In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Penn Millers Holding Corporation and subsidiary as of December 31, 2010 and 2009, and the results of their operations and their cash flows for the years then ended, in conformity with U.S. generally accepted accounting principles.
Penn Millers Holding Corporation and subsidiary (the Company) are engaged in the marketing and sale of commercial property and liability insurance in 33 states throughout the United States. Coverage is written directly by the Company’s employees and through independent producers.
On April 22, 2009, Penn Millers Mutual Holding Company (Penn Millers Mutual), a Pennsylvania mutual holding company, formed Penn Millers Holding Corporation (Corporation) to effect its conversion from a mutual to stock form of organization. On October 16, 2009, Penn Millers Mutual converted from mutual to stock form and was renamed PMMHC Corp. (PMMHC). PMMHC then issued all of its outstanding capital stock to the Corporation, thereby becoming its wholly owned subsidiary. Immediately following the conversion, PMHC Corp., the wholly owned subsidiary of PMMHC, merged with and into PMMHC, thereby terminating PMHC Corp.’s existence. On October 16, 2009, Penn Millers Holding Corporation completed a stock offering (Offering) and sold 5,444,022 shares of common stock in a concurrently-held subscription and community offering for $10 per share, raising approximately $45,172, net of offering costs and the purchase of common stock by the Employee Stock Ownership Plan (ESOP). Shares of the Corporation began trading on October 19, 2009 on the Nasdaq Global Market under the symbol “PMIC.” The historical consolidated financial statements of Penn Millers Mutual prior to the conversion became the consolidated financial statements of the Corporation upon completion of the conversion.
Upon completion of the merger of PMHC Corp. into PMMHC, PMMHC became the stock holding company for Penn Millers Insurance Company (PMIC). PMIC is a property and casualty insurance company incorporated in Pennsylvania. The stock of PMIC is the most significant asset of PMMHC. American Millers Insurance Company (AMIC) is a property and casualty insurance company incorporated in Pennsylvania and is a wholly owned subsidiary of PMIC. PMMHC owns all of the outstanding common stock of PMIC, which owns all of the outstanding common stock of Penn Millers Agency, Inc. and AMIC. The Corporation and PMMHC conduct no business other than acting as holding companies.
The Company reports its operating results in three segments: agribusiness insurance, commercial business insurance, and a third segment, which is referred to as “other.” However, assets are not allocated to segments and are reviewed in the aggregate for decision-making purposes. The agribusiness insurance segment markets its product in a bundled offering that includes fire and allied lines, inland marine, general liability, commercial automobile, workers’ compensation, and umbrella liability insurance. This segment specializes in writing coverage for manufacturers, processors, and distributors of products for the agricultural industry. The commercial business insurance segment targets small and middle market businesses and offers coverages for property, liability, business interruption, crime coverage, workers’ compensation, commercial automobile, and umbrella liability. The types of businesses this segment targets include retail, service, hospitality, wholesalers, manufacturers, and printers. Both the commercial and agribusiness lines are marketed primarily through independent producers. The “other” segment includes the runoff of discontinued lines of insurance business and the results of mandatory assigned risk reinsurance programs that the Company must participate in as a condition of doing business in the states in which it operates.
The Company’s business is subject to concentration of risk with respect to geographic concentration. Although the Company’s operating subsidiaries are licensed collectively in 40 states, direct premiums written for two states, New Jersey and Pennsylvania, accounted for almost 20% of the Company’s direct premiums written for the year ended December 31, 2010. Consequently, changes in the New Jersey or Pennsylvania legal, regulatory, or economic environment could adversely affect the Company.
The Company classifies all of its fixed maturity securities as available for sale. Fixed maturities classified as available for sale are carried at fair value. Short-term investments are recorded at cost, which approximates fair value. The fair value of Level 1 and Level 2 fixed maturities is based upon data supplied by an independent pricing service. The fair value of Level 3 fixed maturity securities is based on cash flow analysis and other valuation techniques.
Prior to April 1, 2009, the Company recognized in earnings an other-than-temporary impairment for a fixed maturity security in an unrealized loss position unless it could assert that it had both the intent and ability to hold the fixed maturity security for a period of time sufficient to allow for a recovery of fair value to the security’s amortized cost basis. During that time, the entire difference between the fixed maturity security’s amortized cost basis and its fair value was recognized in earnings if it was determined to have an other-than-temporary impairment.
Cash and cash equivalents consist of cash, bank drafts, balances on deposit with banks, and investments with maturity at date of purchase of three months or less in qualified banks and trust companies.
The Company relies upon reinsurance agreements to limit its maximum net loss from large single risks or risks in concentrated areas, and to increase its capacity to write insurance. Reinsurance does not relieve the primary insurer from liability to its policyholders. To the extent that a reinsurer may be unable to pay losses for which it is liable under the terms of a reinsurance agreement, the Company is exposed to the risk of continued liability for such losses. Estimated amounts of reinsurance receivables and recoverables, net of amounts payable that have the right of offset, are reported as assets in the accompanying consolidated balance sheets. Prepaid reinsurance premiums represent the unexpired portion of premiums ceded to reinsurers. The Company considers numerous factors in choosing reinsurers, the most important of which are the financial stability and creditworthiness of the reinsurer.
costs. If the estimation of net realizable value indicates that the deferred policy acquisition costs are not recoverable, they would be written off.
The Company and its subsidiary file a consolidated federal income tax return. Incomes taxes are allocated to each legal entity based on income before income tax expense. Deferred tax assets and liabilities are determined based on differences between financial reporting and tax bases of assets and liabilities and are measured using tax rates and laws that are expected to be in effect when the differences reverse. The Company regularly reviews its deferred tax assets for recoverability taking into consideration such factors as historical losses, projected future taxable income and the character of such income and the expected timing of the reversals of existing temporary differences. A valuation allowance is recorded when it is more likely than not that some portion or all of the deferred tax assets will not be realized. The Company’s policy is to account for interest as a component of interest expense and penalties as a component of other expense.
In accordance with the Securities and Exchange Commission (SEC) Staff Accounting Bulletin (SAB) Topic 5A, Expenses of Offering, the Company had deferred offering costs consisting principally of legal, underwriting, and audit fees incurred through the completion of the offering, on October 16, 2009. At December 31, 2009, $3,867 of offering costs were netted against the offering proceeds in equity.
The Company utilizes the corridor method of amortizing actuarial gains and losses. The amortization of experience gains and losses is recognized only to the extent that the cumulative unamortized net actuarial gain or loss exceeds 10% of the greater of the projected benefit obligation and the fair value of plan assets at the beginning of the year. When required, the excess of the cumulative gain or loss balance is amortized over the expected average remaining service life of the employees covered by the plan.
information in the reconciliation of recurring Level 3 measurements about purchases, sales, issuances and settlements shall be presented separately on a gross basis, rather than as one net number. In addition, clarification is provided about existing disclosure requirements, such as presenting fair value measurement disclosures for each class of assets and liabilities that are determined based on their nature and risk characteristics and their placement in the fair value hierarchy (that is, Level 1, 2, or 3), as opposed to each major category of assets and liabilities, as required in the previous guidance. Disclosures about the valuation techniques and inputs used to measure fair value for both recurring and nonrecurring fair value measurements are required for fair value measurement that fall in either Level 2 or Level 3. The Company adopted this new guidance effective January 1, 2010, except for the gross presentation of purchases, sales, issuances and settlements in the Level 3 reconciliation, which is effective for annual and interim reporting periods beginning after December 15, 2010. The disclosures required by this new guidance are provided in the accompanying note 3.
In October 2010, the FASB issued ASU 2010-26, Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts (a consensus of the FASB Emerging Issues Task Force). This ASU amends FASB ASC Topic 944, Financial Services - Insurance, to address which costs related to the acquisition of new or renewal insurance contracts qualify for deferral. The ASU allows insurance entities to defer costs related to the acquisition of new or renewal insurance contracts that are (1) incremental direct costs of the contract transaction (i.e., would not have occurred without the contract transaction), (2) a portion of the employees’ compensation and fringe benefits related to certain activities for successful contract acquisitions, (3) other costs related directly to the insurer’s acquisition activities in (2) that would not have been incurred had the acquisition contract transaction not occurred, and (4) direct-response advertising costs as defined in ASC Subtopic 340-20, Other Assets and Deferred Costs - Capitalized Advertising Costs. An insurance entity would expense as incurred all other costs related to the acquisition of new or renewal insurance contracts. The amendments in the ASU are effective for fiscal years, and interim periods within those years, beginning after December 15, 2011, and can be applied either prospectively or retrospectively. Early application is permitted at the beginning of an entity’s annual reporting period. The Company is currently evaluating the impact that the adoption of this ASU will have on its financial position and results of operations.
All other standards and updates of those standards issued during the year ended December 31, 2010 either (i) provide supplemental guidance, (ii) are technical corrections, (iii) are not applicable to the Company, or (iv) are not expected to have a significant impact on the Company.
The Company’s estimates of fair value for financial assets and financial liabilities are based on the framework established in the fair value accounting guidance, which is a part of ASC 820.
measured at fair value are categorized into three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. These levels are:
Level 3 - Valuations for assets and liabilities that are derived from other valuation methodologies, including option pricing models, discounted cash flow models, and similar techniques, and not based on market exchange, dealer, or broker traded transactions. Level 3 valuations incorporate certain assumptions and projections that are often unobservable in determining the fair value assigned to such assets or liabilities.
Transfers between level categorizations may occur due to changes in the availability of market observable inputs. Transfers in and out of level categorizations are reported as having occurred at the beginning of the quarter in which the transfer occurred. There were no transfers between level categorizations during the years ended December 31, 2010 and 2009.
U.S. government agencies (depending on the specific market or program): broker quotes; U.S. treasury market and floating rate indices; overall credit quality, including assessments of market sectors and the level and variability of sources of payment; credit support including collateral; the establishment of a risk adjusted credit spread over the applicable risk free yield curve for discounted cash flow valuations; assessments of the level of economic sensitivity;
Commercial mortgage-backed securities: overall credit quality, including assessments of the level and variability of credit support and collateral type such as office, retail, or lodging; predictability of cash flows for the deal structure; prevailing economic market conditions;
Residential mortgage-backed securities: estimates of prepayment speeds based upon historical prepayment rate trends; underlying collateral interest rates; original weighted average maturity; vintage year; borrower credit quality characteristics; interest rate and yield curve forecasts; U.S. government support programs; tax policies; and delinquency/default trends; and
Should the independent pricing service be unable to provide a fair value estimate, the Company would attempt to obtain a non-binding fair value estimate, derived from observable inputs, from a number of broker-dealers and review this estimate in conjunction with a fair value estimate reported by an independent business news service or other sources. In instances where only one broker-dealer provides a fair value for a fixed maturity security, the Company uses that estimate. In instances where the Company is able to obtain fair value estimates from more than one broker-dealer, the Company would review the range of estimates and would select the most appropriate value based on the facts and circumstances. Should neither the independent pricing service nor a broker-dealer provide a fair value estimate, the Company would develop a fair value estimate based on cash flow analyses and other valuation techniques that utilize certain unobservable inputs. Accordingly, the Company would classify such a security as a Level 3 investment.
The fair value estimates of the Company’s investments provided by the independent pricing service at December 31, 2010, were utilized, among other resources, in reaching a conclusion as to the fair value of investments. As of December 31, 2010, all of the Company’s fixed maturity investments were priced using this one primary service. Management reviews the reasonableness of the pricing provided by the independent pricing service by employing various analytical procedures. The Company reviews all securities to identify recent downgrades, significant changes in pricing, and pricing anomalies on individual securities relative to other similar securities. This will include looking for relative consistency across securities in various common blocks or sectors, durations, and credit ratings. This review will also include all fixed maturity securities rated lower than “A” by Moody’s or Standard & Poor’s (S&P). If, after this review, management does not believe the pricing for any security is a reasonable estimate of fair value, then it will seek to resolve the discrepancy through discussions with the pricing service or its asset manager. The classification within the fair value hierarchy as presented in ASC 820 is then confirmed based on the final conclusions from the pricing review. The Company did not have any such discrepancies at December 31, 2010.
The fair value of other financial instruments, principally receivables, accounts payable and accrued expenses, approximates their December 31, 2010 and December 31, 2009 carrying values.
The amortized cost and estimated fair value of fixed maturity securities at December 31, 2010 by contractual maturity, are shown below:
The Company believes, based on its analysis, that the fixed maturity and equity securities are not other-than-temporarily impaired. However, depending on developments involving both the issuers and overall economic conditions, these investments may be written down in the consolidated statements of operations in the future.
For the years ended December 31, 2010 and December 31, 2009, the Company incurred impairment charges of $0 and $197, respectively. The impairment in 2009 was related to one fixed maturity security and the carrying value of the security was written down to fair value in the second quarter of 2009. Subsequently, the security was sold in July 2009.
The Company does not engage in subprime residential mortgage lending. The only securitized financial assets that the Company owns are residential and commercial mortgage-backed securities of high credit quality. The
Company’s exposure to subprime lending is limited to investments in corporate bonds of banks, which may contain some subprime loans on their balance sheets. These bonds are reported at fair value. As of December 31, 2010, fixed maturity securities issued by banks accounted for 10.7% of the bond portfolio’s book value.
Comprehensive (loss) income for the years ended December 31, 2010 and 2009 consisted of the following (all amounts net of taxes):
respectively. Accumulated depreciation related to such assets was $11,778 and $11,154 at December 31, 2010 and 2009, respectively.
The Company has a noncontributory defined benefit pension plan covering substantially all employees. Retirement benefits are a function of both the years of service and level of compensation. In October 2009, the plan was amended and all participants’ accrued benefits under the plan were frozen. It is the Company’s policy to fund the plan in amounts not greater than the amount deductible for federal income tax purposes and not less than the minimum required contribution under the Pension Protection Act of 2006. The Company also sponsors a Supplemental Executive Retirement Plan (SERP). The SERP, which is unfunded, provides defined pension benefits outside of the qualified defined benefit pension plan to eligible executives based on average earnings, years of service, and age at retirement.
Weighted average assumptions used to determine net periodic benefit cost for the years ended December 31, 2010 and 2009 are as follows:
The estimated fair value of the Company’s equity and debt mutual index funds is disclosed in Level 1 as the estimates are based on unadjusted market prices.
The estimated fair value of money market mutual funds, which approximates cost, is included in the amount disclosed in Level 1 as the estimates are based on unadjusted market prices.
The following table presents the level within the fair value hierarchy at which the financial assets of the Company’s pension plan are measured on a recurring basis at December 31, 2010.
US Small Cap 1750 Index and it is a small-cap equity, diversified across growth and value styles. It follows a passively managed, full replication approach.
This category seeks to track the performance of a benchmark index that measures the investment return of large-capitalization stocks. The fund employs a passive management investment approach designed to track the performance of the Standard & Poor’s 500 index. It invests all, or substantially all, of its assets in the stocks that make up the index, holding each stock in approximately the same proportion as its weighting in the index.
This category seeks to track the performance of the Barclays Capital U.S. Long Government/Credit Float Adjusted Bond Index with diversified exposure to the long-term, investment-grade U.S. bond market. It is passively managed using index sampling.
The expected contribution in 2011 for the SERP plan will be a minimum of $47, representing the normal benefit payments to the lone participant in payment status.
The Company issued 539,999 shares of its common stock to the ESOP on October 16, 2009. The ESOP was funded entirely by an employer loan in the amount of $5,400, which will be repaid in ten equal installments. For the years ended December 31, 2010 and 2009, the Corporation made a cash contribution of $667 and $111, respectively, to the ESOP. The ESOP used these contributions to make the annual payment to the Corporation related to the outstanding balance of the loan. These shares held by the ESOP will be allocated over the same 10-year period to eligible employees. Shares purchased are held in a suspense account for allocation among participating employees as the loan is repaid.
Suspense shares, allocated shares, shares committed to be released, average price per share and stock compensation expense for the periods ended December 31, 2010 and October 17, 2009 through December 31, 2009 are as follows:
The Company accounts for its stock based compensation in accordance with Accounting Standards Codification (ASC) 718-10, Compensation - Stock Based Compensation. ASC 718-10 addresses all forms of share-based payment awards, including shares under stock options and restricted stock. ASC 718-10 requires all share-based payments to be recognized as expense, based upon their fair values, in the financial statements over the service period of the awards.
On May 12, 2010, 114,960 stock options were awarded to executives, non-management directors and select employees of the Company. The stock options, which vest over five years at 20% per year, have a contractual term of seven years, and vesting is based on the satisfaction of service conditions. The stock options were awarded at a grant date fair value of $5.22 per option as calculated using a Black-Scholes Merton valuation model with the following assumptions:
The expected volatility assumption was derived from share price data over the expected term of the options of fourteen companies the Company considers to be its peers based upon asset size, market capitalization, profitability
Deferred income taxes reflect the tax effect of temporary differences between the amounts of assets and liabilities for financial reporting and the amounts for income tax purposes. Components of the Company’s deferred tax assets and liabilities from continuing operations for the years ended December 31, 2010 and 2009 are as follows:
At December 31, 2010 and 2009, the Company had available $6,489 and $6,295, respectively, of state income tax NOL carryforwards. The Company concluded it is not more likely than not that state taxable income will be generated in the future to utilize the state NOL carryforwards. At December 31, 2010 and 2009, a valuation allowance of $648 and $629, respectively, was recorded against the deferred tax asset associated with the state income tax NOL carryforwards. The state NOL carryforwards have a twenty year carryforward and will expire from 2019 through 2030.
In any interim period, the Company may generate income or loss. To the extent that any income is generated, the related tax expense may be offset by a reduction in the valuation allowance. Conversely, any tax benefits arising from losses may be offset by an additional valuation allowance to reduce the net deferred tax asset to an amount that is more likely than not to be realized. Any reduction of the valuation allowance will be allocated to continuing operations and other comprehensive income based on the intraperiod tax allocation rules. The intraperiod tax allocation rules in FASB ASC 740, related to items charged directly to accumulated other comprehensive income, can result in disproportionate tax effects that remain in accumulated other comprehensive income until certain events occur. The following schedule shows the amounts and corresponding tax effects in accumulated other comprehensive income as of December 31, 2010 and 2009 and the related change for the year:
Effective January 1, 2010, the Company increased its participation in the per-risk reinsurance treaty. Losses between $500 and $1,000 are retained at a rate of 60.0% in 2010 versus a 52.5% retention rate in 2009.
The Company’s assumed reinsurance relates primarily to its participation in various involuntary pools and associations and the runoff of the Company’s participation in voluntary reinsurance agreements that have been terminated.
The effect of reinsurance, with respect to premiums and losses, for the years ended December 31, 2010 and 2009 is as follows:
The favorable prior year reserve development for 2010 of $2,086 includes reversals in additional reserves carried above the actuarial central estimate and was due to lower level of incurred loss emergence relative to expectations in the workers’ compensation, commercial auto, and liability lines of business in the Company’s agribusiness segment. Within the agribusiness segment, the commercial auto line of business was also impacted positively by favorable prior year claims settlements. This favorable development was partly offset by unfavorable
The following table sets forth the net premiums earned by major lines of business for our core insurance products in the years ended December 31, 2010 and 2009:
A reconciliation of the Company’s statutory net income and surplus to net (loss) income and equity, under GAAP, is as follows:
The above statutory basis net income and capital and surplus amounts relate to the Company’s insurance subsidiaries, PMIC and AMIC.
The Company’s insurance subsidiaries are required by law to maintain certain minimum surplus on a statutory basis, are subject to risk-based capital requirements, and are subject to regulations under which payment of a dividend from statutory surplus is restricted and may require prior approval of regulatory authorities. As of December 31, 2010, the Company’s insurance subsidiaries were in compliance with its risk-based capital requirements. Applying the current regulatory restrictions as of December 31, 2010, approximately $6,819 would be available for distribution to the Company during 2011 without prior approval.
(a) On October 16, 2009, Penn Millers Mutual completed its conversion to stock form. The Corporation sold a total of 5,444,022 shares in a subscription and community offering at $10.00 per share, through which the Corporation received proceeds of $45,172, net of conversion and offering costs of $3,867. On July 28, 2009, the board of directors approved the implementation of an ESOP. The ESOP acquired 539,999 shares at $10.00 per share.
(b) In April 2009, the board of directors approved the authorization of 1,000,000 shares of no par preferred stock of the Corporation upon conversion. The authorized but unissued preferred shares may be issued in one or more series and the share of each series shall have such rights as fixed by the board of directors.
period increased to include the number of additional shares of common stock that would have been outstanding if the potentially dilutive securities had been issued. Potentially dilutive securities include outstanding stock options and unvested restricted stock. The dilutive effect of potentially dilutive securities is reflected in diluted earnings per common share by application of the treasury stock method. Under the treasury stock method, an increase in the fair market value of the Company’s common stock can result in a greater dilutive effect from potentially dilutive securities. Potentially dilutive securities representing approximately 33,543 and 0 shares of common stock for the periods ended December 31, 2010 and December 31, 2009, respectively, were excluded from the computation of diluted loss per common share for these periods because their effect would have been antidilutive.