shares of the Company’s Class A Common stock, which has a $5 par value, from 40 million shares to 60 million shares.
The Company’s domestic insurance subsidiaries’ ability to pay dividends to PMA Capital Corporation is limited by the insurance laws and regulations of the Commonwealth of Pennsylvania. Prior to June 2004, all of PMA Capital’s domestic insurance entities were owned by PMA Capital Insurance Company (“PMACIC”). Only PMACIC, a Pennsylvania domiciled company, could pay dividends directly to PMA Capital Corporation.
In 2006, PMACIC may declare and pay ordinary dividends or returns of capital without the prior approval of the Pennsylvania Insurance Department if, immediately after giving effect to the dividend or returns of capital, PMACIC’s risk-based capital equals or exceeds 225% of Authorized Control Level Capital as defined by the National Association of Insurance Commissioners (“NAIC”). In 2007 and beyond, PMACIC may make dividend payments, as long as such dividends are not considered “extraordinary” under Pennsylvania insurance law.
The Pooled Companies, which are not subject to the Pennsylvania Insurance Department’s Order, paid dividends of $12.1 million to PMA Capital Corporation in 2004. As of December 31, 2004, The Pooled Companies can pay up to $23.5 million in dividends in 2005 without the prior approval of the Pennsylvania Insurance Department.
Included in the options outstanding at December 31, 2002 are 260,000 options (“Target Price Options”), with an exercise price of $17.00. Because the stock did not reach the necessary price, the Target Price Options expired as unvested options in 2003.
All options granted in 2004 and 2003 were granted with an exercise price that equaled or exceeded the market value of the Class A Common stock on the grant date (“out-of-the-money”). The weighted average fair value of options granted in 2004 and 2003 was $3.43 per share and $4.91 per share, respectively. Of the total options granted in 2002, 225,000 were granted with an exercise price that was lower than the market value of the Class A Common stock on the grant date, and such options had a weighted average exercise price of $19.50 per share and a weighted average fair value of $14.61 per share. The remaining 215,500 options were granted out-of-the-money, and such options had an exercise price of $19.50 per share and a weighted average fair value of $7.66 per share.
The Company accounts for stock option compensation using the intrinsic value method. Included in the Company’s net income (loss) were pre-tax stock option compensation costs of $(172,000), $239,000 and $215,000 for 2004, 2003 and 2002, respectively. Stock option compensation increased pre-tax income in 2004 due to the impact of the cancellation of unvested stock options.
The effect of 1.5 million, 2.9 million and 3.1 million stock options were excluded from the computation of diluted earnings per share for 2004, 2003 and 2002, respectively, because they would have been anti-dilutive.
compared to a carrying value of $57.5 million. 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. For other financial instruments, the carrying values approximate their fair values. Certain financial instruments, specifically amounts relating to insurance and reinsurance contracts, are excluded from this disclosure.
In 2002, the Company received refunds from the IRS of $10.6 million, resulting primarily from an AMT net operating loss which was generated in 2001 and carried back to 1998 and 1999.
Pension Benefits - The Company sponsors a qualified non-contributory defined benefit pension plan (the "Qualified Pension Plan") covering substantially all employees. After meeting certain requirements under the Qualified Pension Plan, an employee acquires a vested right to future benefits. The benefits payable under the plan are generally determined on the basis of an employee’s length of employment and salary during employment. The Company’s policy is to fund pension costs in accordance with the Employee Retirement Income Security Act of 1974.
The Company uses a January 1 measurement date for its Plans. For the measurement of Other Postretirement Benefits, a 10% annual rate of increase in the per capita cost of covered health care benefits was assumed for 2004. The rate was assumed to decrease gradually to 5% by 2009 and remain at that level thereafter. A one percentage point change in assumed
health care cost trend rates would have an immaterial impact on the total service and interest cost components of the net periodic benefit cost and the postretirement benefit obligation.
B. Defined Contribution Savings Plan - The Company also maintains a voluntary defined contribution savings plan covering substantially all employees. The Company matches employee contributions up to 5% of compensation. Contributions under such plans expensed in 2004, 2003 and 2002 were $2.6 million, $3.3 million and $3.4 million, respectively.
C. Postemployment Benefits - The Company may provide certain benefits to employees subsequent to their employment, but prior to retirement including severance, long-term and short-term disability payments, and other related benefits. Postemployment benefits attributable to prior service and/or that relate to benefits that vest or accumulate are accrued
presently if the payments are probable and reasonably estimable. Postemployment benefits that do not meet such criteria are accrued when payments are probable and reasonably estimable. See Note 14 for additional information regarding severance.
As a result of the decision to exit from and run off the reinsurance business, results for the Run-off Operations for 2003 included a charge of $2.6 million pre-tax, mainly for employee termination benefits. Approximately 80 employees at PMA Re have been terminated in accordance with the Company’s exit plan. Approximately 60 positions, primarily claims and financial, remain. The Company has established an employee retention arrangement for the remaining employees. Under this arrangement, the Run-off Operations recorded expenses of $1.7 million, which include retention bonuses and severance, for 2004, and expects to record expenses of approximately $1.3 million for 2005. Employee termination benefits and retention bonuses of $3.3 million have been paid in accordance with this plan, including $450,000 in 2003. Additionally, in 2004 the Run-off Operations paid a $1 million fee to shorten the term of its Philadelphia office lease from fifteen years to seven and reduce the leased space by approximately 75% effective October 1, 2004.
In May 2002, the Company announced its decision to withdraw from the excess and surplus lines marketplace previously served by the Caliber One operating segment. In January 2003, the Company closed on the sale of the capital stock of Caliber One Indemnity Company. Pursuant to the agreement of sale, the Company has retained all assets and liabilities related to the in-force policies and outstanding claim obligations relating to Caliber One’s business written prior to closing on the sale. As a result of the Company’s decision to exit from and run off this business, its results are reported in Run-off Operations. The sale generated gross proceeds of approximately $31 million and resulted in a pre-tax gain of $2.5 million, which is included in other revenues in the Statement of Operations for 2003.
In addition, the $43 million pre-tax charge includes expenses associated with the recognition of liabilities of approximately $27 million, including reinsurance costs of approximately $19 million, long-term lease costs of approximately $4 million and involuntary employee termination benefits of approximately $3 million. The charge was included in operating expenses (approximately $24 million) and net premiums earned (approximately $19 million) in the Statement of Operations in 2002. At December 31, 2004, the Company had a remaining balance of approximately $410,000 for net lease costs and approximately $114,000 for severance.
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.
Operating income (loss), which is GAAP net income (loss) excluding net realized investment gains and losses, is the financial performance measure used by the Company’s management and Board of Directors to evaluate and assess the results of the Company’s insurance businesses. Accordingly, the Company reports operating income by segment in this footnote as required by SFAS No. 131, “Disclosures About Segments of an Enterprise and Related Information.” The Company’s management and Board of Directors use operating income as the measure of financial performance for the Company’s business segments 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 (loss) does not replace net income (loss) as the GAAP measure of our consolidated results of operations.
The Company's total assets(1) by principal business segment were as follows:
The Company incurred legal and consulting expenses aggregating approximately $4.4 million, $3.7 million and $3.9 million in 2004, 2003 and 2002, respectively, from firms in which directors of the Company are partners or principals.
At December 31, 2003 and 2002, the Company had notes receivable from officers totaling $65,000 and $62,000, respectively, that are accounted for as a reduction of shareholders’ equity. These loans were repaid in 2004.
In January 2003, the Company sold the capital stock of Caliber One Indemnity Company.
The surplus of The PMA Insurance Group’s domestic insurance subsidiaries (for 2003 and 2002) and Caliber One Indemnity Company (2002 only) are eliminated as they are included in the statutory surplus of PMA Capital Insurance Company, then the parent company of these insurance companies. In June 2004, The PMA Insurance Group was transferred from PMA Capital Insurance Company to PMA Capital Corporation.
The Company’s statutory financial statements are presented on the basis of accounting practices prescribed or permitted by the Pennsylvania Insurance Department (for PMA Capital Insurance Company and The PMA Insurance Group) and the Delaware Insurance Department (for Caliber One Indemnity Company). Pennsylvania and Delaware have adopted Codification as the basis of their statutory accounting practices. However, Pennsylvania has retained the prescribed practice of non-tabular discounting of unpaid losses and LAE for workers’ compensation, which was not permitted under Codification. This prescribed accounting practice increased statutory capital and surplus by $101,000, $435,000 and $13.0 million at December 31, 2004, 2003 and 2002, respectively, over what it would have been had the prescribed practice not been allowed.
We have audited the accompanying balance sheets of PMA Capital Corporation and subsidiaries (the “Company”) as of December 31, 2004 and 2003, and the related consolidated statements of operations, cash flows, shareholders’ equity, and comprehensive income for the years then ended. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. The consolidated financial statements of the Company for the year ended December 31, 2002 were audited by other auditors whose report, dated February 5, 2003, expressed an unqualified opinion on those statements.
In our opinion, such 2004 and 2003 consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2004 and 2003, and the results of its operations and its cash flows for the years then ended in conformity with accounting principles generally accepted in the United States of America.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of December 31, 2004, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 16, 2005 expressed an unqualified opinion on management’s assessment of the effectiveness of the Company’s internal control over financial reporting and an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.
We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control over Financial Reporting, that PMA Capital Corporation and subsidiaries (the “Company”) maintained effective internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. 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. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.
material respects, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2004, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
In our opinion, the accompanying consolidated statements of operations, of cash flows, of shareholders’ equity and of comprehensive income (loss) for the year ended December 31, 2002 (appearing on pages 63 through 66 of the 2004 PMA Capital Corporation Annual Report to Shareholders included in this Form 10-K) present fairly, in all material respects, the results of operations and cash flows of PMA Capital Corporation and its subsidiaries for the year ended December 31, 2002 in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.