The Company's entire operations are conducted from these two facilities. The current facilities are expected to be adequate for the Company's operations for the near future.
The table below provides selected consolidated financial data of the Company. The information has been derived from our consolidated financial statements for each of the years in the five-year period ended December 31, 2020. You should read this selected consolidated financial data in conjunction with the audited consolidated financial statements and notes as of and for the year ended December 31, 2020 included in Part II, Item 8 "Financial Statements and Supplementary Data," and Part II,
Effective January 1, 2018, we adopted Accounting Standards Update ("ASU") 2016-01, Financial Instruments - Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities, or ASU 2016-01, resulting in a cumulative-effect adjustment of $71.0 million ($46.2 million, net of tax). This adjustment moved our historical unrealized gains and losses, net of tax, on our equity portfolio from accumulated other comprehensive income (loss) to retained earnings, but had no impact on overall shareholders' equity. In addition, for 2018 and forward, the change in fair value for equity securities is required to be recognized in net earnings rather than in other comprehensive income (loss). The impact to our consolidated statements of operations will vary depending upon the level of volatility in the performance of the securities held in our equity portfolio and the overall market.
On May 5, 2020, the Board of Directors (the “Board”) of Protective formed a special committee of independent directors (the “Special Committee”) to evaluate a Stockholder Support and Contingent Sale Agreement (the “Contingent Sale Agreement”) entered into by and among certain prospective third party purchasers (the “Offering Parties”), certain of Protective’s shareholders and the other parties thereto (The Contingent Sale Agreement was amended and restated on August 17, 2020).
In June 2020, Protective announced that the Board determined the transactions contemplated by the Contingent Sale Agreement were not in the best interests of Protective and our stakeholders. As part of this evaluation, the Board determined that it would also recommend against the potential tender offer contemplated by the Contingent Sale Agreement if it were commenced, and that if the transactions contemplated by the Contingent Sale Agreement were consummated, it expects to take the necessary actions to redeem all or certain of the Class A shares of Protective purchased by the Offering Parties pursuant to Protective’s Code of By-laws. Protective also announced that the Special Committee of the Board was exploring, with the assistance of its independent financial and legal advisors, strategic alternatives that may be available to Protective.
During 2020, we incurred an aggregate of $2.9 million ($2.3 million, net of tax) of expenses in conjunction with the Board’s review of the Contingent Sale Agreement and the activities of the Special Committee.
On January 1, 2020, we adopted the provisions of ASU No. 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, or ASU 2016-13. ASU 2016-13 introduced a current expected credit loss ("CECL") model for measuring expected credit losses for certain types of financial instruments held at the reporting date requiring significant judgment in application based on historical experience, current conditions and reasonable supportable forecasts, but is not prescriptive about certain aspects of estimating expected losses. We adopted the guidance using a modified retrospective approach as of January 1, 2020 and recognized a cumulative effect adjustment of $15.5 million ($12.3 million net of tax), to the opening balance of retained earnings. The adjustment was primarily related to estimating credit losses on our accounts receivable balances, reinsurance recoverable balances and commercial mortgage loans at the date of adoption with $15.0 million ($11.9 million, net of tax) attributed to our ongoing litigation with Personnel Staffing Group ("PSG") discussed in Note T, "Litigation, Commitments and Contingencies," to the Consolidated Financial Statements in Part II, Item 8 of this Annual Report on Form 10-K. During the third quarter of 2020, we performed an update to our CECL allowance calculation related to the PSG matter and recorded an additional allowance of $1.5 million ($1.2 million, net of tax). No additional allowance was recorded in the fourth quarter of 2020. This allowance is included within other operating expenses in the consolidated statement of operations for the year ended December 31, 2020.
On August 31, 2017, our Board of Directors authorized the reinstatement of our share repurchase program for up to 2,464,209 shares of our Class A or Class B Common Stock. The repurchases may be made in the open market or through privately negotiated transactions, from time-to-time, and in accordance with applicable laws, rules and regulations. The share repurchase program may be amended, suspended or discontinued at any time and does not commit us to repurchase any shares of our common stock. We have funded, and intend to continue to fund, the share repurchase program from cash on hand. The actual number and value of the shares to be purchased will depend on the performance of our stock price, market volume and other market conditions. During the year ended December 31, 2020, we paid $1.8 million to repurchase 126,764 shares of Class B Common Stock under the share repurchase program. No share repurchases have been made since March 20, 2020. Additionally, in connection with the Merger Agreement with Progressive discussed above, we are prohibited from repurchasing any of our Class A or Class B Common Stock under the share repurchase program.
Net cash provided by operating activities was $74.9 million during 2020 compared to $86.7 million for 2019. The $11.8 million decrease in operating cash flows during 2020 reflected lower premium volume and lower investment income from our fixed income securities when compared to the same period of 2019. Additionally, net cash from operations in 2019 benefited from the impact of growth in premiums and the timing of related claims payments. Net cash provided by operating activities was $86.7 million for 2019 compared to $100.7 million in 2018. The $14.0 million decrease was primarily related to an increase in payments for losses and loss adjustment expenses and operating expenses, partially offset by higher premium volume as well as higher investment income during 2019.
We maintain a revolving credit facility with a $40.0 million limit, with the option for up to an additional $35.0 million in incremental loans at the discretion of the lenders, which has an expiration date of August 9, 2022. Interest on this revolving credit facility is referenced to the London Interbank Offered Rate ("LIBOR") and can be fixed for periods of up to one year at our option. Outstanding drawings on this revolving credit facility were $20.0 million as of December 31, 2020. At December 31, 2020, the effective interest rate was 1.25% and we had $20.0 million remaining under the revolving credit facility. The current outstanding borrowings were used to repay our previous line of credit. Our revolving credit facility has two financial covenants, each of which were met as of December 31, 2020. These covenants require us to have a minimum U.S. generally accepted accounting principles ("GAAP") net worth and a maximum consolidated debt to equity ratio of 0.35.
We believe investors’ understanding of our performance is enhanced by our disclosure of underwriting income (loss), which is a measure that is not calculated in accordance with GAAP. Underwriting income (loss) represents the pre-tax profitability or loss of our insurance operations and is derived by subtracting net realized and unrealized gains (losses) on investments and net investment income from income (loss) before federal income tax expense (benefit). For the year ended December 31, 2020, we also excluded corporate charges incurred in conjunction with the Board's review of the Contingent Sale Agreement, activities of the Special Committee as well as the CECL allowance adjustment related to the PSG matter discussed above from the calculation of underwriting income (loss). For the year ended December 31, 2018 we had a goodwill impairment charge, which was excluded from the calculation of 2018 underwriting income (loss). We believe the exclusion of these charges and the CECL allowance adjustment increases the period-to-period comparability of our operational results. We use underwriting income (loss) as an internal performance measure in the management of our operations because we believe it gives us and users of our financial information useful insight into our results of operations, our underlying business performance and our ongoing operating trends. Underwriting income (loss) should not be viewed as a substitute for income (loss) before federal income tax expense (benefit) calculated in accordance with GAAP, and other companies may define underwriting income (loss) differently.
Represents the corporate charges incurred in conjunction with the Board's review of the Contingent Sale Agreement, activities of the Special Committee and an adjustment to our CECL allowance related to the PSG litigation matter discussed above.
Gross premiums written for 2020 decreased $27.4 million (4.8%), while net premiums earned decreased $1.8 million (0.4%), as compared to 2019. The lower net premiums earned in 2020 were primarily the result of declines in premiums within our commercial automobile products, specifically public transportation, as a result of a reduction in miles driven, which is the basis for premiums we receive, as well as an overall reduction in public transportation units insured, both due to the impact of COVID-19. During the second half of the year, we saw a recovery in premiums within certain commercial automobile products due to a return to a more normal level of miles driven, but the declines in public transportation continued. Additionally, we experienced reduced premiums associated with lower retention rates as we continue to take actions to improve profitability, including rate increases and non-renewal of certain risks. These decreases were partially offset by rate increases, growth in existing business lines and new business policies sold mainly in our commercial automobile products. The difference in the percentage change for premiums written compared to earned was reflective of the normal differences in the financial statement recognition of earned premiums compared to written, as well as differences in reinsurance ceding rates on the mix of business in-force.
Premiums ceded to reinsurers on our insurance business averaged 19.5% of gross premiums written for 2020 compared to 21.3% for 2019. The decrease in premiums ceded was the result of growth in our commercial automobile products, which carry a lower ceded reinsurance percentage when compared to ceding rates on our workers' compensation products, in addition to the non-renewal of the reinsurance treaty, which impacted the second half of 2020, discussed below.
Losses and loss expenses incurred during 2020 decreased $29.5 million (8.5%) to $319.0 million compared to $348.5 million in 2019, while the loss ratio decreased to 71.6% for 2020 compared to 77.9% for 2019. The loss ratio is calculated as the percentage of losses and loss expenses incurred to net premiums earned. The lower losses and loss expenses and lower loss ratio for 2020 reflected the results of our underwriting actions, including non-renewal of unprofitable business as well as significant rate increases in commercial automobile. Additionally, losses and loss expenses incurred reflected favorable impacts from COVID-19 within all commercial automobile products as a result of declines in accident frequency due to lower traffic density.
Commercial automobile products covered by our reinsurance treaties from July 3, 2013 through July 2, 2019 are subject to an unlimited aggregate stop-loss provision. Currently each of these treaty years is reserved at or above the attachment level of these treaties. For every $100 of additional loss, we are only responsible for our $25 retention under these reinsurance treaties. Commercial automobile products covered by our reinsurance treaty from July 3, 2019 through July 2, 2020 are also subject to an unlimited aggregate stop-loss provision. Once the aggregate stop-loss level is reached, for every $100 of additional loss, we are responsible for our $65 retention under this reinsurance treaty. This increase in our retention compared to recent years reflects the combination of 1) a decreased need for stop-loss reinsurance protection resulting from a significant decrease in our commercial automobile average policy loss limits, 2) a higher cost for this coverage and 3) our confidence in profitability improvements given the limits reductions and rate increases on our commercial automobile products. In 2020, due to continued rate achievement in commercial automobile, improvements in our mix of business and reductions to our average policy loss limits, we decided to non-renew the annual aggregate deductible treaty for policies written on or after July 3, 2020.
Net investment income for 2020 decreased 3.2% to $25.4 million compared to $26.2 million for 2019. The decrease reflected lower interest rates earned on cash and cash equivalent balances in 2020, partially offset by an increase in average funds invested resulting from positive cash flow from operations, as well as the continued reallocation from equity investments in limited partnerships and cash and cash equivalent investments into short-duration, high-quality bonds.
Net realized and unrealized losses on investments of $9.2 million during 2020 were primarily driven by $6.8 million in net realized losses on sales of securities, excluding impairment losses, $2.9 million in impairments and a $1.4 million decrease in the value of our limited partnership investments, partially offset by $1.9 million in unrealized gains on equity securities during the period. Comparative 2019 net realized and unrealized gains on investments of $12.9 million were primarily driven by $9.3 million in unrealized gains on equity securities during the period, net realized gains on sales of securities, excluding impairment losses, of $2.5 million and a $1.6 million increase in the value of our limited partnership investments, partially offset by impairments on our fixed income securities of $0.5 million recognized during the period. Realized investment gains and losses result from decisions regarding overall portfolio realignment as well as the sale of individual securities, including the change in the aggregate value of limited partnerships and, as such, should not be expected to be consistent from period to period.
Gross premiums written for 2019 decreased $7.6 million (1.3%) due to the non-renewal of unprofitable business during the year, while net premiums earned increased $14.4 million (3.3%), as compared to 2018. The higher net premiums earned in 2019 were primarily the result of lower premiums ceded when compared to 2018, as discussed below. The difference in the percentage change for premiums written compared to earned was reflective of the normal differences in the financial statement recognition of earned premiums compared to written, as well as differences in reinsurance ceding rates on the mix of business in-force.
Federal income tax expense was $1.3 million for 2019 compared to a federal income tax benefit of $9.8 million in 2018. The effective tax rate for 2019 was 15.3% compared to 22.3% in 2018. The effective federal income tax rate in 2019 differed from the normal statutory rate primarily as a result of tax-exempt investment income and the dividends received deduction.
Under Financial Accounting Standards Board ("FASB") guidance, if a fixed income security is in an unrealized loss position and the Company has the intent to sell the security, or it is more likely than not that the Company will have to sell the security before recovery of its amortized cost basis, the decline in value is recorded within impairment losses on investments in the consolidated statements of operations. The new cost basis of the investment is the previously amortized cost basis less the impairment recognized. The new cost basis is not adjusted for any subsequent recoveries in fair value. For a fixed income security that the Company does not intend to sell or in cases where it is more likely than not that the Company will not have to sell the security, the Company separates the credit loss component of the impairment from the amount related to all other factors and reports the credit loss component within net realized gains (losses) on investments, excluding impairment losses in the consolidated statements of operations. The impairment related to all other factors (non-credit factors) is reported in other comprehensive income (loss). The allowance is adjusted for any additional credit losses and subsequent recoveries. Upon recognizing a credit loss, the cost basis is not adjusted.
It should be noted, however, that a change in the estimate of amounts due from reinsurers on unpaid claims will not, in itself, result in charges or credits to losses incurred. This is because any change in estimated recovery follows the estimate of the underlying loss. Thus, it is the computation of the gross underlying loss that is critical.
The Company's reserves for losses and loss expenses ("reserves") are determined based on complex estimation processes using historical experience, current economic information and available industry statistics. The Company's claims range from routine "fender benders" to the highly complex and costly third-party bodily injury claims involving large tractor-trailer rigs. Reserving for each class of claims requires a set of assumptions based upon historical experience, knowledge of current industry trends and seasoned judgment. The high limits provided in many of the Company's policies provide for greater volatility in the reserving process for more serious claims. Court rulings, legislative actions and trends in jury awards also play a significant role in the estimation process of larger claims. The Company continuously reviews and evaluates loss developments subsequent to each measurement date and adjusts its reserve estimation assumptions, as necessary, in an effort to achieve the best possible estimate of the ultimate remaining loss costs at any point in time. Changes to previously established loss and loss expense reserve amounts are charged or credited to losses and loss expenses incurred in the accounting periods in which they are determined. See Note C, "Loss and Loss Expense Reserves," to the Consolidated Financial Statements in Part II, Item 8 of this Annual Report on Form 10-K for additional information relating to loss and loss expense reserve development.
The Company uses both standard actuarial techniques common to most insurance companies as well as proprietary techniques developed by the Company in connection with its specialty business products. For its short-tail lines of business, the Company uses predominantly the incurred or paid loss development factor methods. The Company has found that the use of accident quarter loss development triangles, rather than those based upon accident year, are most responsive to claim settlement trends and fluctuations in premium exposure for its short-tail lines. A minimum of 12 running accident quarters is used to project the reserve necessary for incurred but not reported ("IBNR") losses for its short-tail lines.
● Expected loss ratios for the current book of business, particularly the Company's commercial automobile products, where the number of accounts insured, selected SIRs, policy limits and reinsurance structures may vary widely from period to period.
Under reasonably possible scenarios, it is conceivable that the Company's selected loss estimates could be 10% or more redundant or deficient. The majority of the Company's reserves for losses and loss expenses, on a net of reinsurance basis, relate to its commercial automobile products. Perhaps the most significant example of sensitivity to variation in the key assumptions is the loss ratio selection for the Company's commercial automobile products for policies subject to certain major reinsurance treaties. The following table presents the approximate impacts on gross and net loss reserves of both a hypothetical 10 percentage point and a hypothetical 20 percentage point increase or decrease in the loss factors actually utilized in the Company's reserve determination at December 31, 2020 for the prior seven treaty periods, which covers exposures earned on policies written between July 3, 2014 and December 31, 2020. The Company's selection of the range of values presented should not be construed as the Company's prediction of future events, but rather simply an illustration of the impact of such events, should they occur.
Deferred tax assets at December 31, 2020 included approximately $12.9 million related to the timing of deductibility of loss and loss expense reserves, the majority of which relate to policy liability discounts required by the Internal Revenue Code of 1986, as amended, which are perpetual in nature and, in the absence of the termination of the Company's business, will not, in the aggregate, reverse to a material degree in the foreseeable future. The allowance for CECL under ASU 2016-13 represents $3.6 million of deferred tax assets, while unearned premiums discount and deferred ceding commissions represent $2.3 million and $0.5 million of deferred tax assets, respectively. An additional $2.0 million relates to timing differences in the expensing of our stock compensation plans. The balance of deferred tax assets consists of various normal operating expense accruals and is not considered to be material. As of December 31, 2020 and 2019, the Company had no valuation allowance. However, the application of intra-period tax allocation rules to benefits associated with deferred tax assets resulted in a charge to continuing operations as of December 31, 2020 of $1.3 million within the consolidated statement of operations, offset by a corresponding benefit in shareholders' equity within accumulated other comprehensive income.
To the extent inflation influences yields on investments, the Company is also affected. The Company's short-term and fixed investment portfolios are structured in direct response to available interest rates over the yield curve. As available market interest rates fluctuate in response to the presence or absence of inflation, the yields on the Company's investments are impacted. Further, as inflation affects current market rates of return, previously committed investments might increase or decline in value depending on the type and maturity of the investment. For additional information, see Part II, Item 7A, "Quantitative and Qualitative Disclosures about Market Risk," in this Annual Report on Form 10-K.
Borrowings made under the Company's line of credit can be called by the lender, under certain circumstances, with short notice. The Company entered into a line of credit on August 9, 2018 with an expiration date of August 9, 2022.
Report of Independent Registered Public Accounting FirmTo the Shareholders and the Board of Directors of Protective Insurance Corporation
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the Company’s internal control over financial reporting as of December 31, 2020, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) and our report dated March 11, 2021 expressed an unqualified opinion thereon.
As discussed in Note A to the consolidated financial statements, the Company changed its method of accounting for the recognition and measurement of expected credit losses for certain types of financial instruments in 2020 due to the adoption of Accounting Standards Update No. 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments. See below for a discussion of our related critical audit matter for the Personnel Staffing Group recoverable allowance.
The critical audit matters communicated below are matters arising from the current period audit of the financial statements that were communicated or required to be communicated to the audit committee and that: (1) related to accounts or disclosures that are material to the financial statements and (2) involved our especially challenging, subjective, or complex judgments. The communication of the critical audit matters does not alter in any way our opinion on the consolidated financial statements, taken as a whole, and we are not, by communicating the critical audit matters below, providing separate opinions on the critical audit matters or on the accounts or disclosures to which they relate.
Valuation of Incurred but Not Reported Loss and Loss Expense Reserves
As of December 31, 2020, the liability for incurred but not reported loss and loss expense reserves, net of reinsurance (“IBNR”), represented a significant portion of the loss and loss expense reserve, net of reinsurance. As discussed in Note A and Note C to the consolidated financial statements, the carrying amount of the loss and loss expense reserve, net of reinsurance, is management’s best estimate of the ultimate liability for indemnity costs and related adjustment expense necessary to investigate and settle claims and is based upon individual case estimates for reported claims and actuarial estimates for IBNR. The estimate for IBNR is determined based on evaluations of individual reported claims and by actuarial estimation processes considering historical experience, relevant economic information, and available industry statistics. The IBNR estimate is driven by management’s expected loss ratio assumption, which is comprised of various factors, including historical payment patterns and expected future trends in claim severity and frequency.
We obtained an understanding, evaluated the design, and tested the operating effectiveness of controls over the process for estimating IBNR. These audit procedures included, among others, testing management’s review and approval controls over the expected loss ratio assumption for estimating IBNR.
With the assistance of actuarial specialists, our audit procedures included, among others, an evaluation of the Company’s expected loss ratio assumption, which included a comparison of historical payment patterns, expected future trends in claim severity and frequency, and consideration of relevant economic information and other industry factors to our prior year analysis and actual current year loss activity. To evaluate the expected loss ratio assumption, we developed an independent range of reasonable reserve estimates that we compared to management’s best estimate of IBNR. We also analyzed year-to-year movements within our independently developed range. Additionally, we performed a review of the development of prior years’ reserve estimates.
We obtained an understanding, evaluated the design, and tested the operating effectiveness of controls over the process for estimating the allowance. These audit procedures included, among others, testing management review and approval controls over the assumptions for estimating the allowance.
With the assistance of our valuation specialists, our audit procedures included, among others, reviewing contract terms between Personnel Staffing Group and the Company, reading minutes of the meetings of the committees of the board of directors, reading summaries of the lawsuits with Personnel Staffing Group, reviewing legal letters pertinent to the matter, reviewing historical bankruptcy data from similar entities within the industry, and evaluating the Company’s selection of methods used to estimate the allowance compared with those methods used in the industry for similar types of analyses. To evaluate the significant assumptions used by management, we compared the significant assumptions to industry data for entities with similar characteristics to Personnel Staffing Group and financial data specific to Personnel Staffing Group. With the assistance of the valuation specialists, we developed an independent range of reasonable allowance estimates that we compared to management’s best estimate.
Equity securities are recorded at fair value, with unrealized net gains or losses reflected as a component of net unrealized gains (losses) on equity securities and limited partnership investments within the consolidated statements of operations. Realized gains and losses on disposals of equity securities are recorded on the trade date and included in net realized gains (losses) on investments, excluding impairment losses.
Deductible Receivables: Under certain workers’ compensation insurance contracts with deductible features, the Company is obligated to pay the claimant for the full amount of the claim. The Company is subsequently reimbursed by the policyholder for the deductible amount. These amounts are included on a net of allowance basis in the consolidated balance sheets within accounts receivable. The allowance is based upon the Company’s ongoing review of amounts outstanding, changes in policyholder credit standing, and other relevant factors. A probability-of-default methodology, which reflects current and forecasted economic conditions, is used to estimate the allowance for expected credit losses for uncollateralized deductible receivables. As of December 31, 2020, the Company recorded an allowance for expected credit losses of $16,500 ($13,035, net of tax). See Note T - Litigation, Commitments and Contingencies for further discussion.
Recognition of Revenue and Costs: Premiums are earned over the period for which insurance protection is provided. A reserve for unearned premiums is established to reflect amounts applicable to subsequent accounting periods. Commissions to unaffiliated companies and premium taxes applicable to unearned premiums are deferred and expensed as the related premiums are earned. The Company does not defer acquisition costs that are not directly variable with the production of premiums. If it is determined that expected losses and deferred expenses will likely exceed the related unearned premiums, the asset representing deferred policy acquisition costs is reduced and an expense is charged against current operations to reflect any such premium deficiency. In the event that the expected premium deficiency exceeds deferred policy acquisition costs, an additional liability would be recorded with a corresponding expense to current operations for the amount of the excess premium deficiency. Anticipated investment income is considered in determining recoverability of deferred acquisition costs. The Company had no material contract assets, contract liabilities, or deferred contract costs recorded on its consolidated balance sheet at December 31, 2020.
Reinsurance: Reinsurance premiums, commissions, expense reimbursements and reserves related to the Company's reinsured business are accounted for on bases consistent with those used in accounting for the original policies issued and the terms of the reinsurance contracts. Premiums ceded to other insurers have been reported as a reduction of premiums earned. Amounts applicable to reinsurance ceded for unearned premiums and claim loss reserves have been reported as reinsurance recoverable assets. Certain reinsurance contracts provide for additional or return premiums and commissions based upon profits or losses to the reinsurer over prescribed periods. Estimates of additional or return premiums and commissions are adjusted quarterly to recognize actual loss experience to date, as well as projected loss experience applicable to the various contract periods. Estimates of reinstatement premiums on reinsurance contracts covering catastrophic events are, to the extent reasonably determinable, recorded concurrently with the related loss.
Deferred Taxes: Deferred income tax assets and liabilities are recognized for temporary differences between the financial statement and tax return bases of assets and liabilities based on enacted tax rates and laws. The deferred tax benefits of the deferred tax assets are recognized to the extent realization of such benefits is more likely than not. Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be realized. Deferred income tax expense or benefit generally represents the net change in deferred income tax assets and liabilities during the year. Current income tax expense represents the tax liability associated with revenues and expenses currently taxable or deductible on various income tax returns for the year reported.
Restricted Stock: Shares of restricted stock vest over the vesting period from the date of grant and certain shares of restricted stock are accelerated for retirement-eligible recipients in accordance with the non-substantive, post-grant date vesting clause of Accounting Standards Codification ("ASC") Topic 715, Compensation-Retirement Benefits. Restricted stock is valued based on the closing price of the Company's Class B Common Stock on the day the award is granted.
The updated guidance in ASU 2016-13 also amended the previous other-than-temporary impairment (“OTTI”) model for available-for-sale fixed income securities by requiring the recognition of impairments relating to credit losses through an allowance account and limits the amount of credit loss to the difference between a security’s amortized cost basis and its fair value. In addition, the length of time a security has been in an unrealized loss position will no longer impact the determination of whether a credit loss exists. The Company adopted the guidance related to available-for-sale fixed income securities on January 1, 2020 using a prospective transition approach for available-for-sale fixed income securities that were purchased with credit deterioration or had recognized an OTTI write-down prior to the effective date. The effect of the prospective transition approach was to maintain the same amortized cost basis before and after the effective date.
In August 2018, the FASB issued ASU No. 2018-13, Fair Value Measurement (Topic 820): Disclosure Framework - Changes to the Disclosure Requirements for Fair Value Measurement, or ASU 2018-13. This update removed the disclosure requirements for the amounts of and the reasons for transfers between Level 1 and Level 2 and disclosure of the policy for timing of transfers between levels. This update also removed disclosure requirements for the valuation processes for Level 3 fair value measurements. Additionally, this update added disclosure requirements for the changes in unrealized gains and losses for recurring Level 3 fair value measurements and quantitative information for certain unobservable inputs in Level 3 fair value measurements. The Company adopted ASU 2018-13 as of January 1, 2020. As the requirements of this guidance are applicable to disclosure only, the adoption of ASU 2018-13 had no material impact on the Company's consolidated financial statements.
Following is a summary of the components of net realized and unrealized gains (losses) for the years ended December 31, 2020, 2019 and 2018:
As discussed in Note A, the Company adopted the provisions of the new CECL model for measuring expected credit losses for available-for-sale fixed income securities as of January 1, 2020. The updated guidance amended the previous OTTI model for available-for-sale fixed income securities by requiring the recognition of impairments relating to credit losses through an allowance account on the consolidated balance sheet with a corresponding adjustment to earnings and limiting the amount of credit loss to the difference between a security’s amortized cost basis and its fair value. For those securities in an unrealized loss position throughout the year where the Company intended to sell the security at the balance sheet date, a write down to earnings of $1,826 was recorded during the year ended December 31, 2020. The Company also analyzed securities in an unrealized loss position for credit losses and recorded an allowance for credit losses of $1,035 as of December 31, 2020. The Company reviewed its remaining fixed income securities in an unrealized loss position as of December 31, 2020 and determined the losses were the result of non-credit factors, such as the increase in market volatility due to the disruption in global financial markets as a result of the novel coronavirus ("COVID-19") pandemic and responses to it. The Company currently does not intend to sell nor does it expect to be required to sell these securities before recovery of their amortized cost.
Gain and loss activity for fixed income securities, as shown in the previous table, includes adjustments for impairment losses on investments for the years ended December 31, 2020, 2019 and 2018 summarized as follows:
There is no primary market and only a limited secondary market for the Company's investments in limited partnerships and, in most cases, the Company is prohibited from disposing of its limited partnership interests for some period of time and generally must seek approval from the applicable general partner for any such disposal. Distributions of earnings from these partnerships are largely at the sole discretion of the general partners, and distributions are generally not received by the Company for many years after the earnings have been reported. The Company has a commitment to contribute up to an additional $350 to a limited partnership as of December 31, 2020.
The Company's fixed income securities are over 93% invested in investment grade fixed income investments. The Company has no fixed income investments that were originally issued with guarantees by a third-party insurance company nor does the Company have any direct exposure to any guarantor at December 31, 2020.
Approximately $63,660 of fixed income investments (6.1% of the Company's consolidated investment portfolio, which includes money market instruments classified as cash equivalents) consists of non-rated bonds and bonds rated as less than investment grade at year-end. These investments have a $2,230 aggregate net unrealized gain position at December 31, 2020.
Activity in the reserves for losses and loss expenses for the years ended December 31, 2020, 2019 and 2018 is summarized as follows. All amounts are shown net of reinsurance, unless otherwise indicated.
The reconciliation of the net incurred and paid claims development tables to the liability for claims and claim adjustment expenses in the consolidated balance sheet at December 31, 2020 and 2019 is as follows.
Net losses and loss expenses incurred for 2020, 2019 and 2018 have been reduced by ceded reinsurance recoveries of approximately $105,895, $121,927 and $148,173, respectively. Ceded reinsurance premiums and loss recoveries for the purchase of catastrophe reinsurance coverage on the Company's net direct business were not material.
On December 22, 2017, the U.S. Tax Cuts and Jobs Act (the "U.S. Tax Act") was signed into law, which lowered the U.S. corporate income tax rate from 35% to 21% effective January 1, 2018. The Company finalized its accounting for the tax effects of the U.S. Tax Act during 2018. No material adjustments to income tax expense (benefit) were recorded during 2018.
A summary of the difference between federal income tax expense (benefit) computed at the statutory rate and that reported in the consolidated financial statements as of December 31, 2020, 2019 and 2018 is as follows:
Federal income tax expense (benefit) as of December 31, 2020, 2019 and 2018 consists of the following:
The provision for deferred federal income taxes as of December 31, 2020, 2019 and 2018 consists of the following:
In March 2018, the Company's Compensation Committee, now known as the Compensation and Human Capital Committee (the "Committee"), granted equity-based awards pursuant to the Company's Long-Term Incentive Plan (the "Long-Term Incentive Plan"). Certain participants under the Long-Term Incentive Plan were granted equity awards (the "2018 LTIP Awards"), with the number of shares of Class B Common Stock earned pursuant to such awards determined by applying a performance matrix consisting of a measurement of the combined results of the Company's 2018 growth in gross premiums earned and the Company's 2018 combined ratio. The combined ratio is calculated as a ratio of (A) losses and loss expenses incurred, plus other operating expenses, less commission and other income to (B) net premiums earned. No 2018 LTIP Awards were earned based on the Company's performance in 2018, and therefore no shares were issued pursuant to the 2018 LTIP Awards. In addition to the 2018 LTIP Awards, in March 2018 the Committee also granted Value Creation Incentive Plan awards (the "2018 VCIP Awards") to certain participants under the Long-Term Incentive Plan. The 2018 VCIP Awards are performance-based equity awards that could be earned based on the Company's cumulative operating income over a three-year performance period from January 1, 2018 through December 31, 2020 relative to a cumulative operating income goal for the period set by the Committee in March 2018. For the purpose of the 2018 VCIP Awards, cumulative operating income is equal to income before taxes excluding net realized gains (losses) on investments. Any 2018 VCIP Awards earned would have been paid in unrestricted shares of the Company's Class B Common Stock at the end of the three-year performance period, but no later than March 15, 2021. No shares were earned under the 2018 VCIP Awards for the three-year performance period ended December 31, 2020.
On November 13, 2018, the Company entered into an employment agreement with its Interim Chief Executive Officer, John D. Nichols, Jr. Pursuant to the terms of this employment agreement, on November 13, 2018, Mr. Nichols was granted 85,000 restricted shares of the Company's Class B Common Stock (the "Nichols Stock Grant"), of which 42,500 shares vested as of October 17, 2019, 21,250 shares vested as of October 17, 2020, and 21,250 shares will vest as of October 17, 2021. The Company incurred $193 of expense during the year ended December 31, 2020 related to the Nichols Stock Grant.
In March 2019, the Committee granted equity-based awards pursuant to the Long-Term Incentive Plan. Certain participants under the Long-Term Incentive Plan were granted equity awards (the "2019 LTIP Awards"), with the number of shares of Class B Common Stock earned pursuant to such awards determined by applying a performance matrix consisting of a corporate performance component as well as a personal performance component. The corporate performance component of the 2019 LTIP Awards was determined based on the Company's achievement of 2019 underwriting income compared to the plan target. The Company's underwriting income was calculated as income (loss) before federal income tax expense (benefit), less net realized and unrealized gains (losses) on investments, less net investment income. The personal performance component of the 2019 LTIP Awards was determined based on the achievement of personal goals that aligned with departmental and corporate objectives for 2019. 2019 LTIP Awards earned were paid in shares of restricted Class B Common Stock in early 2020. One-third of such shares will vest annually over the three-year period beginning one year from the date of issue. The Company incurred $110 of expense during the year ended December 31, 2020 related to the 2019 LTIP Awards.
On May 22, 2019, the Company entered into an employment agreement with its new Chief Executive Officer, Jeremy D. Edgecliffe-Johnson. Pursuant to the terms of this employment agreement, on May 22, 2019, Mr. Edgecliffe-Johnson was granted 70,000 restricted shares of the Company's Class B Common Stock (the "Edgecliffe-Johnson Stock Grant"), of which 35,000 shares will vest as of June 1, 2022, 21,000 shares will vest as of June 1, 2023, and 14,000 shares will vest as of June 1, 2024. The Company incurred $240 of expense during the year ended December 31, 2020 related to the Edgecliffe-Johnson Stock Grant.
On July 6, 2020, the Committee granted a total of 101,400 restricted shares of the Company's Class B Common Stock to certain members of senior management under the Long-Term Incentive Plan. These 101,400 restricted shares will vest on July 1, 2023, subject to the recipient’s continued employment with the Company through the vesting date. The Company incurred $221 of expense during the year ended December 31, 2020 related to this grant.
The following is a reconciliation of the denominators used in the calculation of basic and diluted earnings (loss) per share for the years ended December 31:
The Company's balance sheet includes paid and estimated unpaid amounts recoverable from reinsurers under various agreements. These recoverables are only partially collateralized. The two largest amounts due from individual reinsurers, net of collateral and offsets, were $55,097 and $46,488 at December 31, 2020.
Inputs other than quoted prices included in Level 1 that are observable for the asset or liability through corroboration with market data at the measurement date.
Transfers between levels, if any, are recorded as of the beginning of the reporting period. There were no significant transfers of assets between Level 1 and Level 2 during 2020 or 2019.
A summary of the carrying value and fair value by level of financial instruments not recorded at fair value on the Company's consolidated balance sheets at December 31, 2020 and 2019 is as follows:
The Company utilizes the services of an investment firm of which one director of the Company is a partial owner. This investment firm manages equity securities and fixed income portfolios held by the Company with an aggregate market value of approximately $7,796 at December 31, 2020. Total commissions and net fees earned by this investment firm and its affiliates on these portfolios were $110, $145 and $103 for the years ended December 31, 2020, 2019 and 2018.
In February 2020, the Indiana Court issued an order dismissing the Indiana Action without prejudice; the Indiana Court declined to rule on the legal effect of the forum selection clause in the parties’ agreements, finding that any interpretation should be addressed by the court in the California Action. Following the court's granting of Protective’s motion to dismiss in the California Action, on May 1, 2020, Protective filed a motion with the Indiana Court to re-open the Indiana Action, which was denied on September 23, 2020. On December 22, 2020, Protective moved for reconsideration of its Motion to Re-Open the Indiana Action, which the Indiana Court granted on February 5, 2021. On February 18, 2021, PSG moved for further reconsideration and for hearing, which was held on March 2, 2021. The Indiana court has taken the matter under advisement. Protective intends to vigorously pursue its claims against PSG, however, the ultimate outcome cannot be presently determined.
Pursuant to the terms of the workers’ compensation policies, Protective has a duty to adjust and pay claims arising under the policies regardless of whether PSG makes payments to Protective for deductible obligations under the policies. Under its contractual obligations to Protective, PSG is required to maintain a “loss fund” for the payment of claims, the balance of which is to remain at or above $4,000; in addition, PSG is required to provide collateral in an amount equal to 110% of Protective’s current open case reserves on workers’ compensation claims arising under the policies.
As of December 31, 2020, Protective had approximately $21,780 in receivables on claims arising under PSG’s workers’ compensation policies and had exhausted all collateral provided by PSG. Protective continues to pay claims settlements under the policies without reimbursement from PSG. For the past six months, the average monthly invoices have been approximately $740. PSG’s estimated ultimate obligation under the agreements is approximately $47,000 as of December 31, 2020 (inclusive of the $21,780 in receivables noted above). At December 31, 2020, based on the Company's assessment that PSG will continue to operate as a business and that the terms of the agreement with PSG will be legally enforceable, the Company believes that it will fully collect all current and future amounts due from PSG relating to this matter.
The Company included this matter in its assessment of the impact of adopting ASU 2016-13, the new guidance for measuring CECL, which is discussed in Note A. A probability-of-default methodology was applied to projected estimated cash flows to estimate the allowance for expected credit losses for this matter. The Company considered the delay in reimbursement for claims paid as well as probability of default assumptions when analyzing the credit loss related to this matter. As of January 1, 2020, in conjunction with the adoption of ASU 2016-13, the Company recorded an allowance for expected credit losses of $15,000 ($11,850, net of tax) as a reduction to equity. During the third quarter of 2020, the Company performed an update to its CECL allowance calculation related to the PSG matter. As noted above, there have been further delays in the litigation process, which have extended the estimated cash flow timing. As a result of these delays and an increase in the estimated ultimate obligation, the Company recorded an additional allowance of $1,500 ($1,185, net of tax) within other operating expenses in the condensed consolidated statement of operations in the third quarter of 2020. No additional allowance was recorded in the fourth quarter of 2020. In the event of a situation that results in no recovery from PSG, the Company would incur an estimated charge to the consolidated statement of operations of $30,500 ($24,095, net of tax), which represents the estimated ultimate obligation discussed above less the CECL allowance.
On February 14, 2021, the Company entered into an Agreement and Plan of Merger (the “Merger Agreement”) with The Progressive Corporation, an Ohio corporation (“Progressive”), and Carnation Merger Sub Inc., an Indiana corporation and wholly-owned indirect subsidiary of Progressive (“Merger Sub”). The Merger Agreement provides for, subject to the satisfaction or waiver of specified conditions, the merger of Merger Sub with and into the Company (the “Merger”), whereupon the separate existence of Merger Sub will cease and Protective will continue as the surviving corporation and as a wholly-owned indirect subsidiary of Progressive.
The Company's Board of Directors (the "Board"), at the unanimous recommendation of the Special Committee of the Board, unanimously determined that the Merger Agreement and the transactions contemplated thereby, including the Merger, are advisable and fair to, and in the best interests of, the Company and its shareholders, and approved, adopted and declared advisable the Merger Agreement and the transactions contemplated thereby. The Merger is expected to close prior to the end of the third quarter of 2021. At the effective time of the Merger, each issued and outstanding share of common stock, without par value, of the Company (other than each share of the Company’s common stock that is owned by the Company as treasury stock or by any subsidiary of the Company and each share of the Company’s common stock owned by Progressive, Merger Sub or any other subsidiary of Progressive immediately prior to the effective time of the Merger) will be automatically canceled and converted into the right to receive $23.30 in cash, without interest for a total transaction value of approximately $338 million.
The Merger Agreement contains various customary representations and warranties from each of the Company, Progressive and Merger Sub. The Company has also agreed to various customary covenants, including but not limited to conducting its business in the ordinary course and not engaging in certain types of transactions during the period between the execution of the Merger Agreement and the closing of the Merger. However, the Merger Agreement permits the Company to continue to pay regular quarterly dividends not to exceed $0.10 per share of the Company’s common stock. The Merger is subject to certain conditions, including approval of the Merger by the Company's Class A shareholders, legal and regulatory approvals including from the Indiana Department of Insurance and the expiration of the applicable waiting period under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended, as well as other customary closing conditions.