The following table sets forth selected consolidated financial data for Mercer Insurance Group, Inc. at and for each of the years in the five year period ended December 31, 2006. You should read this data in conjunction with the Group’s consolidated financial statements and accompanying notes, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and other financial information included elsewhere in this report.
Costs and expenses related to the stock conversion incurred in the years ended December 31, 2003 and 2002. Stock conversion expenses consist primarily of the costs of engaging independent accounting, valuation, legal and other consultants to advise us and our insurance regulators as to the stock conversion process and related matters, as well as printing and postage costs relating to our communications with our policyholders. These costs and expenses are reported in accordance with the American Institute of Certified Public Accountants Statement of Position (“SOP”) 00-3, “Accounting by Insurance Enterprises for Demutualizations and Formations of Mutual Insurance Holding Companies and for Certain Long-Duration Participating Contracts.” SOP 00-3 addresses financial statement presentation and accounting for stock conversion expenses and accounting for retained earnings and other comprehensive income at the date of the stock conversion.
The ratio of net investment income divided by total cash and investments.
The Group manages its business in three segments: commercial lines insurance, personal lines insurance, and investments. The commercial lines insurance and personal lines insurance segments are managed based on underwriting results determined in accordance with U.S. generally accepted accounting principles, and the investment segment is managed based on after-tax investment returns. In determining the results of each segment, assets are not allocated to segments and are reviewed in the aggregate for decision-making purposes.
limitations on rates arising from competitive market place conditions or regulation;
Reserves are closely monitored and are recomputed periodically using the most recent information on reported claims and a variety of actuarial techniques. Specifically, on a quarterly basis, we review, by line of business, existing reserves, new claims, changes to existing case reserves, and paid losses with respect to the current and prior accident years. We use historical paid and incurred losses and accident year data to derive expected ultimate loss and loss adjustment expense ratios by line of business. We then apply these expected loss and loss adjustment expense ratios to earned premium to derive a reserve level for each line of business. In connection with the determination of the reserves, we also consider other specific factors such as recent weather-related losses, trends in historical paid losses, and legal and judicial trends with respect to theories of liability. Some of our business relates to coverage for short-term risks, and for these risks loss development is comparatively rapid and historical paid losses, adjusted for known variables, have been a reliable predictive measure of future losses for purposes of our reserving. Some of our business relates to longer-term risks, where the claims are slower to emerge and the estimate of damage is more difficult to predict. For these lines of business, more sophisticated actuarial methods, such as the Bornhuetter-Ferguson loss development methods (see “Methods” below) are employed to project an ultimate loss expectation, and then the related loss history must be regularly evaluated and loss expectations updated, with the possibility of variability from the initial estimate of ultimate losses. A substantial portion of the business written by Financial Pacific Insurance Company, is this type of longer-tailed casualty business.
When a claim is reported to us, our claims personnel establish a “case reserve” for the estimated amount of the ultimate payment. This estimate reflects an informed judgment based upon general insurance reserving practices and on the experience and knowledge of the estimator. The individual estimating the reserve considers the nature and value of the specific claim, the severity of injury or damage, and the policy provisions relating to the type of loss. Case reserves are adjusted by our claims staff as more information becomes available. It is our policy to settle each claim as expeditiously as possible.
For the property lines of business (special property, personal auto physical damage, and commercial auto physical damage) the results of the reserve calculations were similar and we relied on an average of the four methods utilized.
For the homeowners and commercial multi-peril lines of business (excluding California CMP business for policy years 1996 and prior) we relied on the incurred loss development and incurred Bornhuetter-Ferguson methods in estimating loss reserves. These two methods yield more consistent results although the two paid methods yielded reserves that were similar in total to the incurred methods.
For the liability lines (general liability, personal auto liability, commercial auto liability, workers’ compensation) the paid loss development method yielded less than reliable results for the immature years and we did not use the method in selecting ultimate losses and reserves. For these lines we relied on the incurred Bornhuetter-Ferguson method for the most recent accident years and both of the incurred loss development methods for the remaining years.
Each quarter, we compute our estimated ultimate liability using these principles and procedures applicable to the lines of business written. However, because the establishment of loss reserves is an inherently uncertain process, we cannot be certain that ultimate losses will not exceed the established loss reserves and have a material adverse effect on the Group’s results of operations and financial condition. Changes in estimates, or differences between estimates and amounts ultimately paid, are reflected in the operating results of the period during which such adjustments are made.
Reserves are estimates because there are uncertainties inherent in the determination of ultimate losses. Court decisions, regulatory changes and economic conditions can affect the ultimate cost of claims that occurred in the past as well as create uncertainties regarding future loss cost trends. Accordingly, the ultimate liability for unpaid losses and loss settlement expenses will likely differ from the amount recorded at December 31, 2006.
The Group’s consulting actuary’s determined range of loss and loss adjustment expense reserves on a net basis range from a low of $140.6 million to a high of $173.7 million. The Group’s net loss and loss adjustment expense reserves are carried at $164.5 million. Management’s point estimate of reserves is at the higher end of its actuarially determined range in recognition of the inherent uncertainty in assessing the potential ultimate liabilities given legal developments as well as the evolution in its operations. The evolution in its operations include such things as changes in coverage and pricing in response to market opportunity as well as higher reinsurance retentions and geographic and product diversification all of which affect management’s reserve estimates.
In evaluating the potential impairment of equity securities, the Investment Committee will evaluate certain factors, including but not limited to the following: the relationship of market price per share versus carrying value per share at the date of acquisition and the date of evaluation, the price-to-earnings ratio at the date of acquisition and the date of evaluation, any rating agency announcements, the issuer’s financial condition and near-term prospects, including any specific events that may influence the issuer’s operations, the independent auditor’s report on the issuer’s financial statements; and any buy/sell/hold recommendations or price projections by outside investment advisors.
We use the asset and liability method of accounting for income taxes. Deferred income taxes arise from the recognition of temporary differences between financial statement carrying amounts and the tax bases of our assets and liabilities. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. A valuation allowance is provided when it is more likely than not that some portion of the deferred tax asset will not be realized. The effect of a change in tax rates is recognized in the period of the enactment date.
Pricing in the property and casualty insurance industry historically has been and remains cyclical. During a soft market cycle, price competition is prevalent, which makes it difficult to write and retain properly priced personal and commercial lines business. Our policy is to maintain disciplined underwriting and pricing standards during soft markets, declining business which is inadequately priced for its level of risk. The market has become very highly competitive, with increasing competition recently being seen in virtually all classes of commercial accounts, package policies and in the Pennsylvania personal auto market. This has resulted in slowing premium growth for the Group. We continue to work with our agents to target classes of business and accounts compatible with our underwriting appetite, which includes certain types of religious institution risks, contracting risks, small business risks and property risks.
The availability of reinsurance at reasonable pricing is an important part of our business. The surge in catastrophic activity in 2005 placed reinsurers under greater financial pressures, and this has been reflected in their underwriting appetite, reinsurance terms, and their rates for catastrophe coverage. Our operating territories and the Group’s claim activity experienced only a minor impact from the residual effects of the hurricanes in 2005 that ravaged the Gulf coast, and this was helpful in keeping our reinsurance program in place in 2006 without significant overall rate change on renewal.
The components of income for 2006 and 2005, and the change and percentage change from year to year, are shown in the charts below. The accompanying narrative refers to the statistical information displayed in the chart immediately above the narrative.
Charts and discussion relating to each of our segments (commercial lines underwriting, personal lines underwriting, and the investment segment) follow with further discussion below.
The Group’s GAAP combined ratio for 2006 was 97.0%, as compared to a combined ratio for the prior year of 94.9%. The statutory combined ratio for 2006 and 2005 was 95.2% and 94.1%, respectively. Our commercial lines underwriting income benefited from the contribution of Financial Pacific Insurance Company, which was acquired on October 1, 2005. The personal lines performance, while benefiting from rate increases initiated in 2005 on our homeowners line of business and a redirection of our Pennsylvania personal auto book to better performing tiers of business, underperformed the prior year. Frequency and severity of claims on personal lines was within the normal range of expectations during 2006. Frequency of
losses reported on our commercial lines was also within a normal range of our expectations and we experienced a slight increase in severity during 2006 as compared to 2005. The Group experienced $8.4 million of prior year reserve development in 2006 as compared to a $0.5 million redundancy in 2005. See discussion of prior year development in “Business - Loss and Loss Adjustment Expense Reserves” and “Business - Reconciliation of Reserve for Losses and Loss Adjustment Expenses”.
Net investment income increased $5.6 million or 125.4% to $10.1 million in 2006 as compared to $4.5 million in 2005, primarily as a result of the acquisition of Financial Pacific in addition to higher short-term and long-term interest rates in 2006. Realized investment gains amounted to $151,000 in 2006 as compared to $1.3 million in 2005. The higher level of realized gains in 2005 was attributable to the disposition of securities in anticipation of funding the acquisition of Financial Pacific on October 1, 2005 for $41.1 million (including acquisition costs). Other revenue, which is primarily service charges recorded on insurance premiums, increased $1.2 million or 162.7% to $1.9 million in 2006 as compared to $0.7 million in 2005, reflecting the impact of the acquisition of Financial Pacific. Interest expense of $1.2 million in 2006 and $0.3 million in 2005 represents the inclusion of the trust preferred obligations of Financial Pacific and their related interest charges for the year ending December 31, 2006 and the quarter ending December 31, 2005.
Total revenues for 2006 increased $68.7 million or 84.5% to $149.9 million as compared to $81.3 million in 2005. This increase was due primarily to inclusion of the revenue of Financial Pacific for the entire year of 2006 compared to inclusion of revenue of Financial Pacific for only the fourth quarter in 2005. Financial Pacific contributed $84.9 million and $15.9 million in revenue for the year ending December 31, 2006 and fourth quarter ending December 31, 2005, respectively. Net premiums earned totaled $137.7 million in 2006 as compared to $74.8 million in 2005, representing a 84.2% or $62.9 million increase. This increase was due to the Financial Pacific acquisition which contributed $77.3 million and $13.9 million in net premiums earned for the year ending December 31, 2006 and fourth quarter ending December 31, 2005, respectively. Realized investment gains amounted to $151,000 in 2006 as compared to $1.3 million in 2005. The gains in 2005 were the result of sales of mostly equity securities to fund the Financial Pacific acquisition. Net realized gains in 2006 and 2005 also include the mark-to-market fair value adjustment on the interest rate swaps related to the floating-rate trust preferred securities. The mark-to-market on the swaps resulted in a realized (loss)/gain of $(94,000) and $122,000 in 2006 and 2005, respectively.
In 2006, direct premiums written increased $93.5 million or 101.4% to $185.7 million in 2006 as compared to $92.2 million in 2005. Financial Pacific contributed $120.1 million and $27.9 million in direct written premium for the year ending December 31, 2006 and fourth quarter ending December 31, 2005, respectively.
In 2006, net investment income increased $5.6 million, or 125.4% to $10.1 million in 2006 as compared to $4.5 million in 2005. Our investment income benefited in 2006 from higher short-term and long-term interest rates, an increase in average cash and invested assets to $294.4 million in 2006 from $155.8 million in 2005, and increased largely due to the inclusion of the net investment income of Financial Pacific for the entire year of 2006 compared to inclusion of net investment income of Financial Pacific for only the fourth quarter in 2005. Financial Pacific contributed $6.3 million and $1.4 million in net investment income for the year ending December 31, 2006 and fourth quarter ending December 31, 2005, respectively.
In 2006, investment income on fixed income securities increased $5.8 million, or 112.6% to $11.0 million in 2006 as compared to $5.2 million in 2005. This was driven by an increase in long-term interest rates, an increase in the average invested assets and the inclusion of Financial Pacific for the entire year of 2006. The Group’s tax equivalent yield (yield adjusted for tax-benefit received on tax-exempt securities) on fixed income securities increased to 5.14% in 2006 compared to 4.57% in 2005. Since the acquisition of Financial Pacific, a much larger proportion of the Group’s premium writings relate to casualty, or longer-tail, business. By its nature, longer-tail business requires more time for losses to manifest themselves, with the result that claims tend to be paid later on casualty claims than on other types of claims. The later payment of claims associated with casualty reserves provides a company with the opportunity to use the funds, which will ultimately be paid out as claims, for a longer period of time, thus generating a larger relative portfolio of fixed income securities and higher investment income.
Net realized gains for 2006 were $0.2 million, as compared to $1.3 million in 2005. As noted above, the 2005 gains were taken as part of the process of funding the acquisition of Financial Pacific. In 2006, net realized investment gains of $0.2 million included gains on securities sales of $1.0 million, offset by losses on securities sales of $0.6 million, $0.1 million from the write-down of a fixed-income security determined to be other-than-temporarily impaired and a loss of $0.1 million relating to the mark-to-market valuation on the interest rate swaps. Securities determined to be other-than-temporarily impaired are written down to our estimate of fair market value. The Group has entered into five interest rate swap
The fixed income portfolio is invested 100% in investment grade securities, with the exception of one fixed maturity investment held with a value of $0.5 million, with, as of December 31, 2006, an average rating of AAA, an average maturity of 5.4 years (excluding mortgage-backed securities), and an average tax equivalent yield of 5.14%. In order to enhance the yield on our fixed income securities, our investments generally have a longer average maturity than the life of our liabilities. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations” under the subsection entitled “Quantitative and Qualitative Information about Market Risk.”
In 2006, our commercial lines direct premiums written increased by $93.9 million or 138.6% to $161.6 million as compared to direct written premium in 2005 of $67.7 million. This increase was due primarily to inclusion of the direct premiums written of Financial Pacific for the entire year of 2006 compared to inclusion of direct premiums written of Financial Pacific for only the fourth quarter in 2005. Financial Pacific contributed $120.1 million and $27.9 million in direct premiums written for the year ending December 31, 2006 and fourth quarter ending December 31, 2005, respectively. Net premiums earned increased $63.2 million or 121.6% to $115.1 million in 2006 from $52.0 million in 2005, of which Financial Pacific contributed $77.3 million and $13.9 million of net premiums earned for the year ending December 31, 2006 and fourth quarter ending December 31, 2005, respectively.
Effective January 1, 2006, Financial Pacific restructured its property reinsurance agreement covering the first $2,000,000 of loss from an 80% quota share to a $1,650,000 excess of $350,000 excess of loss contract to take advantage of the Group’s capital. The restructuring also included the assumption of ceded unearned premium at January 1, 2006 by FPIC from the 2005 property quota share and casualty excess of loss agreements. These assumed premiums were then ceded into the respective 2006 treaties, which due to the reduced ceding rates, resulted in a $5.6 million increase in net written and earned premium for the year ending December 31, 2006.
During the third quarter of 2006, the Group commuted all reinsurance agreements with Alea. These reinsurance agreements included participation in the property quota share and casualty excess of loss treaties. As a result of the commutation, the Group received a cash payment of $4.5 million, and recorded a pre-tax net loss on commutation of $160,000.
In the commercial lines segment for 2006, we had underwriting income of $6.2 million, a GAAP combined ratio of 94.6%, a GAAP loss and loss adjustment expense ratio of 62.5% and a GAAP underwriting expense ratio of 32.1%, compared to underwriting income of $5.6 million, a GAAP combined ratio of 89.3%, a GAAP loss and loss adjustment expense ratio of 57.3% and a GAAP underwriting expense ratio of 32.0% in 2005. Our commercial lines loss ratio for 2006 reflects a frequency of losses reported within a normal range of our expectations, and includes a slight increase in severity compared to 2005.
Personal lines direct premiums written remained stable at $24.2 million and $24.5 million in 2006 and 2005, respectively. Net premiums written and earned also remained stable at $22.3 million and $22.6 million, respectively in 2006 compared to $23.0 million and $22.8 million, respectively in 2005.
Financial Pacific was included in the Group’s operating results from October 1, 2005. Financial Pacific’s book of business tends to operate with higher loss ratios and lower expense ratios than the Group’s business prior to the acquisition. In addition, due to Financial Pacific’s higher usage of reinsurance, it also records higher levels of ceded commission and contingent ceded commission. In the year ended December 31, 2006, the Group, based on Financial Pacific’s reinsurance participations, recognized ceded commissions and net contingent ceded commissions on reinsurance contracts of $9.7 million and $1.2 million, respectively as compared to the year ended December 31, 2005, where the Group recognized ceded commissions and net contingent ceded commissions on reinsurance contracts relating to Financial Pacific of $4.2 million and $1.5 million, respectively.
Effective January 1, 2006, the Group adopted the fair value recognition provisions of Statement of Financial Accounting Standards No. 123R “Share-Based Payment” (SFAS 123R), using the modified-prospective-transition method. As a result of adopting SFAS 123R on January 1, 2006, the Group’s 2006 underwriting expenses included a pre-tax charge of $711,000 to recognize the compensation cost of unvested stock options granted under the Group’s plan and the impact of SFAS 123R on the computation of expense
The components of income for 2005 and 2004, and the change and percentage change from year to year, are shown in the charts below. The accompanying narrative refers to the statistical information displayed in the chart immediately above the narrative.
Charts and discussion relating to each of our segments (commercial lines underwriting, personal lines underwriting, and the investments segment) follow with further discussion below.
Our personal lines underwriting performance in 2005 was significantly better than the prior year. This improved performance was driven by the absence in 2005 of the severe weather which occurred in our operating territories in the first quarter of 2004, during which the Group had a significantly higher number of claims in personal lines. The commercial lines performance was also very good in 2005, despite a number of larger losses in the second and third quarters. The number of new claims in 2005 was on the low side of the
normal range of expectations, and more favorable than the prior year, and large losses in the aggregate were within the normal range of expectations. The Group’s GAAP combined ratio declined in 2005 from 98.8% to 94.9%, and the statutory combined ratio improved to 94.1% in 2005 from 95.4% in 2004.
Investment income on fixed income securities was up $1.9 million, or 58.2%. The increase included $1.8 million, or 54.0 percentage points of the increase, as a result of the inclusion of the investment income of Financial Pacific since acquisition.
Interest on cash and cash equivalents in 2005 increased $350,000, or 87.9%, to $748,000. This increase is attributable to higher short-term rates in 2005, as well as the fact that the Group generated $53 million of funds to invest as a result of its demutualization on December 16, 2003. Given a difficult interest rate environment and fixed income securities market at the time, these funds were not largely invested until the second quarter of 2004, and, consequently, a portion of them earned a short-term yield during much of the first six months of 2004 that was considerably lower than similar yields in 2005. In addition, in accumulating funds for the closing of the acquisition of Financial Pacific, proceeds from the sale of securities were invested in short-term instruments, and generated interest on cash equivalents.
In the personal lines segment for 2005, we had an underwriting loss of $1.8 million, a GAAP combined ratio of 107.8%, a GAAP loss and loss adjustment expense ratio of 59.7% and a GAAP underwriting expense ratio of 48.1%, compared to an underwriting loss of $4.9 million, a GAAP combined ratio of 121.0%, a GAAP loss and loss adjustment expense ratio of 76.1% and an underwriting expense ratio of 44.9% for the same period in 2004. Our personal lines business is unaffected by the acquisition of Financial Pacific, which does not write any personal lines business.
Financial Pacific was included in the Group’s operating results from October 1, 2005. It typically operates at a lower expense ratio than that of the balance of the Group. In addition, due to the higher usage of reinsurance, it also records higher levels of ceded commission and contingent ceded commission. In the quarter and year ended December 31, 2005, the Group, based on Financial Pacific’s reinsurance participations, recognized ceded commissions and net contingent ceded commissions on reinsurance contracts of $4.2 million and $1.5 million, respectively.
In the third quarter of 2004, we began renewing most of our New Jersey policies in our Mercer Insurance Company of New Jersey, Inc. subsidiary, thus eliminating the Group’s liability for retaliatory premium taxes. Accordingly, the results for 2005 do not reflect any expense for retaliatory taxes, while 2004 included a pre-tax expense for this item of approximately $200,000. See the Liquidity and Capital Resources section for additional information regarding retaliatory tax and the Group’s claim to recover previously paid retaliatory tax.
Our insurance companies generate sufficient funds from their operations and maintain a high degree of liquidity in their investment portfolios. The primary source of funds to meet the demands of claim settlements and operating expenses are premium collections, investment earnings and maturing investments.
We are in the process of building an information system platform that will phase out legacy systems and consolidate them on one core transactional system. As of December 31, 2006, we have spent $4.4 million on the development of this platform, which includes license fees for software used in the platform.
The Group’s insurance companies are restricted by the insurance laws of their respective states of domicile regarding the amount of dividends or other distributions they may pay without notice to or the prior approval of the state regulatory authority. See discussion of restrictions on dividends and distributions in the section “Business - Regulation”.
In connection with the acquisition of Financial Pacific Insurance Group for approximately $41.1 million in cash including transaction costs on October 1, 2005, all of the securities of Mercer Insurance Group, Inc. (which were purchased with proceeds of the Conversion) were converted into cash, with all but approximately $300,000 of this balance used to fund the acquisition. The remaining liquid assets in Mercer Insurance Group, as well as its other sources of revenue, are adequate to fund its current expenses for the foreseeable future.
On July 6, 2006, September 29, 2006 and December 29, 2006, Mercer Insurance Group, Inc. paid a quarterly shareholder dividend of $0.05 per common share. The amount of dividends paid out these dates totaled $0.9 million, which amount was funded from the Group’s insurance companies, for which approval was sought and received (where necessary) from each of the insurance companies’ primary regulators, and waivers were received pursuant to the requirements of the covenants under the FPIC line of credit. The FPIC line of credit was renewed effective December 5, 2006 for Group-wide use and the FPIC dividend limitation was replaced with the Group’s dividend capacity covenant.
Total assets increased 13%, or $60.3 million, to $507.0 million, at December 31, 2006, from $446.7 million at December 31, 2005. The Group’s total investments increased $49.3 million or 20%, primarily due to net cash provided by operating activities. Reinsurance receivables increased $8.8 million or 11%, primarily due to an increase in ceded loss and loss adjustment expense reserves. Prepaid reinsurance premiums decreased $5.2 million or 24%, primarily due to a change in certain of the Group’s reinsurance contracts for 2006, whereby fewer unearned premium reserves are ceded. Deferred policy acquisition costs increased $5.9 million or 55%, reflecting the increase to net unearned premium reserves. Additionally, deferred income taxes increased $4.2 million or 117%, primarily due to profit commissions received on reinsurance contracts that are currently taxable, increased net unearned premiums and increased net loss and loss adjustment expense reserves.
Total stockholders’ equity increased 12%, or $12.4 million, to $115.8 million, at December 31, 2006, from $103.4 million at December 31, 2005, primarily due to net income of $10.6 million, stock compensation plan amortization of $1.4 million and ESOP shares committed of $1.3 million, offset by stockholder dividends of $0.9 million.
The Group maintains an Employee Stock Ownership Plan (ESOP), which purchased 626,111 shares from the Group at the time of the Conversion in return for a note bearing interest at 4% on the principal amount of $6,261,110. Mercer Insurance Company makes annual contributions to the ESOP sufficient for it to make its required annual payment under the terms of the loan to the Holding Company. It is anticipated that approximately 10% of the original ESOP shares will be allocated annually to employee participants of the ESOP. An expense charge is booked ratably during each year for the shares committed to be allocated to participants that year, determined with reference to the fair market value of the Group’s stock at the time the commitment to allocate the shares is accrued and recognized. The issuance of the shares to the ESOP was fully recognized in the Additional Paid-in Capital account at Conversion, with a contra account entitled Unearned ESOP Shares established in the Stockholders’ Equity section of the balance sheet for the unallocated shares at an amount equal to their original per-share purchase price. Shareholder dividends received on unallocated ESOP shares are used to pay-down principal and interest owed on the loan to the Holding Company.
amount will increase automatically each year by 1% of the number of shares outstanding at the end of the preceding year. At January 1, 2007, the shares authorized under the plan has been increased under this provision to 1,075,870 shares. During 2006, the Group made grants of 10,000 shares of restricted stock, grants of 26,550 incentive stock options and grants of 13,450 non-qualified stock options. A total of 14,000 shares of restricted stock, 35,075 incentive stock options and 27,425 non-qualified stock options were forfeited during 2006. No options granted under the plan have been exercised as of December 31, 2006.
On October 20, 2004, the Group’s Board of Directors authorized the repurchase of up to 250,000 additional shares of its common stock (in addition to the 250,000 share repurchase authorized June 16, 2004 and previously completed). The repurchase of the additional 250,000 shares was completed on March 2, 2005. The repurchased shares will be held as treasury shares available for issuance in connection with Mercer Insurance Group’s 2004 Stock Incentive Plan. In the aggregate, 500,000 shares have been repurchased in the open market since the Conversion, at an aggregate cost of $6.3 million, or $12.53 per share, with 2005 purchases totaling $3.2 million, or $13.18 per share. In addition, 1,563 and 1,950 shares of stock were repurchased from employees in 2005 and 2006, respectively, in order to pay the required tax withholdings on the vesting of restricted stock under the stock incentive plan.
As previously disclosed in the Group’s SEC filings, during 2003 and 2004 the Group paid an aggregate of $3.2 million, plus interest, to the New Jersey Division of Taxation (the “Division”) in retaliatory tax. In conjunction with making such payments, the Group filed notices of protest with the Division with respect to the retaliatory tax imposed. The payments were made in response to notices of deficiency issued by the Division to the Group.
In September 2006, the Securities and Exchange Commission issued Staff Accounting Bulletin (SAB) No. 108 to address diversity in practice in quantifying financial statement misstatements. SAB No. 108 requires that registrants quantify the impact on the current year’s financial statements of correcting all misstatements, including the carryover and reversing effects of prior years’ misstatements, as well as the effects of errors arising in the current year. SAB No. 108 is effective as of the first fiscal year ending after November 15, 2006, allowing a one-time transitional cumulative effect adjustment to retained earnings as of January 1, 2006, for errors that were not previously deemed material, but are material under the guidance in SAB No. 108. The adoption of SAB No. 108 did not have a significant effect on operations, financial condition or liquidity.
The Group was not a party to any unconsolidated arrangement or financial instrument with special purpose entities or other vehicles at December 31, 2006 which would give rise to previously undisclosed market, credit or financing risk.
On October 1, 2005, FPIG and its subsidiaries became wholly-owned members of the Group in an acquisition for cash (see note 11). FPIG also holds an interest in three statutory business trusts that were formed for the purpose of issuing Floating Rate Capital Securities (see note 17).
The companies in the Group are operated under common management. The Group’s operating subsidiaries are licensed collectively in twenty two states, but are currently focused on doing business in six states; Arizona, California, Nevada, New Jersey, Pennsylvania and Oregon. Mercer Insurance Company and Mercer Insurance Company of New Jersey, Inc. have recently been licensed to write property and casualty insurance in New York. Financial Pacific Insurance Company holds an additional fifteen state licenses outside of the Group’s current focus area. Currently, only direct mail surety is being written in some of these states.
Interest on fixed-income securities is credited to income as it accrues on the principal amounts outstanding, adjusted for amortization of premiums and accretion of discounts computed utilizing the effective interest rate method. Premiums and discounts on mortgage-backed securities are amortized/accreted using anticipated prepayments with changes in anticipated prepayments, which are evaluated semi-annually, accounted for prospectively. The model used to determine anticipated prepayment assumptions for mortgage-backed securities uses separate home sale, refinancing, curtailment, and full pay-off components, derived from a variety of industry sources and used by the Group’s fixed income securities manager.
Management believes that the liabilities for losses and loss adjustment expenses at December 31, 2006 are adequate to cover the ultimate net cost of losses and claims to date, but these liabilities are necessarily based on estimates, and the amount of losses and loss adjustment expenses ultimately paid may be more or less than such estimates. Changes in the estimates for losses and loss adjustment expenses are recognized in the period in which they are determined.
Prior to January 1, 2006, the Group accounted for this plan under the provisions of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”) and related interpretations, as permitted by Statement of Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock-Based Compensation”. Under the principles of APB 25, as permitted by SFAS No. 123, stock-based compensation was recognized for grants of restricted stock in the consolidated statement of earnings for the years ended December 31, 2005 and 2004, but not for grants of stock options because options granted under the plan had an exercise price equal to the market value of the underlying common stock on the date of grant. Effective January 1, 2006, the Group adopted the fair value recognition provisions of SFAS No. 123R, “Share-Based Payment”, using the modified-prospective-transition method. Consolidated statement of earnings for prior periods have not been retrospectively adjusted for SFAS No. 123R.
The Group adopted SFAS No. 123R on January 1, 2006 with no impact upon adoption. The compensation expense for the year ending December 31, 2006 was $711. There would have been no charge to earnings for stock option grants if we had continued to account for stock-based compensation under APB 25 for unvested stock options. SFAS No. 123R also eliminated the presentation of the contra-equity account “Unearned restricted stock compensation,” resulting in a reclass of $1,654 to Additional paid-in capital.
assets to identify them as freestanding derivatives or as hybrid financial instruments containing an embedded derivative requiring bifurcation; clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives; and amends SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities”, to eliminate the prohibition on a qualifying special-purpose entity from holding a derivative financial instrument pertaining to a beneficial interest other than another derivative financial instrument. SFAS No. 155 is effective for all financial instruments acquired or issued after the beginning of an entity’s first fiscal year beginning after September 15, 2006. The Group is currently evaluating the impact that SFAS No. 155 will have, if any, on its consolidated financial statements.
Reclassifications have been made in the 2005 and 2004 financial statements and notes to conform them to the presentation of the 2006 financial statements.
The changes in unrealized (losses) gains of securities are as follows:
Original cost of equity securities; original cost of fixed-income securities adjusted for amortization of premium and accretion of discount.
Fixed maturity investments with unrealized losses for less than twelve months are primarily due to changes in the interest rate environment. At December 31, 2006 the Group has 198 fixed maturity securities with unrealized losses for more than twelve months. Of the 198 securities with unrealized losses for more than twelve months, 192 of them have fair values of no less than 96% or more of cost, and the other 6 securities have a fair value greater than 93% of cost. The fixed income portfolio is invested 100% in investment grade securities, with the exception of one fixed maturity investment held with a value of $0.5 million, as of December 31, 2006, and these unrealized losses primarily reflect the current interest rate environment. The Group believes these declines are temporary.
Fixed maturity investments with unrealized losses for less than twelve months are primarily due to changes in the interest rate environment. At December 31, 2005, the Group has 53 fixed maturity securities with unrealized losses for more than twelve months. Of the 53 securities with unrealized losses for more than twelve months, 46 of them have fair values of no less than 96% of cost, and the other 7 securities have a fair value greater than 92% of cost. The fixed income portfolio is invested 100% in investment grade securities, as of December 31, 2006, and these unrealized losses primarily reflect the current interest rate environment. The Group believes these declines are temporary.
Proceeds from the sales of securities were $152,438, $66,537, and $30,548 in 2006, 2005, and 2004, respectively.
The amortized cost of invested securities on deposit with regulatory authorities at December 31, 2006 and 2005 was $4,954 and $4,675, respectively.
Each quarter, we compute the estimated ultimate liability using principles and procedures applicable to the lines of business written. The establishment of loss and loss adjustment expense reserves is an inherently uncertain process and reserve uncertainty stems from a variety of sources. Court decisions, regulatory changes and economic conditions can affect the ultimate cost of claims that occurred in the past as well as create uncertainties regarding future loss cost trends. Changes in estimates, or differences between estimates and amounts ultimately paid, are reflected in the operating results of the period during which such adjustment is made. A discussion of factors contributing to an increase (decrease) in the liability for unpaid losses and loss adjustment expenses for the Group’s two major lines of business, representing 81% of total carried loss and loss adjustment expenses at December 31, 2006, follows:
In the ordinary course of business, the Group seeks to limit its exposure to loss on individual claims and from the effects of catastrophes by entering into reinsurance contracts with other insurance companies. Reinsurance is ceded on excess of loss and pro-rata bases with the Group’s retention in 2006, 2005 and 2004 not exceeding $500 per occurrence. Insurance ceded by the Group does not relieve its primary liability as the originating insurer. The Group also assumes reinsurance from other companies on a pro-rata basis.
Many of the reinsurance treaties participated in by the Group have included provisions that establish minimum and maximum cessions and allow limited participation in the profit of the ceded business. Generally, the Group shares, on a limited basis, in the profitability through contingent ceding commissions. The Group’s exposure in the loss experience is contractually defined at minimum and maximum levels. The terms of such contracts are fixed at inception. Since estimating the emergence of claims to the applicable reinsurance layers is subject to significant uncertainty, particularly in longer-tail lines, the net amounts that will ultimately be realized may vary significantly from the estimated amounts recorded in the accompanying consolidated financial statements.
Effective January 1, 2006, FPIC restructured its property reinsurance agreement covering the first $2,000 of loss from an 80% quota share to a $1,650 excess of $350 excess of loss contract to take advantage of the Group’s capital. The restructuring also included the assumption of ceded unearned premium at January 1, 2006 by FPIC from the 2005 property quota share and casualty excess of loss agreements. These assumed premiums were then ceded into the respective 2006 treaties, which due to the reduced ceding rates, resulted in a $5,600 increase in net written and earned premium for the year ending December 31, 2006.
The effect of reinsurance on unearned premiums as of December 31, 2006 and 2005 is as follows:
The Group maintains a 401(k) qualified retirement savings plan covering substantially all employees. Benefits are based on an employee’s annual compensation, with new employees participating after a six-month waiting period. The Group matches a percentage of each employees’ pre-tax contribution and also contributes an amount equal to 2% of each employee’s annual compensation. Deferral amounts in excess of the qualified plan limitations, as well as Group contributions on such compensation, are funded into nonqualified plans benefiting affected individuals. The cost for these benefits was $469, $177, and $134 for 2006, 2005, and 2004, respectively. In addition, the Group generally makes a discretionary contribution each year, based on Group profitability, to both the qualified 401(k) plan, and, where applicable, to the nonqualified plans. The cost for this portion of the retirement plan was $389, $201, and $255 for 2006, 2005, and 2004, respectively.
The Group sponsored the FPIG 401(k) Plan for employees of FPIG effective with the acquisition of FPIG on October 1, 2005 (see note 11). All employees of FPIC, as defined in the FPIG 401(k) Plan, who have completed six months of service were eligible for participation in the Plan. The Group matched 100% of the employee’s pre-tax contribution up to $2 on an annual basis. In the fourth quarter of 2005, the Group recognized a cost of $19 for the FPIG 401(k) Plan. Effective in 2006, the FPIG 401(k) Plan was terminated and all eligible employees were rolled into the Group’s 401(k) Plan described in the preceding paragraph.
The tax effect of temporary differences that give rise to the Group’s net deferred tax asset as of December 31, is as follows:
In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management believes it is more likely than not the Group will realize the benefits of the deferred tax assets at December 31, 2006 and 2005.
The components of the provision for income taxes are as follows:
All dividends from Financial Pacific Insurance Company to Financial Pacific Insurance Group, Inc. (wholly owned by Mercer Insurance Group, Inc.) require prior notice to the California Department of Insurance. All “extraordinary” dividends require advance approval, and the payment of ordinary dividends made for the purpose of servicing debt of the Group has been restricted and requires prior written consent. A dividend is deemed “extraordinary” if, when aggregated with all other dividends paid within the preceding 12 months, the dividend exceeds the greater of (a) statutory net income (excluding unrealized capital gains) for the preceding calendar year or (b) 10% of statutory surplus as of the preceding December 31. As of December 31, 2006, the amounts available for payment of dividends from Financial Pacific Insurance Company in 2007, without the prior approval, in addition to those dividends required to service debt of the Group, for which pre-approval is required, is approximately $5.6 million.
Since the merger date, the final tax return was filed for FPIG, resulting in a $8 reduction of goodwill. The change in the carrying amount of goodwill for the years ended December 31, 2006 and 2005 is as follows:
Information regarding stock option activity in Mercer Insurance Group’s Plan is presented below:
In determining the charge to the consolidated statement of earnings for 2006 and the pro-forma effect for 2005 and 2004 described in Note 1(m), the per share weighted-average fair value of options granted during 2004 was $4.19, for 2005 was $4.44 and for 2006 was $11.05. The fair value of each option grant is estimated on the date of grant using the Black-Scholes-Merton option-pricing model with the following weighted-average assumptions used for grants in 2004: dividend yield of 0%; expected volatility of 20.91%; risk-free interest rate of 4.73%, and an expected life of 6.5 years, and in 2005: dividend yield of 0%; expected volatility of 18.44%; risk-free interest rate of 4.04%, and an expected life of 7.5 years, and in 2006: dividend yield of 0.77%; expected volatility of 30.94%; risk-free interest rate of 4.62%, and an expected life of 6.9 years.
Information regarding unvested restricted stock activity in Mercer Insurance Group’s Plan is below:
On October 19, 2006, in the case of American Fire & Casualty Company v. New Jersey Division of Taxation (A-134-04), the New Jersey Supreme Court ruled in favor of the foreign insurers, holding that the tax benefits of the premium tax cap afforded to foreign insurers should not be included in calculating the retaliatory tax. Instead, the Court ruled that the retaliatory tax and the premium tax cap must be harmonized to effectuate their respective purposes, thereby preserving the benefits of the premium tax cap for foreign insurers.
Rental expenses of approximately $474 and $117 for the years ended December 31, 2006 and 2005, respectively, has been charged to income in the accompanying consolidated statement of earnings.
As of December 31, 2006 and 2005, the FPIG owed $3,000 under a $4,000 bank line of credit. The line of credit bears interest at the bank’s base rate or an optional rate based on LIBOR. The effective annual interest rate as of December 31, 2006 and 2005 was 8.25% and 7.25%, respectively. The line of credit includes covenants to maintain certain financial requirements including a minimum A.M. Best rating and minimum statutory surplus. All covenants were in compliance as of December 31, 2006 and 2005. This line of credit was renewed with the same capacity effective December 5, 2006 and with a maturity date of November 15, 2007.
The Group had the following Trust Preferred Securities outstanding as of December 31, 2006:
Financial Pacific Statutory Trust II (Trust II) is a Connecticut statutory business trust. The Trust issued 3,000 shares of the Trust preferred securities at a price of $1,000 per share for $3,000. The Trust purchased $3,093 in Junior Subordinated Debentures from the Group that mature on May 15, 2033. The annual effective rate of interest at December 31, 2006 is 7.35%.
The Group has the right, at any time, so long as there are no continuing events of default, to defer payments of interest on the Junior Subordinated Debentures for a period not exceeding 20 consecutive quarters; but not beyond the stated maturity of the Junior Subordinated Debentures. To date no interest has been deferred. FPIG entered into an interest rate swap agreement to hedge the floating interest rate on the Junior Subordinated Debentures (note 18).
The Group had the following Interest Rate Swaps outstanding as of December 31, 2006:
As of December 31, 2006 and 2005, the Group was party to interest-rate swap agreements with an aggregate notional principal amount of $28,000. For the year ending December 31, 2006 and 2005, the Group recognized the change in the economic value of the interest rate swap agreements which is recognized in the consolidated statement of earnings as a realized (loss)/gain of $(94) and $122, respectively. The estimated fair value of the interest-rate swap agreements included in other assets was $395 and $489 as of December 31, 2006 and 2005, respectively.
The Group accepts various forms of collateral for issuance of its surety bonds including cash, irrevocable letters of credit and certificates of deposit. The Group’s policy is to record in the accompanying consolidated financial statements only those funds received as cash deposits. The off-balance sheet collateral held by the Group consists solely of irrevocable letters of credit totaling $1,808 and $1,329 as of December 31, 2006 and 2005, respectively.