Costs and expenses related to the stock conversion incurred in the years ended December 31, 2003 and 2002. These costs and expenses are reported separately in our consolidated income statements within income from continuing operations before income taxes. 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.
Unallocated ESOP shares at December 31, 2005, 2004 and 2003, are not reflected in weighted average shares.
The Company and its subsidiaries underwrite property and casualty insurance in New Jersey and Pennsylvania. Beginning October 1, 2005, with the acquisition of Financial Pacific Insurance Group (Financial Pacific), the Group expanded its underwriting territories to California, Arizona, Nevada and Oregon. Our consolidated operating insurance company subsidiaries are:
Mercer Insurance Company of New Jersey, Inc., a New Jersey property and casualty stock insurance company offering insurance coverages to businesses and individuals located in New Jersey, and New York beginning in 2006, and
Franklin Insurance Company, a Pennsylvania property and casualty stock insurance company offering private passenger automobile and homeowners insurances to individuals located in Pennsylvania, and
Financial Pacific Insurance Company, a California property and casualty stock insurance company offering insurance and surety products to small to medium sized commercial businesses in California, Arizona, Nevada and Oregon and direct mail surety products to commercial businesses in various other states.
Reserves are closely monitored and are recomputed periodically using the most recent information on reported claims and a variety of statistical 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) must be 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 of our recent acquisition, Financial Pacific Insurance Company, is this type of longer-tailed casualty business.
The reported loss development method relies on the assumption that, at any given state of maturity, ultimate losses can be predicted by multiplying cumulative reported losses (paid losses plus case reserves) by a cumulative development factor. The validity of the results of this method depends on the stability of claim reporting and settlement rates, as well as the consistency of case reserve levels. Case reserves do not have to be adequately stated for this method to be effective; they only need to have a fairly consistent level of adequacy at all stages of maturity. Historical “age-to-age” loss development factors were calculated to measure the relative development of an accident year from one maturity point to the next. We then selected appropriate age-to-age loss development factors based on these historical factors and used the selected factors to project the ultimate losses.
In July of 1995, the California Supreme Court rendered its Opinion of Admiral Insurance Company vs. Montrose Chemical Corporation (the Montrose Decision). In that decision, the Supreme Court ruled that in the case of a continuous and progressively deteriorating loss, such as pollution liability (or construction defect liability), an insurance company has a definitive duty to defend the policyholder until all uncertainty related to the severity and cause of the loss is extinguished.
As a result of the Montrose Decision, Financial Pacific Insurance Company (a subsidiary of the Group since October 1, 2005) experienced a significant increase in construction defect liability cases, to which it would not have been subject under the old interpretation of the law. In response, Financial Pacific implemented a series of underwriting measures to limit the prospective exposure to Montrose and construction defect liability. These changes to coverage and risk selection resulted in a marked improvement in the post-Montrose underwriting results.
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 Company’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.
The table below summarizes the effect on net loss reserves and surplus in the event of reasonably likely changes in the variables considered in establishing loss and loss adjustment expense reserves. The range of reasonably likely changes was established based on a review of changes in accident year development by line of
The chart below displays case and IBNR reserves for the Group as of December 31, 2005 and 2004 by line of business:
We have one significant non-traded equity security, a non-voting common stock in Excess Reinsurance Company, which is carried at $1.1 million. Excess Reinsurance Company paid a special dividend to the Group in 2005 and 2004 in the amount of $183,000 and $274,000, respectively. Its fair value is estimated at the statutory book value as reported to the National Association of Insurance Commissioners (NAIC). Other non-traded securities, which are not material in the aggregate, are carried at cost.
We defer policy acquisition costs, such as commissions, premium taxes and certain other underwriting expenses that vary with and are primarily related to the production of business. These costs are amortized over the effective period of the related insurance policies. The method followed in computing deferred policy acquisition costs limits the amount of deferred costs to their estimated realizable value, which gives effect to the premium to be earned, related investment income, loss and loss adjustment expenses, and certain other costs expected to be incurred as the premium is earned. Future changes in estimates, the most significant of which is expected loss and loss adjustment expenses, may require acceleration of the amortization of deferred policy acquisition costs.
Revenue and income by segment is as follows for the years ended December 31, 2005, 2004 and 2003:
The availability of reinsurance at reasonable pricing is an important part of our business. The recent surge in catastrophic activity, particularly along the Gulf Coast, has placed reinsurers under greater financial pressures than experienced in recent years, and this has been reflected in their underwriting appetite, reinsurance terms, and to some degree, their rates. Our operating territories and the Group’s claim activity experienced only a minor impact from the residual effects of the hurricanes that ravaged the Gulf coast, and this was helpful in keeping our reinsurance program in place and without significant rate change on renewal.
Our personal lines underwriting performance in 2005 is significantly better than the prior year. This improved performance has been 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 Company 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
Net investment income increased 57.2% to $4.5 million, primarily as a result of increased yields on short-term investments held in the fixed-income investment portfolio and the acquisition of Financial Pacific and its net investment income. Realized investment gains amounted to $1.3 million in 2005, compared to a gain of $484,000 in 2004, with the higher level of realized gains in 2005 attributable to the disposition of securities in anticipation of funding the acquisition of Financial Pacific, Inc. on October 1, 2005, for $40.4 million in cash (excluding acquisition costs). Our other income, primarily service charges recorded on insurance premiums paid over the term of the policy instead of when the policy is issued, increased 115.6% in 2005 to $772,000, reflecting the inclusion of service charges recognized by Financial Pacific since its acquisition.
Total revenues for 2005 were up 36.7%, or $21.8 million, over 2004 revenues to $81.3 million. This increase was due primarily to inclusion of the revenue of Financial Pacific since its acquisition, which added $15.9 million of revenue, or 26.7 percentage points of the 36.7% increase in revenue in 2005. Net premiums earned increased 34.0%, or $19.0 million, to $74.8 million, with 24.9 percentage points, or $13.9 million of the 2005 increase, relating to the inclusion of Financial Pacific in the Group’s results. In 2005, net investment income increased 57.2% to $4.5 million, driven by higher short-term interest rates, and the inclusion of Financial Pacific’s net investment income since acquisition, which added $1.4 million, or 50.8 percentage points of the 57.2% increase. Realized gains increased 161.8% in connection with sales of mostly equity securities to fund the Financial Pacific acquisition. Realized gains also included in 2005 a gain of $122,000 relating to the mark-to-market fair value adjustment on interest rate swaps related to the floating-rate trust preferred securities.
In implementing the investment policy guidelines and directions of the Investment Committee of the Board of Directors, the fixed income securities managers during 2004 changed the composition of the fixed income securities portfolio to be more heavily weighted in tax-exempt securities, industrial and miscellaneous fixed income securities, and mortgage-backed securities, and less heavily weighted towards U.S government and government agencies fixed income securities, with a goal of increasing yields while continuing to maintain high credit qualities.
Dividend income in 2005 was down $114,000, or 16.9% from 2004. The decrease was caused by the sale of some equity securities during 2005 in order to fund the Financial Pacific acquisition, and also because the Group received a special dividend of $183,000 in 2005 on its investment in Excess Reinsurance Company, as compared to $274,000 in 2004.
The Company has entered into five interest rate swap agreements to hedge against interest rate risk on its floating rate trust preferred securities. For the quarter and year ended December 31, 2005, the Company’s net realized gain on the interest rate swap agreements was $122,000.
The fixed income portfolio is invested 100% in investment grade fixed income securities, with, as of December 31, 2005, an average rating of AAA, an average duration of 5.3 years (excluding mortgage-backed securities), and average tax equivalent yield of 4.57%. Our average portfolio duration approximates that of our insurance liabilities, and the portfolio maturities are laddered to ensure adequate liquidity.
The following table summarizes the period of time that equity securities sold at a loss during 2005 had been in a continuous unrealized loss position:
Our premiums earned growth reflects the Company’s focus on growing the commercial lines book, while working within our underwriting standards. Growth rates in our commercial lines direct premiums written have declined recently as compared to previous years, due to a more competitive marketplace. Some of our classes of business, consisting generally of the larger accounts, are more sensitive to competition than others. Competitive pressures tend to be more moderate for our smaller accounts, with a higher retention rate and less pressure on the renewal premium. We continually work with our agents to target classes of business and accounts compatible with our underwriting appetite, which includes certain types of religious institution risks, small business risks and property risks.
In the commercial lines segment for 2005, we had 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%, compared to an underwriting gain of $5.6 million, a GAAP combined ratio of 82.8%, a GAAP loss and loss adjustment expense ratio of 31.9% and an underwriting expense ratio of 50.9% for the same period in 2004. Our commercial lines loss ratio for 2005 has been adversely affected by a modestly higher amount of large property and casualty losses as compared to 2004, however the volume of new claims in 2005 is generally favorable. In addition, Financial Pacific’s commercial lines tend to operate with higher loss ratios and lower expense ratios than the Group’s commercial lines business prior to the acquisition of Financial Pacific, and so it is expected that a similar impact on commercial lines loss and expense ratios will be observed in quarter-on-quarter comparisons until Financial Pacific has been included in the Group’s operations for four quarters.
Excluding the policy count added by the acquisition of Financial Pacific, the Group’s largest increase in policy count was within our Religious Institutions sector, where our increasing market presence is helping us add new premium, and in our Special Contractors sector. We expect this trend of increasing commercial writings to continue by targeting selected types of risks with selected producers.
The Financial Pacific book focuses on targeted classes of business. One of the targeted classes, Contractors Commercial Liability, generates premium currently representing approximately 50% of Financial
Pacific’s book of business. While this class remains an important component, the Company is actively working to diversify its book of business by increasing production in other target programs, as well as leveraging our existing contractors liability book to add additional coverages such as commercial auto and commercial property. Financial Pacific’s geographic diversification includes California, Nevada, Arizona and Oregon, which accounted for $23.1 million, $2.5 million, $1.4 million and $1.0 million, respectively of direct premiums written of Financial Pacific for the fourth quarter of 2005.
The personal lines performance in 2005 was affected by a significantly lower frequency of losses and by a lower severity of losses as compared to 2004. The 2004 losses were significantly higher than usual, and were attributable to harsh weather conditions which resulted in a high number of losses from frozen pipes, structural collapses, more frequent automobile losses and accidents, and other losses of the type caused by an extended period of harsh weather.
Besides the improved loss frequency resulting from the more moderate weather in 2005, the personal lines book benefited from the underwriting initiatives undertaken in both the homeowners and Pennsylvania personal automobile lines in the last two years. These initiatives included the reclassification of certain homeowners risks from our preferred program to our standard program, resulting in a higher premium, as well as modified underwriting standards relating to the types of Pennsylvania personal automobile risks the Company will write. The Company implemented a rate increase for the homeowners line in New Jersey on July 1, 2005, and has achieved an overall average rate increase of approximately 5.7%. The impact of the Company’s underwriting initiatives in its Pennsylvania personal automobile line has resulted in lower direct premium written, as contraction in the number of policies in certain tiers has occurred more quickly than premium expansion in the targeted tiers. The direct loss ratio for our Pennsylvania personal automobile book has improved, however, as our targeted tiers have become a proportionately larger part of our book.
Although the Company expects to continue growing its personal lines book, it will continue to devote greater focus to growth in the commercial lines book.
The Company maintains various Agency Profit Sharing plans, which, in addition to base commissions, annually reward agents for the growth and profitability of the business they produce while representing the Company. The additional commission is computed only on the aggregate growth and profitability of the book of business the agent produces each year. The Company does not have any marketing services agreements, placement services agreements, or similar arrangements.
We are currently in the process of converting our information system, which is targeted for completion in the latter half of 2006. When completed, we expect some costs to moderate as implementation costs and costs associated with operating dual systems end. These reduced costs will be offset by some higher staffing costs, but we also should be positioned to expand premium volume in the near term without material incremental expense because of increased processing capacity.
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 Company’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 Company’s claim to recover previously paid retaliatory tax.
Federal income tax expense was $2.9 million for 2005, an effective rate of 29.5%, compared to $1.1 million, an effective rate of 25.1%, in 2004. The increase in the effective tax rate in 2005 is primarily attributable to the fact that tax-exempt investment income and dividend income (which reduce the effective tax rate) represented a smaller percentage of net income in 2005 than in 2004.
Net loss and loss adjustment expenses incurred increased in 2004 overall by only $405,000, or 1.5%, to $28.1 million, reflecting lower claims frequency in 2004 over 2003, despite growth in exposures in 2004 as our net premium earned grew by 16.5%. The lower loss and loss adjustment expense ratio in 2004 resulted from more normal weather patterns than were experienced in our operating territory in 2003, which included hail, tornados, and windstorms, all of which resulted in a higher than usual frequency of claims throughout most of 2003.
Loss development of prior year net loss and loss adjustment expense reserves was a favorable $0.9 million in 2004 and was generally attributable to accident years 2002 and 2003 for commercial multi-peril, commercial auto and other liability. Loss reserves for these and all other lines of business have been established based on company trends and our consideration of industry trends, and recent settlement of
reported cases has been favorable. This favorable development is a reflection of the disciplined underwriting employed by the Company in its risk selection process.
Net investment income increased $1.1 million, or 66.4% in 2004, due principally to the increased portfolio holdings resulting from the receipt of approximately $53 million of proceeds upon the completion of the Conversion. In addition, the Company received a special dividend of $274,000 in 2004 on its investment in Excess Reinsurance Company, compared to no dividend in 2003.
Effective January 1, 2004, the Company engaged a new management firm for its fixed income securities portfolio. One of its assignments was to invest the proceeds of the Conversion, which, given a difficult interest rate environment and fixed income securities market, was not largely completed until the second quarter of 2004. Consequently, a significant portion of the Conversion proceeds earned a cash-equivalent yield during this period. In addition, investment expenses increased in 2004 by approximately $210,000 for the cost of such management, compared to the prior commission-based fixed income securities management which existed while the Company was a mutual insurance company prior to the Conversion.
In implementing the investment policy guidelines and directions of the Investment Committee of the Board of Directors, the fixed income securities managers have changed the composition of the fixed income
The equity securities sold at a loss had been expected to appreciate in value but after reevaluation were sold so that sale proceeds could be reinvested. Securities were sold due to a desire to reduce exposure to certain issuers and industries or in light of changing economic conditions.
In the commercial lines segment for 2004, we had an underwriting gain of $5.6 million, a GAAP combined ratio of 82.8%, a GAAP loss and loss adjustment expense ratio of 31.9% and a GAAP underwriting expense ratio of 50.9%, compared to an underwriting gain of $3.1 million, a GAAP combined ratio of 88.1%, a GAAP loss and loss adjustment expense ratio of 39.1% and an underwriting expense ratio of 49.0% for 2003.
Underwriting expenses increased by $4.9 million, or 22.4%, to $27.0 million for 2004, from 2003. This increase was principally attributable to an increase in other underwriting expenses, growth in commissions
resulting from higher premium volume, and increased charges relating to corporate expenses and compensation expenses, including bonuses and agents profit-sharing, which were at higher levels than in 2003. In 2004, the Company had pre-tax costs associated with Sarbanes - Oxley compliance of $832,000, for which there were no costs in 2003, pre-tax costs of $383,000 associated with grants of restricted stock, for which there were no costs in 2003, and pre-tax costs of $874,000 associated with the allocation of shares to employee participants by the ESOP for 2004, for which the 2003 pre-tax cost was $568,000.
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 reducing the Company’s liability for retaliatory premium taxes, which should produce, on an annual basis, approximately $800,000 in relief from such taxes.
We are also in the process of building an information system platform that will allow our producers to conduct their business through the Internet or through the method they have historically used. As of December 31, 2005, we have spent $3.8 million on the development of this platform, which includes license fees for software used in the platform. It is anticipated to be completed in the latter part of 2006, at an additional cost of $800,000. Mercer Insurance Company possesses sufficient resources for these future expenditures without incurring any debt.
Total liabilities increased to $343.3 million at December 31, 2005, from $81.2 million at December 31, 2004, principally due to the acquisition of Financial Pacific Insurance Group. At December 31, 2005, the Financial Pacific acquisition added $176.2 million in loss and loss adjustment reserves, $46.8 million in unearned premiums, $17.4 million in reinsurance balances payable, trust preferred securities of $15.5 million, and approximately $9.4 million in other accounts payable and accrued liabilities. The Group’s liabilities without regard to the acquisition of Financial Pacific Insurance Group decreased by approximately $2.9 million, or 3.6%, primarily due to a $1.8 million decrease in unearned premiums to $32.2 million and a $500,000 decrease in loss and loss adjustment expense reserves to $35.5 million.
Total stockholders’ equity increased by $3.0 million, or 3.0%, due principally to 2005 earnings, offset in part by purchases of treasury stock in the amount of $3.2 million. Unrealized gains on the investment portfolio decreased $2.3 million (after-tax), due principally to the sale of a portion of the Company’s equity portfolio in preparation for funding the acquisition of Financial Pacific Insurance Group, Inc., on October 1, 2005.
The Company maintains an ESOP, which purchased 626,111 shares from the Company 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 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 Company’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.
Mercer Insurance Group, Inc. adopted a stock-based incentive plan at its 2004 annual meeting of shareholders. Pursuant to that plan, Mercer Insurance Group may issue a total of 876,555 shares, which amount will increase automatically each year by 1% of the number of shares outstanding at the end of the preceding year. At December 31, 2005, the shares authorized under the plan has been increased under this provision to 944,597 shares. The fair market value of any common stock used for restricted stock awards initially is classified as unearned compensation, and is then amortized ratably against earnings. As Mercer Insurance Group accrues compensation expense to reflect the vesting of such shares, unearned compensation is reduced accordingly. This compensation expense is deductible for federal income tax purposes upon vesting under current law. During 2004, the Company made grants of 215,000 shares of restricted stock, grants of 173,000 Incentive Stock Options, and grants of 364,700 non-qualified stock options. As of September 30, 2005, 7,500 shares of restricted stock and 18,500 stock options were forfeited, and 5,000 shares of restricted stock and 15,000 Incentive Stock options were granted. Additional grants of 10,000 shares of restricted stock, 112,575 Incentive Stock options, and 27,425 non-qualified options were made after September 30, 2005 to individuals employed by Financial Pacific Insurance Group in connection with its acquisition on October 1, 2005 by Mercer Insurance Group.
Insurance Group’s 2004 Stock Incentive Plan. In the aggregate, 500,000 shares have been repurchased 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 shares of stock were repurchased from employees in order to pay the required tax withholdings on the first vesting of restricted stock under the stock incentive plan.
In conjunction with making such payments, the Company filed notices of protest with the Division with respect to the retaliatory tax imposed. The basis for the protests was that the Division’s imposition of the retaliatory tax was unconstitutional and based on an incorrect interpretation of the law which denied the Company the ability to take advantage of New Jersey’s premium tax cap, which limits the premiums tax to the lesser of the Company’s New Jersey premiums or 12.5 percent of the Company’s total premiums received from both New Jersey and out-of-state policyholders. The protests currently are pending with the Division’s Conferences and Appeals branch.
Concurrent with the processing of the Company’s protests of the retaliatory tax, other foreign insurers have been litigating virtually identical issues in New Jersey courts. On March 9, 2005, the Appellate Division of the New Jersey Superior Court reversed a decision of the New Jersey Tax Court that had sustained the Division’s imposition of the retaliatory tax against a foreign insurer. The Division has since appealed the decision of the Appellate Division to the New Jersey Supreme Court, which has agreed to hear the case. The Company expects that the Division’s ruling on the Company’s protest will be based on the ultimate resolution of the case now being appealed to the New Jersey Supreme Court. The New Jersey Supreme Court has heard oral arguments, and currently has the case under consideration. It is not known how the New Jersey Supreme Court will rule in this case, and therefore the Company is unable to determine whether all, or any portion, of the retaliatory tax will be refunded. Any such refund would be reduced by related Federal Income Tax. Due to the contingencies involved, the Company has not accrued any refund of the retaliatory tax.
obligation, and operating lease obligations acquired with Financial Pacific. Projected cash disbursements pertaining to these obligations, as projected at December 31, 2005, are as follows:
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Mercer Insurance Group, Inc.’s internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 16, 2006, expressed an unqualified opinion on management’s assessment of, and the effective operation of, internal control over financial reporting.
On June 1, 2002, FHC was added to the Group when MIC purchased a 49% controlling interest in FHC and its wholly owned insurance subsidiary FIC (see note 12). The remaining 51% of FHC was purchased by MIG in conjunction with the Conversion.
The companies in the Group are operated under common management. The Group provides property and casualty insurance to both individual and commercial customers in New Jersey and Pennsylvania, and through the FPIG acquisition, property and casualty insurance and surety products to small and medium sized businesses in California, Arizona, Nevada and Oregon, as well as direct mail surety products to commercial businesses in various other states.
The Group’s business activities are separated into three operating segments, which are commercial lines of insurance, personal lines of insurance and the investment function. The commercial lines of business consist primarily of multi-peril and commercial auto coverage. These two commercial lines represented 55% and 12%, respectively, of the Group’s net premiums written in 2005. The personal lines business consist primarily of homeowners insurance in Pennsylvania and New Jersey and private passenger automobile insurance in Pennsylvania. These two personal lines represented 11% and 5%, respectively, of net written premiums in 2005.
Mercer’s business is subject to concentration risk with respect to both gross revenue and geographic concentration. Approximately 17%, 24% and 24% of the Company’s direct premiums written were produced in 2005, 2004 and 2003, respectively, by two agents, including one who is a related party (see Note 16 for information about related party transactions). In addition, although the Group’s operating subsidiaries are licensed collectively in twenty two states, direct premiums written for three states, New Jersey, California and Pennsylvania, constituted 54%, 25% and 16% of the 2005 direct premium written, 78%, 0%, and 22% of the 2004 direct premium written, and 77%, 0% and 23% of the 2003 direct premium written. Consequently, changes in production by these two agents or in the New Jersey, California or Pennsylvania legal, regulatory or economic environment could adversely affect the Company.
Due to periodic shifts in the portfolio arising from income tax and asset-liability matching, as well as securities markets and economic factors, management considers the entire portfolio of fixed-income securities as available for sale. Fixed-income securities available for sale and equity securities are stated at fair value with changes in fair value, net of deferred income tax, reflected in stockholders’ equity as accumulated other comprehensive income. Realized gains and losses are determined on the specific identification basis. A decline in the market value of an investment below its cost that is deemed other than temporary is charged to earnings. 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 created by the Company’s fixed income securities manager.
Cash, cash equivalents, and short-term investments are carried at cost which approximates fair value. The Group considers all highly liquid investments with a maturity of three months or less when purchased to be cash equivalents.
Cash and cash equivalents as of December 31, 2005 include restricted cash of $1,057, consisting of funds held for surety bonds.
Cash, cash equivalents, and short-term investments - The carrying amounts reported in the consolidated balance sheet for these instruments approximate their fair values.
Premium and reinsurance receivables - The carrying amounts reported in the consolidated balance sheet for these instruments approximate their fair values.
The Group cedes insurance to, and assumes insurance from, unrelated insurers to limit its maximum loss exposure through risk diversification. Ceded reinsurance receivables and unearned premiums are reported as assets; loss and loss adjustment expense reserves are reported gross of ceded reinsurance credits. Premiums receivable is recorded gross of ceded premiums payable.
Premiums include direct writings plus reinsurance assumed less reinsurance ceded to other insurers and are recognized as revenue over the period that coverage is provided using the daily pro-rata method. Unearned premiums represent that portion of premiums written that are applicable to the unexpired terms of policies in force. Revenue related to service fees is earned as billed. Agency commission and related fees are recognized based on the policy issue date.
The liability for losses includes the amount of claims which have been reported to the Group and are unpaid at the statement date as well as provision for claims incurred but not reported, after deducting
anticipated salvage and subrogation. The liability for loss adjustment expenses is determined as a percentage of the liability for losses based on the historical ratio of paid adjustment expenses to paid losses by line of business.
Management believes that the liabilities for losses and loss adjustment expenses at December 31, 2005 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.
See Note 1(q) below, “New Accounting Pronouncements” for further information about the Group’s adoption of Financial Accounting Standards No. 123R, “Share-Based Payment.”
The Group uses 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 the Group’s assets and liabilities and operating loss carryforwards. 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
Goodwill is tested annually for impairment, and is tested for impairment more frequently if events and circumstances indicate that the asset might be impaired. An impairment loss is recognized to the extent that the carrying amount exceeds the asset’s fair value. This determination is made at the reporting unit level and consists of two steps. First, the Group determines the fair value of a reporting unit and compares it to its carrying amount. Second, if the carrying amount of a reporting unit exceeds its fair value, an impairment loss is recognized for any excess of the carrying amount of the reporting unit’s goodwill over the implied fair value of that goodwill. The implied fair value of goodwill is determined by allocating the fair value of the reporting unit in a manner similar to a purchase price allocation, in accordance with Statement No. 141. The residual fair value after this allocation is the implied fair value of the reporting unit goodwill. The Group has two reporting units with goodwill at December 31, 2005. The Group performed the annual impairment tests as of December 31, 2005 and 2004, and the results indicated that the fair value of the reporting units exceeded their carrying amounts.
The Group entered into five interest rate swap agreements to hedge against interest rate risk on its floating rate Trust preferred securities. Interest rate swaps are contracts to convert, for a period of time, the floating rate of the Trust preferred securities into a fixed rate without exchanging the instruments themselves.
In December 2004, the Financial Accounting Standards Board issued SFAS No. 123R, “Share-Based Payments,” which is a revision of SFAS No. 123, “Accounting for Stock-Based Compensation.” SFAS 123R requires that the compensation cost relating to share-based payment transactions be recognized in financial statements. The compensation cost will be measured based on the fair value of the equity or liability instruments issued. The Statement is effective as of the beginning of the first interim or annual period beginning after June 15, 2005. The impact of adopting SFAS No. 123R on net income and earnings per share is not currently expected to be materially different from the pro forma amounts included in note 1(m) above, which includes all share-based payment transactions through December 31, 2005. The impact that any future share-based payment transactions will have on our financial position or results of operations is not yet known.
The estimated fair value and unrealized loss for securities in a temporary unrealized loss position as of December 31, 2005 are as follows:
Fixed maturity investments with unrealized losses for less than twelve months are primarily due to changes in the interest rate environment. At December 31, 2004, the Group has sixteen fixed maturity securities with unrealized losses for more than twelve months. Of the sixteen securities with unrealized losses
The gross realized investment losses included write-downs for the other than temporary impairment of securities totaling $517, $15, and $454 for the years ended 2005, 2004 and 2003, respectively.
As a result of changes in estimates of insured events in prior years, the liabilities for losses and loss adjustment expense increased by $4,163 in 2005, and decreased by $886 and $596 in 2004, and 2003, respectively. These adjustments are primarily concentrated in the commercial multi-peril line in 2005, the commercial automobile, commercial multi-peril, and other liability lines in 2004, and the commercial multi-peril and workers’ compensation lines in 2003.
The provision for losses and loss adjustment expenses for claims occurring in prior years includes $4.7 million of adverse development related to Financial Pacific. The prior year development was caused by revisions in the ceded reserve estimates for commercial multi peril liability as well as strengthening of net loss and loss adjustment expense reserves for commercial multi peril liability as a result of improvements in the
assumptions and techniques supporting the reserve estimates partially offset by favorable development in other lines of business, predominantly commercial auto liability.
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 2005 and 2004 not exceeding $500, and in 2003 not exceeding $300 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 contain 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.
As of December 31, 2005, $6.3 million is due from Alea North America Insurance Company (“Alea”), which was previously was rated A- (Excellent), but presently is rated NR-4 (not rated by company request). Alea Group, the parent of Alea is now in voluntary runoff. Some of the Company’s treaties with Alea have contractual provisions that require a trust account to be set up in the event of downgrade. Management is currently working with Alea through its reinsurance intermediary to have Alea fund such a trust, which would
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 Company contributions on such compensation, are funded into a nonqualified plan benefiting affected individuals. The cost for these benefits was $177, $134, and $135 for 2005, 2004, and 2003, respectively. In addition, the Company generally makes a discretionary contribution each year, based on Company profitability, to both the qualified 401(k) plan, and, where applicable, to the nonqualified plan. The cost for this portion of the retirement plan was $201, $255, and $223 for 2005, 2004, and 2003, respectively.
At December 31, 2005, the Group’s subsidiary FHC has Federal income tax net operating loss carryforwards available to offset future Federal taxable income as follows:
A reconciliation of the Group’s statutory net income and surplus to the Group’s net income and stockholder’s equity, under U.S. generally accepted accounting principles, is as follows:
During 2006, the maximum dividend that may be paid by Financial Pacific Insurance Company without approval, in addition to those dividends required to service debt, for which pre-approval is required, is $3,933. During the quarter ended December 31, 2005, Financial Pacific Insurance Company paid dividends to Financial Pacific Insurance Group of $615.
On December 15, 2003, at the time of the Conversion, the Group acquired the remaining minority interest in FHC in exchange for 502,525 shares of Group. Additional goodwill of $1,797 was recorded at the time the minority interest was acquired.
Financial Pacific Insurance Group, Inc. is a holding company which wholly owns Financial Pacific Insurance Company (FPIC) and the Financial Pacific Insurance Agency (FPIA). FPIC writes commercial lines property and casualty insurance business predominantly in four western states, and FPIA is a California insurance agency selling property and casualty insurance products. The acquisition was made to further the Group’s goal of achieving additional product and geographic diversity and expansion of its commercial lines book.
The purchase price has been allocated based on an estimate of the fair value of the assets acquired and liabilities assumed as of October 1, 2005, as follows:
The following unaudited pro forma information presents the combined results of operations of Mercer Insurance Group, Inc. and Financial Pacific Insurance Group, Inc. for the twelve months ended December 31, 2005 and 2004, respectively, with pro forma purchase accounting adjustments as if the acquisition had been consummated as of the beginning of the periods presented. This pro forma information is not necessarily indicative of what would have occurred had the acquisition and related transactions been made on the dates indicated, or of future results of the Company.
The change in the carrying amount of goodwill for the years ended December 31, 2005 and 2004 is as follows:
Information regarding fixed stock option activity in Mercer Insurance Group’s plan is presented below:
In determining the pro-forma effect described in Note 1(m), the per share weighted-average fair value of options granted during 2004 was $4.19, and for 2005 was $4.44. The fair value of each option grant is estimated on the date of grant using the Black-Scholes 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 18.82%; risk-free interest rate of 4.35%, and an expected life of 7.1 years.
Grants of 215,000 shares of restricted stock were awarded to employees and non-employee Directors in 2004, with a forfeiture of 7,500 shares in 2005. Grants of 15,000 shares were awarded in 2005. The weighted average price per share on the grant date in 2004 was $12.21 per share, and in 2005 was $13.10 per share.
Included in the 2004 stock option grants were grants of 173,000 Incentive Stock Options, and 364,700 non-qualified stock options, and in the 2005 grants 112,575 Incentive Stock Options and 27,425 non-qualified stock options.
As of December 31, 2005, the Group occupied office space and leased equipment and vehicles under various operating leases that have remaining noncancelable lease terms in excess of one year. A summary of minimum future noncancelable lease commitments as of December 31, 2005 follows:
The Group produces a large percentage of its business through one insurance agent, Davis Insurance Agency (Davis), the owner of which is also an officer and board member of the companies within the Group. In 2005, 2004, and 2003, premiums written through Davis totaled 8%, 12% and 13%, respectively, of the Group’s direct written premiums. Commissions paid to Davis were $1,231, $1,336 and $1,314 in 2005, 2004, and 2003, respectively.
The Group had the following Trust Preferred Securities outstanding as of December 31, 2005:
The Trust preferred securities are subject to mandatory redemption, in whole or in part, upon repayment of the Junior Subordinated Debentures at maturity or their earlier redemption. The Group has the right to redeem the Junior Subordinated Debentures after December 4, 2007 for Trust I, after May 15, 2008 for Trust II and after September 30, 2008 for Trust III.
The Group has interest-rate related hedging instruments to manage its exposure on its debt instruments. The type of hedging instruments utilized by the Group are interest rate swap agreements (swaps). Interest differentials to be paid or received because of swap agreements are reflected as an adjustment in the consolidated statement of earnings over the swap period. By using hedging financial instruments to hedge exposures to changes in interest rates, the Group exposes itself to credit risk and market risk.
Credit risk is the failure of the counterparty to perform under the terms of the contract. When the fair value of a contract is positive, the counterparty owes the Group, which creates credit risk for the Group. When the fair value of a contract is negative, the Group owes the counterparty and, therefore, it does not possess credit risk. The Group minimizes the credit risk in hedging instruments by entering into transactions with high-quality counterparties whose credit rating is higher than Aa.
The Group is party to interest rate swap agreements to hedge the floating interest rate on the Junior Subordinated Debentures purchased by Trust I, Trust II and Trust III. The variable-rate debt obligations expose the Group to variability in interest payments due to changes in interest rates. Management believes it is prudent to limit the variability of a portion of its interest payments. To meet this objective, management enters into swap agreements to manage fluctuations in cash flows resulting from interest rate risk. These swaps change the variable-rate cash flow exposure on the debt obligations to fixed-rate cash flows. Under the terms of the interest rate swaps, the Group makes fixed interest rate payments and receives variable interest rate payments, thereby creating the equivalent of fixed-rate debt.
As of December 31, 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, 2005, the Group’s net unrealized gain on the interest rate swap agreements recognized in the consolidated statement of earnings was $122.
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 $1,329 as of December 31, 2005.