Operating income (loss), which we define as GAAP net income (loss) excluding net realized investment gains (losses) and results from discontinued operations, is the financial performance measure used by our management and Board of Directors to evaluate and assess the results of our 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. Accordingly, we report pre-tax operating income (loss) by segment in Note 16 of our Consolidated Financial Statements. Operating income (loss) does not replace net income (loss) as the GAAP measure of our consolidated results of operations.
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, 2009, compared with December 31, 2008, and the results of operations of PMA Capital for 2009 and 2008, compared with each 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.
This discussion and analysis should be read in conjunction with our audited Consolidated Financial Statements and Notes thereto presented in Item 8 of this Form 10-K (“Consolidated Financial Statements”). You should also read our discussion of Critical Accounting Estimates beginning on page 54 for an explanation of those accounting estimates that we believe are most important to the understanding of our financial condition and results of operations and that require our most difficult, subjective and complex judgments.
We are a holding company whose operating subsidiaries provide insurance and fee-based services. The PMA Insurance Group earns revenues and generates cash primarily by writing insurance policies and collecting insurance premiums. Direct premiums written at The PMA Insurance Group were $551.8 million in 2009, compared to $517.9 million in 2008 and $510.3 million in 2007. Because time normally elapses between the receipt of premiums and the payment of claims and operating expenses, we are able to invest the available premiums and earn investment income. The types of payments that we make at The PMA Insurance Group are:
acquisition and operating expenses, which are direct and indirect costs of acquiring both new and renewal business, including commissions paid to agents and brokers and the internal expenses to operate the business segment; and
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 for losses, which represent 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 would incur a charge to earnings in any period our reserves are increased. In 2009, we recorded a charge to increase loss reserves for prior years at The PMA Insurance Group, as discussed on page 56 of this MD&A, and in 2008 and 2007, we recorded charges to increase loss reserves for prior years at the discontinued operations, as discussed on page 57 of this MD&A.
We had net income of $21.2 million in 2009, compared to $5.7 million in 2008 and a net loss of $42.5 million in 2007. Operating income, which we define as net income (loss) excluding net realized investment gains (losses) and results from discontinued operations, increased to $40.5 million in 2009, compared to $21.5 million in 2008 and $14.4 million in 2007.
Income from continuing operations included the following after-tax net realized investment gains and losses:
The PMA Insurance Group had pre-tax operating income of $43.1 million in 2009, compared to $46.7 million in 2008 and $38.0 million in 2007. The decrease in 2009, compared to 2008, included a net pre-tax charge of $3.0 million due to loss emergence on our workers' compensation business for accident year 2008 and a reduction in our accrual for additional audit premiums on rate-sensitive workers’ compensation business of $6.7 million. The increase in 2008, compared to 2007, was due primarily to improved underwriting results, as reflected in our lower combined ratio. The results for 2008 also included a pre-tax gain of $2.1 million on the sale of a property that housed one of our branch offices.
We provide combined ratios and operating ratios for The PMA Insurance Group as we believe they are important measures for our insurance business. The “combined ratio” is a measure of property and casualty underwriting performance. The combined ratio computed on a GAAP basis is equal to losses and loss adjustment expenses, plus acquisition and operating expenses and policyholders’ dividends, all divided by net premiums earned. A combined ratio of less than 100% reflects an underwriting profit. Because time normally elapses between the receipt of premiums and the payment of claims and certain related expenses, we invest the available premiums. Underwriting results do not include investment income from these funds. Given the long-tail nature of our liabilities, we believe that the operating ratios are also important in evaluating our business. 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.
Direct premium production increased in 2009 and 2008, compared to each immediately preceding year. The increase in direct premium production for 2009, compared to 2008, was due to an increase in the amount of captive accounts business written, partially offset by a decline in workers’ compensation direct premium production which was due to a lower retention rate and a reduced amount of new business in 2009. The increase in direct premium production for 2008, compared to 2007, primarily reflected increases in renewal premiums and larger account business.
Fronting premiums were $54.7 million in 2009, compared to $34.8 million in 2008 and $59.8 million in 2007, of which we retained approximately 14%, 12% and 4%, respectively, of the underwriting results. The fluctuation of fronting premiums between 2009, 2008 and 2007 primarily relates to the commencement and termination of fronting programs during those periods. One fronting arrangement was terminated in early 2008, and we entered into two new fronting arrangements during August 2008. The workers’ compensation business produced under these two arrangements is primarily located in the southeastern part of the United States and California. We earn 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 financial strength ratings of “A-” (Excellent) or higher.
Direct workers’ compensation premiums written were $456.7 million in 2009, compared to $455.1 million in 2008 and $457.4 million in 2007. The increase in direct workers’ compensation premiums written for 2009, compared to 2008, was due to more premiums written under fronting arrangements and, to a lesser extent, a lower amount of return premium adjustments, which were mostly offset by a decline in workers’ compensation direct premium production of $25.7 million. The premium adjustments, which decreased by $7.4 million for workers’ compensation business in 2009, primarily reflected a lower amount of return premium adjustments on loss-sensitive products where the insured shares in the underwriting result of the policy. We write these retrospective products because we believe they provide us with greater certainty in achieving our targeted underwriting results as the customer shares in the underwriting result of the policy with
Payrolls on our renewal customer base decreased modestly in 2009 and increased 3% in 2008, compared to each immediately preceding year. Our renewal retention rate on existing workers’ compensation accounts was 81% for 2009, compared to 87% for both 2008 and 2007. The decline in the retention rate in 2009 primarily reflected a lower retention on rate-sensitive middle-market business as we continue to maintain disciplined underwriting standards in a price competitive environment. While the retention rate was also down on loss-sensitive workers’ compensation business, the decrease was lower than that on rate-sensitive business and retention rates remained higher for business written on a loss-sensitive basis than for business written on a rate-sensitive basis. The proportion of our workers’ compensation business written on a loss-sensitive basis increased modestly in 2009. Direct premium production included $83.0 million of new workers’ compensation business in 2009, compared to $116.1 million in 2008 and $101.1 million in 2007. The decline for 2009, compared to 2008, primarily reflected a lower amount of rate-sensitive new business.
Total premiums ceded increased by $44.7 million in 2009 and decreased by $14.8 million in 2008, compared to each immediately preceding year. Premiums ceded for workers’ compensation increased by $14.2 million in 2009, compared to 2008, primarily due to more premiums ceded under fronting arrangements. Premiums ceded for workers’ compensation decreased by $20.3 million in 2008, compared to 2007, primarily due to lower premiums ceded under fronting arrangements, which were partially offset by an increase in the amount of workers’ compensation business sold to captive accounts, where a substantial portion of the direct premiums are ceded. Premiums ceded for Commercial Lines increased by $30.5 million in 2009, compared to 2008, mainly resulting from an increase in the amount of Commercial Lines business sold to captive accounts. Premiums ceded for Commercial Lines increased by $5.5 million in 2008, compared to 2007, mainly resulting from more direct premiums written.
Net premiums earned increased 6% in 2009 and 3% in 2008, compared to each immediately preceding year. 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 increasing premium writings, the dollar increase in premiums written will typically be greater than the increase in premiums earned, as was the case in 2008. The increase in net premiums earned in 2009, compared to 2008, reflected the effects of higher net premiums written in the second half of 2008, compared to the same period in 2009. 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 or exposure-based adjustments, the premium adjustments 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 adjustments are made.
The loss and LAE ratio increased 0.8 points in 2009, compared to 2008, due primarily to loss emergence on our 2008 workers’ compensation business and a decrease in additional audit premiums. As a result of the loss emergence, we recorded a net charge of $3.0 million comprised of an increase in our workers’ compensation loss reserves of $5.0 million, which was partially offset by $2.0 million of additional premiums due under our loss-sensitive products for the portion of this development that is shared with the insureds. The reduction in the accrual for additional audit premiums reflected lower than expected payrolls on audited policies, which were primarily written in 2007 and 2008. Over the past several years, audit premiums have been approximately 1% of workers’ compensation premiums. In 2009, audit premiums were modestly negative. As a result of this decrease, we reduced our accrual for additional audit premiums by $6.7 million during 2009.
The total expense ratio improved 0.4 points in 2009, compared to 2008, as the increase in net premiums earned outpaced the 2% increase in our controllable expenses, which include salary, benefits and other employee-related costs. In 2008, the total expense ratio improved by 1.5 points, compared to 2007. The improvement in 2008 resulted from a lower acquisition expense ratio, which was partially offset by a higher operating expense ratio. The acquisition expense ratio in 2008 benefited by 2.0 points from reductions in premium-based state assessments. Commissions earned under our fronting arrangements also reduced the acquisition expense ratio by 0.6 points in 2009 and 0.7 points in 2008, as the ceding commissions earned on this business reduce our commission expense. The lower operating expense ratio in 2007, compared to both 2009 and 2008, reflected recoveries on reinsurance receivable balances that had previously been written-off.
The policyholders’ dividend ratio increased 0.5 points in 2009, compared to 2008. The higher policyholders’ dividend ratio was primarily in our captive business and reflected better than anticipated underwriting and investment results in many of the captive programs. In this business, the policyholders may receive a dividend based, to a large extent, on their program’s underwriting and investment results. The policyholders’ dividend ratio decreased 0.5 points in 2008, compared to 2007. The 2008 ratio reflected slightly higher loss experience in our captive programs, which resulted in lower dividends on captive products.
On June 30, 2008, we acquired PMA Management Corp. of New England, Inc. Our operating results for 2008 include the operating results of PMA Management Corp. of New England, Inc. only from the date of acquisition.
Our Fee-based Business had pre-tax operating income of $7.2 million for both 2009 and 2008, compared to $3.7 million in 2007. The results for 2009, compared to 2008, benefited as claims service revenues increased at a faster rate than the increase in operating expenses. The impact of the higher claims service revenues in 2009 was offset by lower net
commissions earned by our agency business. The increase in pre-tax operating income in 2008, compared to 2007, primarily related to the inclusion of Midlands’ results for full year 2008.
Revenues for our Fee-based Business were $80.8 million in 2009, compared to $71.6 million in 2008 and $38.1 million in 2007. The increase in revenues for 2009, compared to 2008, primarily reflected an increase in claims service revenues of $10.5 million, which was partially offset by a decline in commission income of $1.5 million. Organic claims service revenue growth was 11% in 2009, compared to 2008, and primarily reflected increases in managed care revenues earned from existing clients and new business. Managed care services include medical bill review, access to our preferred provider network partnerships, pharmacy discounts and nurse case management services. Claims service revenues also increased in 2009 as a result of our June 2008 acquisition of PMA Management Corp. of New England, Inc. The decline in commission income for 2009 was mainly the result of continued soft pricing in excess workers’ compensation business. We began experiencing an increase in the competitiveness of this business during 2008 and that trend continued through 2009. Commission income is primarily derived from producing excess workers’ compensation business and providing program administrator services to self-insured clients.
The increase in revenues of $33.5 million in 2008, compared to 2007, was primarily due to the inclusion of Midlands’ revenues, which contributed $28.0 million in 2008, compared to $6.5 million in 2007. The increase also reflected additional claims services provided to self-insured clients and an increase in managed care services.
Operating expenses for our Fee-based Business increased to $73.6 million in 2009, up from $64.4 million in 2008 and $34.4 million in 2007. Commission expenses included in operating expenses for these periods were $5.2 million in 2009, compared to $5.8 million in 2008 and $1.1 million in 2007. The increase in operating expenses for 2009, compared to 2008, primarily reflected additional expenses, mainly salaries, benefits and other employee-related costs, incurred in connection with the growth of our claims services revenues, including amounts related to the inclusion of PMA Management Corp. of New England’s expenses for full year 2009.
Discontinued operations, formerly reported as our Run-off Operations, include the results of our reinsurance and excess and surplus lines businesses, from which we withdrew in November 2003 and May 2002, respectively. On December 24, 2009, we sold the Run-off Operations for $100,000. In connection with the closing, we contributed $13.1 million to the Run-off Operations and entered into two capital support agreements. The capital contribution included cash of $3.1 million and a note payable in two equal installments of $5.0 million in June 2010 and June 2011. The capital support agreements may require us to make payments to the Run-off Operations in the event its payments on claims in the excess workers’ compensation and certain excess liability (occurrence) lines of business exceed certain pre-established limits. Such support is limited to an amount not to exceed $45.9 million and any payments with respect to the supported lines of business are not expected to commence until 2018 and may extend to 2052. Generally Accepted Accounting Principles require guarantees to be recorded at fair value at inception, which we estimate is approximately $13 million for the capital support agreements. Upon the closing of the transaction, we recorded an after-tax charge of $18.3 million, which represented the impact of the capital contribution and the estimated fair value of the capital support, as well as other costs associated with the closing of the sale.
Summarized financial results from discontinued operations, which are reported as a single line, net of tax, below income from continuing operations in our Consolidated Statements of Operations, were as follows:
Unpaid losses and LAE reflect our 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 “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. 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 primary long-tail line is our workers’ compensation business. This business is subject to more unforeseen development than shorter tailed lines of business.
At December 31, 2009, 2008 and 2007, our gross reserves for asbestos-related losses were $26.0 million, $29.5 million and $25.7 million, respectively ($10.3 million, $11.4 million and $10.8 million, net of reinsurance, respectively). At December 31, 2009, 2008 and 2007, our gross reserves for environmental-related losses were $7.5 million, $10.1 million and $10.3 million, respectively ($362,000, $463,000 and $0, net of reinsurance, respectively).
Pooled Companies’ loss and loss adjustment expense reserves, which report was subsequently rejected by the Department. The examiner was directed to reopen the examination and to obtain additional data, documentation and information from us relative to our financial condition. We believe the Pooled Companies’ estimate of loss and loss adjustment expense reserves is reasonable and have provided the Bureau with several independent analyses and other information that support our position. We are continuing to provide additional information to the Bureau and are having discussions to resolve this issue. If we are not able to reach a resolution with the Department on this issue, it could have a material adverse effect on our business, results of operations and financial condition. See “Critical Accounting Estimates - Unpaid Losses and Loss Adjustment Expenses” beginning on page 54 for additional information. In addition, see the “Cautionary Note Regarding Forward-Looking Statements” on page 60 and “Item 1A - Risk Factors” for a discussion of factors that may adversely impact our losses and LAE in the future.
At December 31, 2009 and 2008, we had amounts receivable from our reinsurers and retrocessionaires totaling $827.5 million and $826.1 million, respectively. As of December 31, 2009, $20.7 million, or 3%, of these amounts were due to us on losses we have already paid, compared to $21.2 million, or 3%, at December 31, 2008. The remainder of the reinsurance receivables related to unpaid claims.
At December 31, 2009, our reinsurance and retrocessional protection for major lines of business that we write was as follows:
Our maximum limit for any one claimant is $5.8 million. Effective January 1, 2009, our maximum limit increased to $7.5 million in layers excess of $10.0 million and effective January 1, 2010, our total limit increased to $139.8 million.
Certain portions of The PMA Insurance Group’s workers’ compensation reinsurance include coverage for terrorist acts. Effective January 1, 2010, our reinsurance of $139.0 million excess of $1.0 million includes coverage for certified and non-certified terrorist acts, except for nuclear, biological, chemical and radiological events. In all cases, at least two full limits of coverage are available in the aggregate. For nuclear, biological, chemical and radiological events, our coverage includes domestic and non-certified events for $5.0 million excess of $1.0 million.
Net cash flows used in operating activities from discontinued operations decreased as a result of a lower amount of losses and LAE paid in 2009, compared to 2008. The positive operating cash flows at our discontinued operations in 2007 were due to cash received of $171.9 million related to the commutation of a reinsurance agreement covering potential adverse loss development.
The amount of dividends our principal insurance subsidiaries which comprise The PMA Insurance Group (the “Pooled Companies”) can pay is restricted by Pennsylvania laws and regulations. These laws and regulations require prior written notice to the Pennsylvania Insurance Department before any dividend can be paid and limit the amount of dividends that can be paid without the Department's prior approval. The current statutory limitation is the greater of (i) 10% of the insurer’s policyholders’ surplus, as shown on its last annual statement on file with the Pennsylvania Insurance Commissioner or (ii) the insurer’s statutory net income for the previous calendar year, but in no event to exceed statutory unassigned surplus. Pennsylvania law gives the Pennsylvania Insurance Commissioner broad discretion to disapprove requests for dividends in excess of these limits. Pennsylvania law also provides that following the payment of any dividend, the insurer’s policyholders’ surplus must be reasonable in relation to its outstanding liabilities and adequate for its financial needs, and permits the Pennsylvania Insurance Commissioner to bring an action to rescind a dividend which violates these standards. In the event that the Pennsylvania Insurance Commissioner determines that the policyholders’
Net tax payments received from subsidiaries were $30.9 million in 2009, $25.1 million in 2008 and $37.7 million in 2007. As a result of our net operating loss carryforward, generated mostly by our former Run-off Operations, our holding company will continue to receive taxes from its subsidiaries under our tax sharing agreement, but we do not expect that we will be required to pay federal income taxes, other than alternative minimum tax, in the foreseeable future provided that the net operating loss carryforward remains available to us. In August 2009, we adopted a Section 382 Shareholder Rights Plan designed to prevent an ownership change under Section 382 of the Internal Revenue Code that would significantly impair our ability to use the carryforward.
On October 1, 2007, we acquired Midlands Holding Corporation for $19.8 million, plus acquisition costs of approximately $300,000. 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 during the four years following our date of acquisition. In 2009 and 2008, we paid additional cash of $2.4 million and $2.5 million to the former shareholders of Midlands for contractual earn-out and guaranteed payments. We expect to be able to pay most of any future earn-out payments through cash generated from Midlands’ operations. We also used holding company cash of $3.4 million for the return of estimated net worth on the closing date, which was adjusted for an additional payment of $811,000 in April 2008.
The operating lease obligations referred to in the table above are primarily obligations of our insurance subsidiaries and are net of sublease rentals of $1.4 million in 2010.
Includes expected benefit payments on our non-qualified pension and other postretirement benefit plans, which will be paid from the general assets of the Company. The amount for 2010 also includes expected contributions to our qualified plan. We froze our qualified and non-qualified pension plans in 2005.
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 $133.0 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 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. Our remaining junior subordinated debt of $43.8 million matures in 2033. The weighted average interest rates on this junior subordinated debt equal the three-month LIBOR plus 4.12%, and interest on this debt is also payable on a quarterly basis. At December 31, 2009, the weighted average interest rate on all of our junior subordinated securities was 4.20%.
We used the $20.0 million net proceeds from the junior subordinated debt issued in 2007 to purchase, in the open market, our 6.50% Convertible Debt. In 2007, we retired $18.1 million principal amount of our 6.50% Convertible Debt for which we paid $21.2 million, exclusive of accrued interest. As the derivative component of the bonds was already reflected in the debt balance, the purchase activity did not result in any significant realized gain or loss.
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 2009 or 2007. Our accumulated benefit obligation was greater than the fair value of plan assets by $23.2 million and $28.9 million at December 31, 2009 and December 31, 2008, respectively. The funded status of our qualified pension plan improved in 2009, due primarily to the increase in the fair value of the investments that support these obligations. In 2009, 2008 and 2007, we were not required to make any contribution to the pension plan under the minimum funding requirements of the Employee Retirement Income Security Act of 1974. Although we were not required to make any minimum funding contributions, we believe that the Pension Protection Act, enacted in 2006, will accelerate the timing of our future contributions. Our plan assets were composed of 28% fixed maturities, 50% equities and 22% other investments at December 31, 2009. We currently estimate that the pension plan’s assets will generate a long-term rate of return of 8.25%, 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 was $2.6 million in 2009, ($162,000) in 2008 and $59,000 in 2007. The increase in our pension expense in 2009, compared to the prior periods, was primarily due to the decline in the fair value of plan assets during 2008 which lowered the expected return on assets component of our pension expense in 2009.
Under the terms of the sale of one of our insurance subsidiaries, PMA Insurance Cayman, Ltd. (renamed Trabaja Reinsurance Company), to London Life and Casualty Reinsurance Corporation in 1998, we have agreed to indemnify the buyer, up to a maximum of $15 million, if the actual claim payments in the aggregate exceed the estimated payments upon which the loss reserves of the former subsidiary were established. If the actual claim payments in the aggregate are less than the estimated payments upon which the loss reserves have been established, we will participate in such favorable loss reserve development. Trabaja Reinsurance Company is our second largest reinsurer. As of December 31, 2009, we are not aware of any significant changes from our original estimate. See Note 6 to the Consolidated Financial Statements for additional information.
Mortgage-backed and other asset-backed securities (“structured securities”) in the table above include collateralized mortgage obligations (“CMOs”) of $153.2 million and $215.6 million as of December 31, 2009 and 2008, respectively. Our CMO holdings have an average credit quality of AAA- and are concentrated in tranches with limited prepayment, extension and default risk, such as planned amortization class bonds.
Of the $153.2 million in CMOs at December 31, 2009, $83.2 million, or 23% of our structured securities, were commercial mortgage-backed securities (“CMBS”). The CMBS were carried at 95% of amortized cost at December 31, 2009. All of the CMBS in our portfolio were either the senior or super senior tranches of their respective mortgage pools, and had a weighted average life of 5.6 years and an average credit quality of AAA-. During 2009, the CMBS generated cash flows which totaled $7.8 million of principal paydowns from their underlying mortgages. On a weighted average basis, the CMBS we hold have a current credit support of 30% of the par of the securities, and 9% of the underlying pool collateral is delinquent. We reduced our CMBS portfolio from 17% of our consolidated portfolio at December 31, 2008 to 10% at December 31, 2009 through sales of securities in the open market during the second and third quarters of 2009.
We also hold $9.9 million, or 3% of our structured securities, in residential mortgage-backed securities whose underlying collateral was either a sub-prime or alternative A mortgage. The $9.9 million, which includes $8.4 million of alternative A collateral and $1.5 million of sub-prime collateral, had an estimated weighted average life of 3.3 years, with $842,000 of that balance expected to pay off within one year, and an average credit quality of AAA-. Based upon the quality of the
At December 31, 2009 and 2008, our fixed maturities had an overall average credit quality of AA+. The credit quality of our fixed maturities at the end of each year was broken down as follows:
Investment income for the period divided by average invested assets for the same period.
We review the securities in our investment portfolio on a periodic basis to specifically identify individual securities that have incurred an other than temporary decline in fair value below cost or amortized cost. Our analysis includes all securities whose fair value is significantly below cost or amortized cost at the time of the analysis, with additional emphasis placed on securities whose fair value has been less than cost or amortized cost for an extended period of time. As part of our periodic review process, we utilize information received from our outside professional asset manager to assess each issuer’s current credit situation. This review encompasses, among other things, recent issuer activities, such as defaults, quarterly earnings announcements, and other pertinent financial news for the issuer, recent developments and economic outlooks for particular industries, and rating agency actions. When our review identifies an other than temporary impairment in the valuation of a fixed income security, we compare its projected discounted cash flows to the amortized cost in order to determine the credit related portion and the non-credit related portion of the loss. The credit related portion is recorded as a charge in the statement of operations while the non-credit related portion is recorded through other comprehensive income in the balance sheet.
For structured securities, we project cash flows using loss adjusted cash flows that contemplate current market factors such as prepayment assumptions, expected default assumptions, and the current condition of the guarantor of the security. For structured securities, the discount rate used in the present value calculation is the security’s current effective interest rate. The discount rate used for other fixed income securities is the security’s effective interest rate on the date acquired.
As a result of our review in 2009, we recorded other than temporary impairments of $5.9 million. Of these impairments, $4.4 million related to the write-down of a portion of our CMBS portfolio that was subsequently sold in 2009 in order to reduce our exposure to this asset sector. These write-downs were measured based on public market prices.
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 in 2008 and 2007 were measured based on public market prices.
The 40 fixed income securities that have been in an unrealized loss position for 12 months or more have an average unrealized loss per security of approximately $182,000. Of these 40 securities, 14 are CMBS that had a total fair value of $68.9 million, or 94% of their combined amortized cost, and unrealized losses of $4.3 million at December 31, 2009. There are also seven asset-backed securities, whose underlying collateral are non-mortgage classes such as auto loans and credit card receivables, which had a total fair value of $10.7 million and unrealized losses of $1.1 million.
See Note 9 to our Consolidated Financial Statements for additional discussion about investments at the discontinued operations.
At December 31, 2009, we estimated that under all insurance policies and reinsurance contracts issued by our insurance business, our liability for all events that occurred as of December 31, 2009 was $1.3 billion. This amount included estimated losses from claims plus estimated expenses to settle claims. Our estimate also included estimated amounts for losses occurring on or prior to December 31, 2009 whether or not these claims had been reported to us.
Any changes to our range of loss reserve estimates would also affect our assumptions regarding ceded reserves. To the extent that changes in our range of estimates resulted in a change to our carried reserves and the amount of reinsurance receivable against such carried reserves, the net result of these changes would directly affect our pre-tax income.
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 20 of this Report on Form 10-K.
We have established a carried loss and LAE reserve for unpaid claims at December 31, 2009 that we believe is a reasonable and adequate provision based on the information then available to us and we believe such amounts are fairly stated at
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. During the fourth quarter of 2009, we increased reserves at The PMA Insurance Group by $5.0 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 December 31, 2009, unpaid losses and loss adjustment expenses were $1,270 million, which included case reserves of $649 million and IBNR reserves of $621 million.
At The PMA Insurance Group, the components of our (favorable) unfavorable development of reserves for losses and LAE for prior accident years by accident year, excluding accretion of discount, were as follows:
In 2009, The PMA Insurance Group had unfavorable prior year loss development of $1.7 million. During the fourth quarter, our actuaries observed loss emergence and increased claims severity in workers’ compensation business written for accident year 2008. As a result of the loss emergence, The PMA Insurance Group increased its workers’ compensation loss reserves for prior years by $5.0 million. This adverse loss development was partially offset by favorable prior year loss development of $3.3 million, primarily reflecting better than expected loss experience from rent-a-captive workers’ compensation business.
During 2008, The PMA Insurance Group had favorable prior year loss development of $7.8 million. In 2008, our 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 policies that are subject to dividend plans, the ultimate amount of the dividend that the insured may receive is 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 2008, the discontinued operations recorded unfavorable prior year loss development of $20.8 million. 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. Specifically, we experienced higher than expected severity of losses in these lines of business at our discontinued operations during the year causing our actuaries to increase the expected size of future loss payments on these types of claims. 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.
For additional information about our liability for unpaid losses and loss adjustment expenses, see Note 5 to the Consolidated Financial Statements as well as “Item 1 - Business - Loss Reserves.”
Based on our evaluation of securities with an unrealized loss at December 31, 2009, 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, 2009 should have been written-down to their fair value, then we would have recorded an additional other-than-temporary impairment loss of $10.2 million pre-tax at our continuing operations.
Based on our evaluation of reinsurance receivables at December 31, 2009, we have established an allowance for amounts that we have concluded are uncollectible at the balance sheet date. In evaluating collectibility, we considered historical payment performance of our reinsurers, the fact that our reinsurers are current on their obligations to our insurance subsidiaries, and any known disputes or collection issues as of the balance sheet date. To these factors, we applied our informed judgment in ascertaining the appropriate level of allowance for uncollectible amounts. At December 31, 2009, approximately $48.2 million of uncollateralized reinsurance receivables, including $18.2 million due for ceded IBNR, are due from reinsurers who have ratings that declined to below “Adequate,” defined as B++ or below by A.M. Best, or who were under regulatory supervision or in liquidation.
Prior to 2007, we had established a valuation allowance in the amount of $60.5 million. This was based upon our assessment that it was more likely than not that a portion of the gross deferred tax assets related to the net operating loss carryforward and all of the deferred tax asset related to the AMT credit carryforward would not be realized. We periodically reassess the valuation allowance previously established against the net deferred tax assets. Factors considered in our assessment included historical earnings, scheduled reversal of deferred tax liabilities and revised projections of future earnings.
In 2009, we reduced the valuation allowance by $20.0 million. This change resulted from the profitable operating results at our insurance operations and fee-based businesses over the past several years, our expectation that profitable results will continue going forward, and the removal of the volatility and uncertainty related to the run-off businesses that were sold in December 2009.
The valuation allowance of $40.5 million is a reserve against a portion of the gross deferred tax assets related to the net operating loss 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 7 to our Consolidated Financial Statements.
The factors that could cause actual results to differ materially from those in the forward-looking statements, include, but are not limited to:
the effects of emerging claims and coverage issues, including changing judicial interpretations of available coverage for certain insured losses;
our ability to effectively compete in the highly competitive property and casualty insurance industry;
uncertainties related to possible terrorist activities or international hostilities and whether the Terrorism Risk Insurance Program Reauthorization Act of 2007 is modified or extended beyond its December 31, 2014 termination date;
fluctuations in interest rates and other events that can adversely impact our investment portfolio;
statutory requirements and rating agency expectations that limit our ability to receive dividends from our insurance subsidiaries;
limitations on our ability to use our deferred tax assets in the event we experience an ownership change;
Includes cash from discontinued operations of $1,371 and $5,665 as of December 31, 2008 and 2007, respectively.
identify individual securities that have incurred an other than temporary decline in fair value below cost or amortized cost. As part of its periodic review process, management utilizes information received from its outside professional asset manager to assess each issuer’s current credit situation. This review encompasses, among other things, recent issuer activities, such as defaults, quarterly earnings announcements, and other pertinent financial news for the issuer, recent developments and economic outlooks for particular industries, rating agency actions, and the length of time and extent to which fair value has been less than cost or amortized cost. When management’s review identifies an other than temporary impairment in the valuation of a fixed income security, it compares its projected discounted cash flows to the amortized cost in order to determine the credit related portion and the non-credit related portion of the loss. The credit related portion is recorded as a charge in the statement of operations while the non-credit related portion is recorded through other comprehensive income in the balance sheet.
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 resulting adjustments are reflected in earnings in the period identified. See Note 5 for additional information.
E. Reinsurance - In the ordinary course of business, PMA Capital’s insurance subsidiaries assume and cede premiums with other insurance companies and are members of various insurance pools and associations. The Company’s insurance subsidiaries cede business in order to limit the maximum net loss and limit the accumulation of many smaller losses from a catastrophic event. The insurance subsidiaries remain primarily liable to their clients in the event their reinsurers are unable to meet their financial obligations. Reinsurance receivables include claims paid by the Company and estimates of unpaid losses and LAE that are subject to reimbursement under reinsurance and retrocessional contracts. The method for determining the reinsurance receivable for unpaid losses and LAE involves reviewing actuarial estimates of unpaid losses and LAE to determine the Company’s ability to cede unpaid losses and LAE under its existing reinsurance contracts. This method is continually reviewed and updated and any resulting adjustments are reflected in earnings in the period identified. Under certain of the Company’s reinsurance and retrocessional contracts, additional premium and interest may be required if predetermined loss and LAE thresholds are exceeded.
J. 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, access to the Company’s preferred provider network partnerships, pharmacy discounts, and nurse case management services.
Company’s adoption of this guidance did not have a material effect on its financial condition, results of operations or liquidity.
In April 2009, the FASB issued guidance on “Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly.” This guidance provides a list of factors that a reporting entity should evaluate to determine whether there has been a significant decrease in the volume and level of activity for the asset or liability in relation to normal market activity for the asset or liability. When the reporting entity concludes there has been a significant decrease in the volume and level of activity for the asset or liability, further analysis of the information from that market is needed and significant adjustments to the related prices may be necessary to estimate fair value. This guidance clarifies that when there has been a significant decrease in the volume and level of activity for the asset or liability, some transactions may not be orderly. In those situations, the entity must evaluate the weight of the evidence to determine whether the transaction is orderly. The guidance provides a list of circumstances that may indicate that a transaction is not orderly. A transaction price that is not associated with an orderly transaction is given little, if any, weight when estimating fair value.
In April 2009, the FASB issued guidance on “Recognition and Presentation of Other Than Temporary Impairments.” This guidance clarifies the interaction of the factors that should be considered when determining whether a debt security is other than temporarily impaired. For debt securities, management must assess whether (a) it intends to sell the security and (b) it is more likely than not that it will be required to sell the security prior to its anticipated recovery. These steps are done before assessing whether the entity will recover the cost basis of the investment. Previously, this assessment required management to assert it has both the intent and the ability to hold a security for a period of time sufficient to allow for an anticipated recovery in fair value to avoid recognizing an other than temporary impairment. This change does not affect the need to forecast recovery of the value of the security through either cash flows or market price.
In April 2009, the FASB issued guidance on “Interim Disclosures about Fair Value of Financial Instruments.” This guidance requires disclosures about fair value of financial instruments for interim reporting periods of publicly traded companies as well as in annual financial statements.
The Company’s adoption of the guidance issued in 2009 did not have a material impact on its financial condition, results of operations or liquidity.
The amortized cost and fair value of fixed maturities available for sale at December 31, 2009, by contractual maturity, were as follows:
The remaining impairments recorded in 2009 consisted of three structured securities and one real estate investment trust security. Of these four securities, one security, a non-agency residential mortgage-backed security with alternative A mortgage collateral, incurred an other than temporary credit loss because it was determined the present value of the future cash flows expected to be received over the security’s expected remaining life fell below its amortized cost. The security was subsequently sold in 2009. The Company intends to sell the remaining securities once market conditions allow.
The change in fair value of trading securities during 2007 related to a security that was previously held and classified as trading at the Company’s discontinued operations and transferred to PMA Capital Corporation as part of a $37.5 million extraordinary dividend in April 2007.
On December 31, 2009, the Company had securities with a total amortized cost of $50.6 million and fair value of $52.7 million on deposit with various governmental authorities, as required by law. The Company also pledged, as collateral, securities with an amortized cost of $12.8 million and fair value of $12.9 million, which related to a $13.6 million sale-leaseback transaction involving a new claims system. In addition, the Company had securities with a total amortized cost of $2.1 million and fair value of $2.0 million held in trust for the benefit of an insured client for future claims activity. These securities that are on deposit, pledged as collateral, and held in trust are included in total investments on the balance sheet.
As of December 31, 2009 and 2008, the carrying amounts for the Company’s financial instruments, except for its 8.50% Monthly Income Senior Notes due 2018 (“Senior Notes”), approximated their estimated fair value. The Company primarily measures the fair value of fixed maturities, other investments and its debt 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 financial instruments:
Level 1 - Fair value measures are based on unadjusted quoted market prices in active markets for identical securities. The fair value of securities 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 and its publicly traded mutual funds in the Level 1 category.
The following tables provide the fair value measurements of applicable Company assets and liabilities by level within the fair value hierarchy as of December 31, 2009 and 2008. These assets and liabilities are measured on a recurring basis.
The amount of total losses for the period included in earnings
At December 31, 2009, the Company also had accounts payable, accrued expenses and other liabilities of $12.5 million that are measured for fair value on a non-recurring basis. This amount represents the estimated fair value of the capital support agreements related to the sale of the Company’s Run-off Operations in 2009 and is categorized as a Level 3 fair value measurement. The Company used a probability-weighted discounted cash flow valuation model to approximate the fair value of this liability.
In 2009, The PMA Insurance Group had unfavorable prior year loss development of $1.7 million. During the fourth quarter, the Company’s actuaries observed loss emergence and increased claims severity in workers’ compensation business written for accident year 2008. As a result of the loss emergence, The PMA Insurance Group increased its workers’ compensation loss reserves for prior years by $5.0 million. This adverse loss development was partially offset by favorable prior year loss development of $3.3 million, primarily reflecting better than expected loss experience from rent-a-captive workers’ compensation business.
The Company’s loss reserves were stated net of salvage and subrogation of $18.1 million and $16.3 million at December 31, 2009 and 2008, respectively.
At December 31, 2009, 2008 and 2007, gross reserves for asbestos-related losses were $26.0 million, $29.5 million and $25.7 million, respectively ($10.3 million, $11.4 million and $10.8 million, net of reinsurance, respectively). Of the net asbestos reserves, $153,000, $2.0 million and $2.2 million related to IBNR losses at December 31, 2009, 2008 and 2007, respectively.
At December 31, 2009, 2008 and 2007, gross reserves for environmental-related losses were $7.5 million, $10.1 million and $10.3 million, respectively ($362,000, $463,000 and $0, net of reinsurance, respectively). Of the net environmental reserves, $86,000, $118,000 and $0 related to IBNR losses at December 31, 2009, 2008 and 2007, respectively. All incurred asbestos and environmental losses were for accident years 1986 and prior.
Included in direct premiums written were amounts written under fronting arrangements of $54.7 million in 2009, $34.8 million in 2008 and $59.8 million in 2007. Ceded premiums written included amounts written under fronting arrangements of $46.9 million in 2009, $30.6 million in 2008 and $57.3 million in 2007.
In July 2009, the Company commuted its reinsurance with Houston Casualty Company. This reinsurance covered workers’ compensation business written in 1999 and 2000. As a result of this commutation, the Company received cash of $43.9 million and reduced its reinsurance receivables. This commutation did not have a material impact on the Company’s results of operations, but did improve liquidity by the amount of cash received.
Trabaja Reinsurance Company (“Trabaja”), formerly PMA Insurance Cayman, Ltd. (“PMA Cayman”), is a wholly-owned subsidiary of London Life and Casualty Reinsurance Corporation (“London Reinsurance Group”). The Company sold PMA Cayman to London Reinsurance Group for $1.8 million, and transferred approximately $230 million of cash and invested assets as well as loss reserves to the buyer in 1998. Under the terms of the sale of PMA Cayman to London Reinsurance Group in 1998, the Company has agreed to indemnify London Reinsurance Group, up to a maximum of $15 million, if the actual claim payments in the aggregate exceed the estimated payments upon which the loss reserves of PMA Cayman were established. If the actual claim payments in the aggregate are less than the estimated payments upon which the loss reserves have been established, then the Company will participate in such favorable loss reserve development.
Reconciliations between the total income tax expense (benefit) and the amounts computed at the statutory federal income tax rate of 35% were as follows:
At December 31, 2009, the Company had a net operating loss (“NOL”) carryforward of $251.7 million, which will expire in years 2021 through 2029, a net capital loss carryforward of $15.7 million, which will begin to expire in 2012, and a $10.3 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 $88.1 million, will be applied to reduce taxable income of the Company.
In 2009, the Company reduced the valuation allowance by $20.0 million. This change resulted from the profitable operating results at the Company’s insurance operations and fee-based businesses over the past several years, management’s expectation that profitable results will continue going forward, and the removal of the volatility and uncertainty related to the run-off businesses that were sold in December 2009.
Changes in the gross and net carrying amounts of the Company’s intangible assets, all of which relate to its Fee-based Business, were as follows:
The Company expects to recognize $816,000 of amortization expense per year over the next five years and $3.1 million thereafter.
On June 30, 2008, the Company acquired PMA Management Corp. of New England, Inc. for $7.3 million. The purchase price has been allocated to the estimated fair values of the acquired assets and liabilities as follows:
On October 1, 2007, the Company acquired Midlands Holding Corporation for $19.8 million, plus acquisition costs of approximately $300,000. 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 during the four years following the date of acquisition. The Company paid $2.4 million in 2009 and $2.5 million in 2008 to the former shareholders of Midlands for contractual earn-out and guaranteed payments.
The purchase price of Midlands has been allocated to the estimated fair values of the acquired assets and liabilities as follows:
The value of the non-contractual customer relationships was calculated using a 15% annual attrition rate. The non-contractual customer relationships are being amortized on a straight-line basis over 10 years. The Company recognized $669,000 of expenses related to the amortization of non-contractual customer relationships in both 2009 and 2008 and $167,000 in 2007.
In 2007, the Company recognized an after-tax impairment loss of $40.0 million related to the sale of the Run-off Operations. The components of the loss were as follows:
See Note 4 for information regarding the Company’s categorization of the fair value of its financial instruments.
The Company early adopted the related guidance, effective January 1, 2007. Upon adoption of this guidance, the Company elected to reclassify all of the fixed income securities in the discontinued operations’ investment portfolio from available for sale to trading. Although the Company’s adoption of this guidance had no net impact on shareholders’ equity, it did impact net income, as changes in fair value were recorded through realized gains and losses rather than other comprehensive income. The Company’s discontinued operations recognized pre-tax net realized losses of $730,000 in 2009 and pre-tax net realized gains of $1.8 million in 2008 and $1.1 million in 2007 for subsequent changes in fair value on its trading securities.
Activity in the discontinued operations’ liability for unpaid losses and LAE is summarized below.
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.
Unpaid losses and LAE for the Company’s discontinued operations’ workers’ compensation claims, net of reinsurance, at December 31, 2008 was $50.1 million, net of discount of $17.2 million. The discount rate used was approximately 5%.
The Company’s discontinued operations’ loss reserves at December 31, 2008 were stated net of salvage and subrogation of $283,000.
At December 31, 2008 and 2007, the discontinued operations’ gross reserves for asbestos-related losses were $7.9 million and $7.5 million, respectively ($1.3 million and $1.6 million, net of reinsurance, respectively). Of the net asbestos reserves, $50,000 and $350,000 related to IBNR losses at December 31, 2008 and 2007, respectively.
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 were released shortly thereafter. 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.
The Company has the right to call its Senior Notes at any time at 100% of the face amount of the notes, plus accrued interest.
The Company froze its Qualified Pension Plan and Non-qualified Pension Plans as of December 31, 2005. Under the terms of the freeze, eligible employees retained all of the rights under these plans that they had vested as of December 31, 2005.
The following tables set forth the amounts recognized in the Company’s consolidated financial statements with respect to pension benefits and other postretirement benefits. Benefits paid in the table below include only those amounts paid directly from plan assets. As a result of the freeze, the projected benefit obligation equals the accumulated benefit obligation for the Qualified Pension Plan and the Non-qualified Pension Plans. The Pension Benefit Obligation in the below table includes $7.1 million and $6.9 million at December 31, 2009 and 2008, respectively, for the Non-qualified Pension Plans.
The following table provides the fair value measurements of the plan assets by level within the fair value hierarchy as of December 31, 2009. These assets are measured on a recurring basis.
Following are expected cash flows for the Company’s pension and other postretirement benefit plans:
Qualified Pension Plan benefits will be paid from the pension trust assets which have a fair value of $62.0 million at December 31, 2009. Non-qualified Pension Plans and other postretirement benefits will be paid from the general assets of the Company.
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.
In 2009, the Company entered into a sale-leaseback transaction involving a new claims system, which it expects to implement in 2010. The Company received $13.6 million in sale proceeds and will lease the claims system for a period of up to five years. Under the terms of the transaction, the Company will have annual lease payments of $3.1 million for the next five years beginning in 2010. Total expenses incurred under operating leases were $8.3 million in 2009, $7.8 million in 2008 and $6.3 million 2007.
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, 2009 and 2008, the Company had recorded liabilities of $9.2 million and $7.7 million for these assessments, which are included in accounts payable, accrued expenses and other liabilities on the balance sheet.
The Company is involved in numerous lawsuits arising, for the most part, in the ordinary course of business, either as a liability insurer defending third-party claims brought against its insureds, or as an insurer defending coverage claims brought against it by its policyholders or other insurers. While the outcome of all litigation involving the Company, including insurance-related litigation, cannot be determined, such litigation is not expected to result in losses that differ from recorded reserves by amounts that would be material to the Company’s financial condition, results of operations or liquidity. For additional information about the Company’s liability for unpaid losses and loss adjustment expenses, see Note 5. In addition, reinsurance recoveries related to claims in litigation, net of the allowance for uncollectible reinsurance, are not expected to result in recoveries that differ from recorded receivables by amounts that would be material to the Company’s financial condition, results of operations or liquidity.
In May 2007, the Company’s Board of Directors authorized the Company and its subsidiaries to repurchase up to $10.0 million of its Class A Common Stock from time to time in the open market at prevailing prices or in privately negotiated transactions. During 2007, the Company repurchased 986,522 shares of its Class A Common Stock at a cost of $10.0 million under this authorization.
The Company has 2,000,000 shares of Preferred Stock, $0.01 par value per share authorized. There are no shares of Preferred Stock issued or outstanding.
On August 6, 2009, the Company’s Board of Directors terminated its existing shareholder rights plan and adopted a new plan. Under the new plan, shareholders of record at the close of business on August 17, 2009 received a dividend distribution of one preferred share purchase right for every share of Class A Common Stock held. Subject to certain limited exceptions, if any person or group becomes a 5% shareholder of PMA Capital without first obtaining the approval of the Company’s Board, holders of the rights would become entitled to purchase securities of the Company that would significantly dilute the voting power and economic ownership of the acquiring shareholder. Rights owned by the acquiring shareholder would become void.
The new plan is designed to protect the Company’s ability to use its tax net operating loss carryforward to reduce potential future federal income tax obligations. An ownership change, as defined by the Internal Revenue Service, would severely limit the Company’s ability to use the NOL carryforward and the value of the NOL carryforward would, therefore, be significantly impaired.
Shareholders will have the opportunity to approve the plan at the Company’s next annual meeting of shareholders. The plan will expire on August 6, 2010 if not approved by shareholders before that date. The rights plan terminates if Section 382 of the Internal Revenue Code is repealed or if the Company utilizes all of its NOL carryforward and other tax assets that are subject to limitation under Section 382. The latest that the rights plan will expire is August 6, 2019.
Information regarding the Company’s stock option plans for the years ended December 31 were as follows:
The Company recognizes compensation expense for restricted stock awards over the vesting period of the award. Compensation expense recognized for restricted stock was $296,000 in 2009, $512,000 in 2008 and $771,000 in 2007. At December 31, 2009, unrecognized compensation expense for non-vested restricted stock was $127,000, which is expected to be recognized over a weighted average period of 6 months.
In the first quarter of each of the last three years, the Compensation Committee approved Officer Long Term Incentive Plans pursuant to which stock may be awarded to all officers approximately three years from the date of the plan’s approval if the Company meets certain performance objectives. The Company recognized expenses related to its long term incentive plans of $300,000 in 2009, $1.9 million in 2008 and $1.0 million in 2007.
On March 13, 2009, the Company issued shares from its treasury related to the payout of its 2006 Officer Long Term Incentive Plan. The total fair value of the awards was $1.5 million, which consisted of 362,726 shares awarded at a market value of $4.02 per share, and was accrued prior to issuance. Employees who received the award were given the option to remit either cash or shares of Class A Common Stock to satisfy their tax obligations relating to the award. Employees remitted 117,399 shares to the Company to satisfy their payment of withholding taxes for this award.
The effects of stock options of 1.1 million for 2009, 328,000 for 2008 and 380,000 for 2007 were excluded from the computations of diluted earnings per share, because they were anti-dilutive.
Diluted shares used in the computations of diluted earnings per share for 2008 and 2007 also do not assume the effects of the potential conversion of the Company’s convertible debt into 2,000 and 736,000 shares of Class A Common Stock, respectively, because they were anti-dilutive.
Depreciation and amortization expense for the Fee-based Business segment included $816,000 in 2009, $742,000 in 2008 and $167,000 in 2007 related to the amortization of intangible assets.
Corporate and Other includes the effect of eliminating transactions between the ongoing business segments.
The PMA Insurance Group’s operations are concentrated in twelve contiguous states in the eastern part of the U.S. The economic trends in these individual states may not be independent of one another. Also, The PMA Insurance Group’s products are highly regulated by each of these states. For most of The PMA Insurance Group’s products, the insurance departments of the states in which it conducts business must approve rates and policy forms. In addition, workers’ compensation benefits are determined by statutes and regulations in each of these states. While The PMA Insurance Group considers factors such as rate adequacy, regulatory climate and economic factors in its underwriting process, unfavorable developments in these factors could have an adverse impact on the Company’s financial condition and results of operations. In 2009, workers’ compensation net premiums written represented 90% of The PMA Insurance Group’s net premiums written and comprised 92% in both 2008 and 2007.
The Company incurred legal and consulting expenses aggregating approximately $623,000 in 2008 and $810,000 in 2007 from firms in which directors of the Company were partners or principals. The director to whom these incurred expenses related no longer serves on the Company’s Board of Directors.
Statutory net income for 2009 included a benefit from the commutation of a reinsurance agreement with an affiliated entity.
The Company sold PMA Capital Insurance Company on December 24, 2009.
We conducted our audit 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 effective internal control over financial reporting was maintained in all material respects. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, PMA Capital Corporation and subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 31, 2009, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
See Note 9 for information regarding the results of the Company’s discontinued operations during these periods.