We believe that such owned and leased properties are suitable and adequate for our current business operations.
Operating income (loss), which is GAAP net income (loss) excluding net realized investment gains (losses) and results from discontinued operations, is the financial performance measure used by our management and Board of Directors to evaluate and assess the results of our businesses. Net realized investment activity is excluded because (i) net realized investment gains and losses are unpredictable and not necessarily indicative of current operating fundamentals or future performance of the business segments and (ii) in many instances, decisions to buy and sell securities are made at the holding company level, and such decisions result in net realized gains and losses that do not relate to the operations of the individual segments. Accordingly, we report operating income (loss) by segment in Note 16 of our Consolidated Financial Statements. Operating income (loss) does not replace net income (loss) as the GAAP measure of our consolidated results of operations.
As a result of our acquisition of Midlands in 2007, the combined operating results of PMA Management Corp. and Midlands have been reported in a new reporting segment, Fee-based Business. The results of PMA Management Corp. were previously included with the results of The PMA Insurance Group. For comparative purposes, the financial results of The PMA Insurance Group and PMA Management Corp. have been reclassified in all prior periods to reflect this change.
This discussion and analysis should be read in conjunction with our audited Consolidated Financial Statements and Notes thereto presented in Item 8 of this Form 10-K (“Consolidated Financial Statements”). You should also read our discussion of Critical Accounting Estimates beginning on page 56 for an explanation of those accounting estimates that we believe are most important to the portrayal of our financial condition and results of operations and that require our most difficult, subjective and complex judgments.
This Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) contains forward-looking statements, which involve inherent risks and uncertainties. Statements that are not historical facts, including statements about our beliefs and expectations, and statements containing words such as “believe,” “estimate,” “anticipate,” “expect” or similar words are forward-looking statements. These forward-looking statements may include estimates, assumptions or projections and are based on currently available financial, competitive and economic data and our current operating plans. Although management believes that our expectations are reasonable, there can be no assurance that our actual results will not differ materially from those expected, and therefore, you should not place undue reliance on such forward-looking statements. See “Cautionary Statements” on page 63 for a list of factors that could cause our actual results to differ materially from those contained in any forward-looking statement. Also, see “Item 1A - Risk Factors” for a further discussion of risks that could materially affect our business.
In November 2007, we announced that we were actively pursuing the sale of our Run-off Operations. Our Run-off Operations include our reinsurance and excess and surplus lines businesses which we placed into run-off in 2003 and 2002, respectively. In February 2008, we announced that we entered into a non-binding letter of intent with a third party and expect to execute a definitive stock purchase agreement in the first quarter of 2008. The transfer of ownership will be subject to regulatory approval. Because of the expected divestiture, we determined that these operations should be reflected as discontinued operations. As such, we recorded an after-tax impairment loss of $40.0 million in the fourth quarter of 2007, as the book value of our Run-off Operations was greater than the estimated net proceeds we expect to receive in a sale.
The Pennsylvania Insurance Department approved our requests for extraordinary dividends of $73.5 million in 2006 and $37.5 million in 2007 from PMA Capital Insurance Company (“PMACIC”), our reinsurance subsidiary in run-off. As a result of the extraordinary dividends received from PMACIC, we were able to significantly reduce our outstanding debt, acquire Midlands, repurchase shares of our Class A Common Stock and improve liquidity at our holding company.
On October 1, 2007, we entered into a Stock Purchase Agreement under which we acquired all of the stock of Midlands Holding Corporation. Under the Stock Purchase Agreement, we paid cash of $19.8 million for the company’s stock on the closing date. The ultimate purchase price for the stock, which could range from $22.8 million to $44.5 million, will be based on the future earnings growth of Midlands, the operating subsidiary of Midlands Holding Corporation, over the next four years.
In May 2007, our Board of Directors authorized us to repurchase up to $10.0 million of our Class A Common Stock from time to time in the open market at prevailing prices or in privately negotiated transactions. In 2007, we repurchased 986,522 shares, or 3%, of our Class A Common Stock at a cost of $10.0 million under this authorization.
dividends and premium adjustments that are paid to policyholders of certain of our insurance products.
Operating income, which we define as net income (loss) excluding realized gains (losses) and the results from discontinued operations, increased to $14.4 million for 2007, compared to $4.5 million in 2006 and an operating loss of $5.1 million in 2005.
premiums earned. A combined ratio of less than 100% reflects an underwriting profit. Because time normally elapses between the receipt of premiums and the payment of claims and certain related expenses, we invest the available premiums. Underwriting results do not include investment income from these funds. Given the long-tail nature of our liabilities, we believe that the operating ratios are also important in evaluating our business. The operating ratio is equal to the combined ratio less the net investment income ratio, which is computed by dividing net investment income by net premiums earned.
Direct writings of commercial lines of business other than workers’ compensation, such as commercial auto, general liability, umbrella, multi-peril and commercial property lines (collectively, “Commercial Lines”), increased by $4.3 million in 2007, compared to 2006. Our renewal retention rate on existing commercial lines accounts in 2007 was 89% and new business premium was $13.4 million. Direct writings of commercial lines premiums decreased by $1.5 million in 2006, compared to 2005. Our renewal retention rate on existing accounts in 2006 was 84% and new business premium was $6.9 million, compared to 80% and $15.8 million, respectively, in 2005. Overall pricing on other commercial lines decreased by 2% in 2007, compared to prior year. In 2006, overall pricing increased modestly, compared to 2005, and it increased by 4% in 2005.
Premiums assumed decreased by $10.3 million in 2007, compared to 2006, primarily due to a reduction in the involuntary residual market business assigned to us. Although our direct premiums written in 2007 increased, we believe the decline in assumed premiums assigned to us was a result of more business written in the traditional market and less business assigned to the total involuntary market pool. In 2006, premiums assumed increased by $1.1 million, compared to 2005, due to an increase in the involuntary residual market business assigned to us, which mainly resulted from the fluctuation in our direct premiums written. Companies that write premiums in certain states generally must share in the risk of insuring entities that cannot obtain insurance in the voluntary market. Typically, an insurer’s share of this residual market business is assigned on a lag based on its market share in terms of direct premiums in the voluntary market. These assignments are accomplished either by direct assignment or by assumption from pools of residual market business.
The loss and LAE ratio improved 1.8 points in 2007, compared to 2006. The improved loss and LAE ratio primarily reflected a lower current accident year loss and LAE ratio in 2007, compared to 2006. While our underwriting criteria remained consistent in 2007, our current accident year loss and LAE ratio continued to benefit from changes in the type of workers’ compensation products selected by our insureds and a reduced amount of integrated disability and assumed premiums in 2007. Pricing changes coupled with payroll inflation for rate-sensitive workers’ compensation were slightly below overall estimated loss trends. We estimated our medical cost inflation to be 7% during 2007, compared to our estimate of 8.5% in 2006. We believe workers’ compensation medical inflationary trends are generally lower in 2007 relative to 2006. In addition, the medical cost inflation rate has declined due to our enhanced network and managed care initiatives. However, we expect that medical cost inflation will continue to be a significant component of our overall loss experience.
The policyholders’ dividend ratio increased 1.1 points in 2007, compared to 2006. The current year reflected better loss experience, which resulted in larger dividends on participating products where the policyholders may receive a dividend based, to a large extent, on their loss experience.
The total expense ratio improved 1.7 points in 2007, compared to 2006. Overall operating expenses decreased in 2007, compared to 2006, reflecting lower loss based state assessments and a reduction in the allowance for uncollectible reinsurance. We earn an administration fee under our agreement with Midwest based on the amount of premiums earned. The fees earned under our agreement with Midwest reduced our 2007 acquisition expense ratio by 0.7 points. Although our agreement with Midwest terminated in March 2008, we will continue to earn fee income on this business until the underlying policies expire.
Net investment income increased by $3.1 million and $3.2 million in 2007 and 2006, respectively, compared to the immediately preceding year. The improvements in 2007 and 2006 were primarily due to higher yields on increased average invested asset bases.
On October 1, 2007, we acquired Midlands, an Oklahoma City-based managing general agent, program administrator and provider of TPA services. As a result of this acquisition, we reported the combined operating results of Midlands and PMA Management Corp. as our Fee-based Business segment. The results of PMA Management Corp. were previously included in The PMA Insurance Group segment. PMA Management Corp. provides claims administration, risk management and managed care related services to self-insured clients and large deductible and captive clients. For comparative purposes, we have reclassified our prior period financial presentation to conform to these changes. Our operating results for 2007 include only the operating results of Midlands from the date of acquisition.
Operating expenses were $4.3 million higher in 2006 than in 2005. Of this increase, $2.2 million related to direct costs associated with the claims and managed care services provided to self-insured clients, and $1.2 million was attributable to large deductible and captive clients.
Effective in 2007, we reported the results of our former Run-off Operations segment as discontinued operations. As a result of this change, the Corporate and Other segment was impacted by investment income previously eliminated in the Corporate and Other segment. For comparative purposes, all prior periods have been reclassified to reflect this change.
The Corporate and Other segment primarily includes corporate expenses and debt service. Corporate and Other recorded net expenses of $19.6 million, $21.6 million and $24.6 million in 2007, 2006 and 2005, respectively. The reductions in 2007 and 2006, compared to the immediately preceding year, were primarily due to lower interest expense. The reduced
For segment reporting purposes, we allocate interest income for the portion of our debt held at The PMA Insurance Group back to this segment and reduce investment income in the Corporate and Other segment. Although the Corporate and Other segment did not benefit from the reduced level of consolidated interest expense on the $9.1 million principal amount of our 6.50% Convertible Debt held at The PMA Insurance Group at December 31, 2007 and 2006, it did benefit from the reduced level of 6.50% Convertible Debt due to the $35 million mandatory redemption which occurred in June 2006, as well as the $18.1 million and $25.4 million of open market purchases made by PMA Capital Corporation in 2007 and 2006, respectively.
Summarized financial results from discontinued operations, which are reported as a single line, net of tax, below income from continuing operations in our consolidated statements of operations, were as follows:
Premiums earned in 2007, 2006 and 2005 were primarily attributable to retrospective adjustments of policies written prior to our exit from the reinsurance business. Premiums are earned principally on a pro rata basis over the coverage periods of the underlying policies. However, with respect to policies that provide for premium adjustments, such as experience-rated or exposure-based adjustments, such premium adjustments may be made subsequent to the end of the policy’s coverage period and will be recorded as earned premiums in the period in which the adjustment is made, as was the case in 2007, 2006 and 2005.
The timing of commutations and novations is unpredictable as each agreement is an individually negotiated transaction with one of our ceding companies. We will only execute commutation or novation agreements when we believe the result is economically beneficial. Due to these uncertainties, we do not have an expected level of commutation or novation activity in any year, and as such, the future timing of these agreements and their financial impact cannot be reasonably estimated.
Losses and LAE incurred in 2005 also included a first quarter charge of $30 million for adverse prior year loss development. In the first quarter of 2005, our actuaries identified higher than expected claim frequency and severity on policies covering contractors’ liability for construction defects from accident years 1998 to 2001 written by our former excess and surplus lines operation and an increase in reported losses and continued volatility in pro rata professional liability reinsurance business written from accident years 1997 to 2001.
Acquisition and operating expenses for 2007, 2006 and 2005 were significantly lower compared to the immediately preceding year due to our exit from the reinsurance business. In accordance with our exit plan, 109 employees have been terminated and 21 positions, primarily claims and financial personnel, remain at December 31, 2007. We have established an employee retention arrangement for the remaining employees. Under this arrangement, we have recorded expenses of $838,000, $1.0 million and $1.4 million, which included retention bonuses and severance, in 2007, 2006 and 2005, respectively.
Partially offsetting the reduced asset base in 2006, compared to 2005, were higher yields of approximately 30 basis points and lower net interest credited on funds held arrangements of $1.5 million. In a funds held arrangement, the ceding
Unpaid losses and LAE reflect our best estimate of future amounts needed to pay claims and related settlement costs with respect to insured events which have occurred, including events that have not been reported to us. Due to the “long-tail” nature of a significant portion of our business, in many cases, significant periods of time, ranging up to several years or more, may elapse between the occurrence of an insured loss, the reporting of the loss to us and our payment of that loss. We define long-tail business as those lines of business in which a majority of coverage involves average loss payment lags of several years beyond the expiration of the policy. Our major long-tail lines primarily include our workers’ compensation business. This business is subject to more unforeseen development than shorter tailed lines of business.
At December 31, 2007, 2006 and 2005, our gross reserves for asbestos-related losses were $25.7 million, $17.3 million and $22.3 million, respectively ($10.8 million, $9.8 million and $12.6 million, net of reinsurance, respectively). At December 31, 2007, 2006 and 2005, our gross reserves for environmental-related losses were $10.3 million, $11.9 million and $14.0 million, respectively ($0, $3.0 million and $4.1 million, net of reinsurance, respectively).
We believe that our unpaid losses and LAE are fairly stated at December 31, 2007. However, estimating the ultimate claims liability is necessarily a complex and judgmental process inasmuch as the amounts are based on management’s informed estimates, assumptions and judgments using data currently available. As additional experience and data become available regarding claims payment and reporting patterns, legal and legislative developments, judicial theories of liability, the impact of regulatory trends on benefit levels for both medical and indemnity payments, changes in social attitudes and economic conditions, the estimates are revised accordingly. If our ultimate losses, net of reinsurance, prove to differ substantially from the amounts recorded at December 31, 2007, then the related adjustments could have a material adverse impact on our financial condition, results of operations and liquidity. See “Critical Accounting Estimates - Unpaid Losses and Loss Adjustment Expenses” beginning on page 56 for additional information. In addition, see “Cautionary Statements”
Under our reinsurance and retrocessional coverages in place for our continuing operations during 2007, 2006 and 2005, we ceded earned premiums totaling $117.6 million, $58.8 million and $46.0 million, and we ceded losses and LAE of $102.8 million, $36.0 million and $42.3 million to reinsurers and retrocessionaires.
In the first quarter of 2006, we stopped writing integrated disability business. Effective August 1, 2007, we purchased reinsurance covering substantially all unpaid losses and LAE related to our integrated disability business. Under the agreement, the reinsurer also handles the servicing and benefit payments related to this business. Upon entering into this agreement, we ceded $25.7 million in carried loss and LAE reserves and paid $22.7 million in cash. Because the coverage is retroactive, we deferred the initial benefit of this cession, which is being amortized over the estimated settlement period of the losses using the interest method.
At December 31, 2007, we had reinsurance receivables for our continuing operations due from the following unaffiliated reinsurers in excess of 5% of our shareholders’ equity:
Includes Munich Reinsurance America, Inc. ($22.0 million) and American Alternative Insurance Company ($178,000).
At December 31, 2007, our reinsurance and retrocessional protection for major lines of business that we write was as follows:
Our maximum limit for any one claimant is $5.8 million. Effective January 1, 2008, our maximum limit increased to $7.5 million in layers excess of $10 million.
The PMA Insurance Group retains 25% of the first $3 million in property losses (including auto physical damage) on a quota share basis. Excess of loss reinsurance extends our per risk limits as shown above.
The PMA Insurance Group, exclusive of the business written by Midwest, does not write a significant amount of natural catastrophe exposed business. We actively manage our exposure to catastrophes through our underwriting process, where we generally monitor the accumulation of insurable values in catastrophe-prone regions. Our geographic exposure to loss is principally confined to the Northeast, the Mid-Atlantic States and the Southeast corresponding to the locations of our branch operations. The PMA Insurance Group, exclusive of the business written by Midwest, maintains property catastrophe reinsurance protection of 95% of $18.0 million excess of $2.0 million per occurrence.
Midwest underwrites and services workers’ compensation policies in California, which is exposed to earthquake peril. Upon inception, this business was 100% ceded to non-affiliated reinsurers. Effective April 1, 2007 and September 1, 2007, we retained 5% and 10%, respectively, of this business. Included as part of our reinsurance program for this business, but not included in our table above, is workers’ compensation catastrophe protection up to a limit of $100.0 million.
Although we believe that we have adequate reinsurance to protect against the estimated probable maximum gross loss from a catastrophe, an especially severe catastrophe or series of catastrophes, or a terrorist event, could exceed our reinsurance and/or retrocessional protection and may have a material adverse impact on our financial condition, results of operations and liquidity. In 2007, 2006 and 2005, our loss and LAE ratios were not significantly impacted by catastrophes.
In January 2006, the Terrorism Risk Insurance Extension Act of 2005 (“TRIEA”) became effective. TRIEA, which extended most of the original provisions of TRIA, expired on December 31, 2007. In December 2007, the Terrorism Risk Insurance Program Reauthorization Act of 2007 (“TRIPRA”) became effective. TRIPRA, which extends the program established under TRIA, provides a seven-year extension through December 31, 2014. For terrorist acts to be covered under TRIPRA, they must be certified as such by the United States Government and may be committed by individuals
Because of the unpredictable nature of terrorism, and the deductibles that The PMA Insurance Group would be subject to under TRIPRA, if future terrorist attacks occur, they may result in losses that could have a material adverse effect on our financial condition, results of operations and liquidity. For additional information regarding the underwriting criteria of our insurance operating segment, see “Item 1 - Business - The PMA Insurance Group, Underwriting.”
We believe that the potential for adverse reserve development is increased because our former reinsurance business is in run-off and we no longer have ongoing business relationships with most of our ceding companies. As a result, to the extent that there are disputes with our ceding companies over claims coverage or other issues, we believe that it is more likely that we will be required to arbitrate these disputes. Although we believe that we have incorporated this potential in our reserve analyses, we also believe that as a result of the nature of the reinsurance business and the fact that the reinsurance business is in run-off, there exists a greater likelihood that reserves may develop adversely in this segment. See the discussion under “Discontinued Operations - Premiums, Losses and Expenses” beginning on page 40 for additional information regarding increases in loss reserves for prior years.
For our discontinued operations during 2007, 2006 and 2005, we ceded earned premiums totaling ($582,000), ($157,000) and $2.9 million, and we ceded losses and LAE of ($3.6) million, $9.2 million and $28.3 million to reinsurers and retrocessionaires.
Amounts receivable from our reinsurers and retrocessionaires for our discontinued operations are presented with the gross assets of discontinued operations in a separate line on the Balance Sheet. At December 31, 2007 and 2006, we had amounts receivable from our reinsurers and retrocessionaires totaling $150.1 million and $319.9 million, respectively. As of December 31, 2007, $10.0 million, or 7%, of these amounts were due to us on losses we have already paid, compared to $10.0 million, or 3%, at December 31, 2006. The remainder of the reinsurance receivables related to unpaid claims.
At December 31, 2007 and 2006, our assets of discontinued operations with respect to reinsurance receivables were supported by $56.7 million and $83.6 million of collateral, respectively. Of the uncollateralized reinsurance receivables at December 31, 2007, approximately 95% was due from reinsurers rated “A-” or better by A.M. Best and is broken down as follows: “A++” - 11%; “A+” - 29%; “A” - 54% and “A-” - 1%. We believe that our assets of discontinued operations with respect to reinsurance receivables, net of the valuation allowance, are fully collectible. The timing of payments and the collectibility of reinsurance receivables have not had a material adverse effect on our liquidity.
The retroactive reinsurance purchased for adverse development protection was executed to protect the statutory capital of our reinsurance and excess and surplus lines businesses. As this contract was considered retroactive under Statement of Financial Accounting Standards No. 113, “Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts,” it did not protect GAAP capital or earnings volatility associated with adverse development.
As a result of our decision to exit from the reinsurance and excess and surplus lines of business, we expect that we will continue to use cash from the operating activities of these operations into the foreseeable future. In 2008, we entered into a non-binding letter of intent to sell our Run-off Operations to a third party. We expect to execute a definitive stock purchase agreement in the first quarter of 2008. The transfer of ownership will be subject to regulatory approval. Based on the letter of intent, we expect to receive cash at closing of $10 million and a $10 million, 5-year note, whose ultimate value is based on the future development of the loss reserves. We also expect to pay closing costs of approximately $500,000 related to the sale.
In a 2004 order (the “2004 Order”) approving the transfer of the Pooled Companies from PMACIC to PMA Capital Corporation, the Pennsylvania Insurance Department (the “Department”) prohibited PMACIC from declaring or paying any dividends, return of capital or other types of distributions to PMA Capital Corporation prior to 2006. Under the terms of the 2004 Order, PMACIC was permitted to request an “extraordinary” dividend, as defined under Pennsylvania law, in 2006 provided that immediately after giving effect to the dividend or return of capital, PMACIC’s risk-based capital equaled or exceeded 225% of Authorized Control Level Capital, as defined by the National Association of Insurance Commissioners. In 2006, the Department approved our request for an “extraordinary” dividend in the amount of $73.5 million from PMACIC. We used the proceeds to reduce our debt obligations and to maintain liquidity at the holding company. In 2007, the Department approved our request for an additional “extraordinary” dividend in the amount of $37.5 million from PMACIC. We used the proceeds to purchase Midlands, to repurchase shares of our Class A Common Stock and to maintain liquidity at the holding company. Given the anticipated sale of PMACIC, we do not expect to receive any dividends from this operation in 2008. As of December 31, 2007, the statutory surplus of PMACIC was $47.6 million.
The Pooled Companies, which are not subject to the Department’s 2004 Order, did not pay dividends to PMA Capital Corporation in 2007 or 2006. The Pooled Companies paid dividends of $7.0 million to PMA Capital Corporation in 2005. As of December 31, 2007, the Pooled Companies can pay up to $29.2 million in dividends to PMA Capital Corporation during 2008 without the prior approval of the Department. In considering their future dividend policy, the Pooled Companies will consider, among other things, the impact of paying dividends on their financial strength ratings. The Pooled Companies had statutory surplus of $335.4 million as of December 31, 2007, including $10.0 million relating to surplus notes.
Net tax payments received from subsidiaries were $37.7 million, $9.4 million and $5.6 million in 2007, 2006 and 2005, respectively. Net tax payments received in 2007 included tax payments related to off-shore reinsurance.
On October 1, 2007, we entered into a Stock Purchase Agreement with the shareholders of Midlands Holding Corporation, pursuant to which we acquired all of the stock of Midlands Holding Corporation. Under the Stock Purchase Agreement, we paid cash of $19.8 million for the company’s stock on the closing date. The ultimate purchase price for the stock, which could range from $22.8 million to $44.5 million, will be based on the future earnings growth of Midlands over the next four years. At December 31, 2007, we accrued $837,000 for estimated earnings growth payments. We expect to be able to pay most of any future earn-out payments through cash generated from Midlands’ operations. We also used holding company cash of $3.4 million for the return of estimated net worth on the closing date, which is subject to final adjustment in April 2008.
See discussion below for the variable interest rates on the junior subordinated debt and Surplus Notes. The obligations related to the junior subordinated debt and the Surplus Notes have been calculated using the interest rates in effect at December 31, 2007. This calculation includes the impact of interest rate swap agreements.
Includes expected benefit payments on our non-qualified pension and other postretirement benefit plans, which will be paid from the general assets of the Company.
Our unpaid losses and LAE do not have contractual maturity dates and the exact timing of payments cannot be predicted with certainty. However, based on historical payment patterns, we have included an estimate, gross of discount of $154.5 million, of when we expect our unpaid losses and LAE (without the benefit of reinsurance recoveries) to be paid. We maintain an investment portfolio with varying maturities that we believe will provide adequate cash for the payment of claims.
During 2007, we retired $18.1 million principal amount of our 6.50% Convertible Debt through open market purchases by PMA Capital Corporation. We paid $21.2 million for these bond purchases, exclusive of accrued interest. As the derivative component of the bonds was already reflected in the debt balance, the purchase activity did not result in any significant realized gain or loss.
The 6.50% Convertible Debt is secured equally and ratably with our $54.9 million 8.50% Monthly Income Senior Notes due 2018 (“8.50% Senior Notes”) by a first lien on 20% of the capital stock of our principal operating subsidiaries. This lien is released if the 6.50% Convertible Debt is no longer outstanding. The indenture governing the 6.50% Convertible Debt contains restrictive covenants with respect to limitations on our ability to incur indebtedness, enter into transactions with affiliates or engage in a merger or sale of all or substantially all of our assets. Subsequent to December 31, 2007, we retired the remaining $1.3 million principal amount of our 6.50% Convertible Debt for which we paid $1.5 million, exclusive of accrued interest. We are currently in the process of releasing the lien and restrictive covenants.
In June 2007, we issued $20.6 million of 30-year floating rate junior subordinated securities to a wholly-owned statutory trust subsidiary. We used the $20.0 million net proceeds to purchase, in the open market, our 6.50% Convertible Debt. The junior subordinated debt matures in 2037 and is redeemable, in whole or in part, immediately at 107.5% of par, or in 2012 at par, plus accrued and unpaid interest. The interest rate on the junior subordinated debt equals the three-month London InterBank Offered Rate (“LIBOR”) plus 3.55%, and interest on this debt is payable on a quarterly basis.
In September 2007, we entered into a new interest rate swap that we have designated as a cash flow hedge to manage interest costs and cash flows associated with the variable interest rates on a portion of our junior subordinated debt. There was no consideration paid or received for this swap. The swap will effectively convert $20.0 million of the junior subordinated debt to fixed rate debt with an interest rate of 8.29%.
We did not make a contribution to our qualified pension plan in 2007, 2006 or 2005. Our accumulated benefit obligation was greater than the fair value of plan assets by $4.9 million and $10.8 million at December 31, 2007 and December 31, 2006, respectively. The funded status of our qualified pension plan improved in 2007, due primarily to the increase in interest rates. In 2007 and 2006, we were not required to make any contribution to the pension plan under the minimum funding requirements of the Employee Retirement Income Security Act (“ERISA”) of 1974. In August 2006, the Pension Protection Act of 2006 (“PPA”) became law. Although we are not required to make any minimum funding contributions to our pension plan in 2007, we believe that the PPA will accelerate the timing of our future contributions. Our plan assets are composed of 35% fixed maturities, 55% equities and 10% other investments at December 31, 2007. We currently estimate that the pension plan’s assets will generate a long-term rate of return of 8.25%, which we believe is a reasonable long-term rate of return, in part because of the historical performance of the broad financial markets. We also maintain non-qualified pension plans with respect to which we pay benefits from the general assets of the Company. We expect benefit payments related to these non-qualified plans to be less than $500,000 in 2008. Pension expense in 2007, 2006 and 2005 was $59,000, $593,000 and $5.4 million, respectively.
In 2005, we decided to “freeze” our Qualified Pension Plan and Non-qualified Pension Plans as of December 31, 2005. Under the terms of the freeze, eligible employees retained all of the rights under these plans that they had vested as of December 31, 2005. We incurred a one-time non-cash charge of $229,000 in 2005 due to these changes. Effective January 1, 2006, our 401(k) and 401(k) Excess Plans were renamed The PMA Capital Corporation Retirement Savings Plan and The PMA Capital Retirement Savings Excess Plan and were enhanced to include quarterly age-based employer contributions.
Under the terms of the sale of one of our insurance subsidiaries, PMA Insurance Cayman, Ltd. (renamed Trabaja Reinsurance Company), to London Life and Casualty Reinsurance Corporation in 1998, we have agreed to indemnify the buyer, up to a maximum of $15.0 million, if the actual claim payments in the aggregate exceed the estimated payments upon which the loss reserves of the former subsidiary were established. If the actual claim payments in the aggregate are less than the estimated payments upon which the loss reserves have been established, we will participate in such favorable loss reserve development. Trabaja Reinsurance Company is our largest reinsurer. As of December 31, 2007, we are not aware of any significant changes from our original estimate. See Note 7 to the Consolidated Financial Statements for additional information.
Investment grade fixed income securities, substantially all of which are publicly traded, constitute substantially all of our invested assets. The market values of these investments are subject to fluctuations in interest rates.
We have structured our investment portfolio to provide an appropriate matching of maturities with anticipated claims payments. If we decide or are required in the future to sell securities in a rising interest rate environment, we would expect to incur losses from such sales. As of December 31, 2007, the duration of our investments that support the insurance reserves was 3.7 years, which approximates the duration of our insurance reserves of 3.9 years.
Mortgage-backed and other asset-backed securities in the table above include collateralized mortgage obligations (“CMOs”) of $318.2 million and $275.6 million carried at fair value as of December 31, 2007 and 2006, respectively. CMO holdings are all AAA rated and concentrated in tranches with limited prepayment, extension and default risk, such as planned amortization class bonds.
Of the $807.2 million in our investment portfolio, $21.8 million, or 3%, were residential mortgage-backed securities whose underlying collateral was either a sub-prime or alternative A mortgage. The $21.8 million, which includes $19.7 million of alternative A collateral and $2.1 million of sub-prime collateral, had an estimated weighted average life of 3.1 years, with $6.6 million of that balance expected to pay off within one year, and an average credit quality of AAA. The portfolio also held securities with a fair value of $23.0 million, or 3%, whose credit ratings were enhanced by various financial guaranty insurers. Of the credit enhanced securities, $17.9 million were asset-backed securities with a weighted average life of 3.7 years and whose underlying collateral had an imputed internal rating of “A”. None of these securities were wrapped asset backed security collateralized debt obligation exposures.
In addition to company-specific financial information and general economic data, we also consider our ability and intent to hold a particular security to maturity or until the fair value of the security recovers to a level at least equal to the amortized cost. Our ability and intent to hold securities to such time is evidenced by our strategy and process to match the cash flow characteristics of the invested asset portfolio, both interest income and principal repayment, to the actuarially determined estimated liability payout patterns of each insurance company’s claims liabilities. Where we determine that a security’s unrealized loss is other than temporary, a realized loss is recognized in the period in which the decline in value is determined to be other than temporary.
For securities that were in an unrealized loss position, the length of time that such securities have been in an unrealized loss position, as measured by their month end fair values, was as follows:
At December 31, 2007, of the 71 securities that have been in an unrealized loss position for more than 12 months, 70 securities have a total fair value of 99% of the amortized cost basis at December 31, 2007, and the average unrealized loss per security is approximately $22,000. The one security with an unrealized loss greater than 20% of its amortized cost at December 31, 2007 has a fair value of $545,000 and an amortized cost of $1.4 million. This security, which matures in 2033, is rated AAA, and its $1.4 million principal is backed and guaranteed at maturity by discounted agency securities. We have both the ability and intent to hold this security until it matures.
See “Item 1 - Business - Investments” and Notes 2B, 4 and 5 to our Consolidated Financial Statements for additional discussion about our investment portfolio.
In general, our businesses are subject to a changing social, economic, legal, legislative and regulatory environment that could materially affect them. Some of the changes include initiatives to restrict insurance pricing and the application of underwriting standards and reinterpretations of insurance contracts long after the policies were written in an effort to
provide coverage unanticipated by us. The eventual effect on us of the changing environment in which we operate remains uncertain.
Effective January 1, 2007, we early adopted Statement of Financial Accounting Standards No. 157, “Fair Value Measurements” (“SFAS 157”), and SFAS 159. See Notes 4 and 13 to our Consolidated Financial Statements for the impact of our adoption of these Statements.
In December 2007, the FASB issued Statement of Financial Accounting Standards No. 141 (revised 2007), “Business Combinations” (“SFAS 141R”). SFAS 141R replaces Statement of Financial Accounting Standards No. 141, “Business Combinations” (“SFAS 141”), although it retains the fundamental requirement in SFAS 141 that the purchase method of accounting be used for all business combinations. SFAS 141R establishes principles and requirements for how the acquirer in a business combination (a) recognizes and measures the assets acquired, liabilities assumed and any non-controlling interest in the acquiree, (b) recognizes and measures the goodwill acquired in a business combination or a gain from a bargain purchase and (c) determines what information to disclose regarding the business combination. SFAS 141R applies prospectively to business combinations for which the acquisition date is on or after the beginning of our 2009 fiscal year, and therefore, has no impact on the accounting for our 2007 acquisition of Midlands.
At December 31, 2007, we estimated that under all insurance policies and reinsurance contracts issued by our ongoing insurance business, our liability for all events that occurred as of December 31, 2007 was $1,213.0 million. This amount included estimated losses from claims plus estimated expenses to settle claims. Our estimate also included estimated amounts for losses occurring on or prior to December 31, 2007 whether or not these claims had been reported to us. At December 31, 2007, our estimate for such amounts recorded as liabilities of discontinued operations was $339.1 million.
Paid Loss Development - This method projects ultimate losses based on historical development trends of paid losses.
With respect to The PMA Insurance Group, our actuaries separately review the reserves for our workers’ compensation and integrated disability, commercial automobile and commercial multi-peril/general liability lines of business. The PMA Insurance Group’s loss reserves are comprised primarily of reserves for our workers’ compensation and integrated disability business (85% of the segment loss reserves). Commercial multi-peril/general liability reserves comprise 12% of this segment’s carried reserves, with 24% of such commercial multi-peril/general liability reserves being asbestos and environmental reserves (see page 42 of this Report on Form 10-K for more detail regarding asbestos and environmental loss reserves).
Our discontinued operations’ loss reserves are comprised primarily of excess of loss and pro rata reinsurance reserves (86% of the loss reserves). The excess of loss and pro rata reinsurance reserves are primarily casualty reserves, as only 8% of such reserves are for property business at December 31, 2007. The discontinued operations’ pro rata business is mainly quota share reinsurance of ceding companies’ excess or umbrella insurance. Therefore, our actuarial analysis of our excess of loss and pro rata reinsurance business is generally based upon similar assumptions and loss development patterns.
best estimate. At December 31, 2007, management’s best estimate reflects an estimate of loss and LAE reserves that is approximately the mid-point of our actuaries’ range of loss reserves.
We believe that the major factors that can cause actual results to vary from our estimates on our reinsurance business are changes in the experience and case reserving methodologies of our various ceding companies. This would affect the claims being reported to us, which, in turn, would affect our estimate of the frequency and severity of claims for the discontinued operations. The long-tail nature of a significant portion of this business (in many cases, significant periods of time, ranging up to several years or more, may elapse between the occurrence of an insured loss, the reporting of the loss to us and our payment of that loss) is also a major factor that could impact reserve development.
We have established a carried loss and LAE reserve for unpaid claims at December 31, 2007 that we believe is a reasonable and adequate provision based on the information then available to us and we believe such amounts are fairly stated at December 31, 2007. However, based upon our actuarial analysis at December 31, 2007, and as discussed in the previous paragraphs, there is a reasonable probability that the range of reserve estimates (which represents various estimations of the amount required to ultimately settle all losses and LAE for unpaid claims) at The PMA Insurance Group and the discontinued operations could be approximately five percent (5%) and seven percent (7%), respectively, greater or less than the loss and LAE reserve recorded for each such business on our consolidated financial statements at December 31, 2007, if significant assumptions, such as frequency, severity and medical cost inflation, which are components of our actuarial analysis develop differently than we currently anticipate. Because our carried reserves reflect management’s best estimate and are not determined by a formula that is automatically the direct product of the actuarial methods used to develop our range of reserves, we are unable to quantify in any meaningful way the effect of a change to any one of these significant assumptions underlying our actuarial process on our carried reserves. It is also possible that the amount required to settle all losses and LAE for unpaid claims or our estimates in future periods could exceed or be less than the reasonable range of possible outcomes that we can currently estimate.
If our future estimate of ultimate unpaid losses is greater than the recorded amounts, we would have to increase our reserves in subsequent periods. Any increase in our net reserves would result in a charge to earnings in the period recorded. For example, during the third quarter of 2007 and first quarter of 2005, we increased net reserves for our discontinued operations by $22 million and $30 million, respectively, and took earnings charges as a result. Accordingly, any reserve adjustment could have a material adverse effect on our financial condition, results of operations and liquidity.
During 2005, the discontinued operations recorded unfavorable prior year loss development of $28.8 million, which included a $30 million charge taken in first quarter. In the first quarter of 2005, our actuaries identified higher than expected claim frequency and severity on policies covering contractors’ liability for construction defects from accident years 1998 to 2001 written by our former excess and surplus lines operation and an increase in reported losses and
continued volatility in pro rata professional liability reinsurance business written from accident years 1997 to 2001. Specifically on policies covering contractors’ liability for construction defects, our discontinued operations experienced higher than expected reported claim frequency and slightly higher severity during the first quarter causing our actuaries to increase the number of expected claims to be reported in the future and slightly increase the average size of the future expected claims.
For additional information about our liability for unpaid losses and loss adjustment expenses, see Notes 4 and 6 to the Consolidated Financial Statements as well as “Item 1 - Business - Loss Reserves.”
All investments in our portfolio are carried at fair value. For all but two of our investment securities, we obtain the values from independent pricing services which use prices obtained in the public markets. These market prices reflect publicly reported values of recent purchase and sale transactions for each specific, individual security.
As part of determining the fair value for each specific investment that we hold, we evaluate each issuer’s ability to fully meet their obligation to pay all amounts, both interest and principal, due in the future. Because we have invested in fixed income obligations with an overall average credit quality of AAA-, and all of our investments are currently meeting their obligations with respect to scheduled interest income and principal payments, we believe that we will fully realize the value of our investments. However, future general economic conditions and/or specific company performance issues may cause a particular issuer, or group of issuers in the same industry segment, to become unable to meet their obligation to pay principal and interest as it comes due. If such events were to occur, then we would evaluate our ability to fully recover the recorded value of our investment. Ultimately, we may have to write down an investment to its then determined net realizable value and reflect that write-down in earnings in the period such determination is made.
Based on our evaluation of reinsurance receivables at December 31, 2007, we have established an allowance for amounts that we have concluded are uncollectible at the balance sheet date. In evaluating collectibility, we considered historical payment performance of our reinsurers, the fact that our reinsurers are current on their obligations to our insurance subsidiaries, and any known disputes or collection issues as of the balance sheet date. To these factors, we applied our informed judgment in ascertaining the appropriate level of allowance for uncollectible amounts. At December 31, 2007, approximately $48.9 million of uncollateralized reinsurance receivables at our continuing operations, including $29.0 million due for ceded IBNR, are due from reinsurers who have ratings that declined to below “Adequate,” defined as B++ or below by A.M. Best, or who were under regulatory supervision or in liquidation.
We record deferred tax assets and liabilities to the extent of the tax effect of differences between the financial statement carrying values and tax bases of assets and liabilities. The recoverability of deferred tax assets is evaluated based upon management’s estimates of the future profitability of our taxable entities based on current forecasts. We establish a valuation allowance for deferred tax assets where it appears more likely than not that we will not be able to recover the deferred tax asset. At December 31, 2007, PMA Capital has a net deferred tax asset of $118.9 million, resulting from $211.2 million of gross deferred tax assets reduced by a deferred tax asset valuation allowance of $60.5 million and by $31.9 million of deferred tax liabilities. In establishing the appropriate value of this asset, management must make judgments about our ability to utilize the net tax benefit from the reversal of temporary differences and the utilization of operating loss carryforwards that expire mainly from 2018 through 2027.
The valuation allowance of $60.5 million reserves against $50.9 million of gross deferred tax assets related to the NOL carryforward and the $9.6 million projected deferred tax asset related to the AMT credit carryforward because we believe it is more likely than not that this portion of the benefit will not be realized. We will continue to periodically assess the realizability of our net deferred tax asset. If our estimates of future income were to be revised downward and we determined that it was then more likely than not that we would not be able to realize the value of our net deferred tax asset, then this could have a material adverse effect on our results of operations and financial condition. For additional information, see Note 14 to our Consolidated Financial Statements.
On October 1, 2007, we entered into a Stock Purchase Agreement, pursuant to which we acquired all of the stock of Midlands Holding Corporation. As a result of this acquisition, we recorded $11.0 million and $11.1 million of identifiable intangible assets and goodwill, respectively. Intangible assets consist of non-contractual customer relationships, licenses and a trade name. Goodwill represents the excess of the fair value of the net identifiable assets over the purchase price. At December 31, 2007, we accrued $837,000 for estimated earnings growth payments, which increased goodwill.
our ability to increase the amount of new and renewal business written by The PMA Insurance Group at adequate prices or revenues of our fee-based businesses;
any future lowering or loss of one or more of our financial strength and debt ratings, and the adverse impact that any such downgrade may have on our ability to compete and to raise capital, and our liquidity and financial condition;
You should not place undue reliance on any such forward-looking statements in this Form 10-K. Forward-looking statements are not generally required to be publicly revised as circumstances change and we do not intend to update the forward-looking statements in this Form 10-K to reflect circumstances after the date hereof or to reflect the occurrence of unanticipated events.
Consolidated Statements of Operations for the years ended December 31, 2007, 2006 and
Consolidated Statements of Cash Flows for the years ended December 31, 2007, 2006 and
Consolidated Statements of Shareholders’ Equity for the years ended December 31, 2007, 2006 and 2005
Premiums receivable (net of valuation allowance: 2007 - $9,341; 2006 - $9,363)
Treasury stock, at cost (2007 - 2,456,839 shares; 2006 - 1,558,751 shares)
Fee-based Business - Fee-based Business consists of the results of PMA Management Corp. and Midlands Management Corporation (“Midlands”), and is a new reporting segment, resulting from the Company’s acquisition of Midlands on October 1, 2007. PMA Management Corp. is a TPA whose results were previously included in The PMA Insurance Group segment. Midlands is an Oklahoma City-based managing general agent, program administrator and provider of TPA services.
Discontinued operations - Discontinued operations, formerly the Company’s Run-off Operations segment, consist of the results of the Company’s former reinsurance and excess and surplus lines businesses. The Company’s former reinsurance operations offered excess of loss and pro rata property and casualty reinsurance protection mainly through reinsurance brokers. The Company withdrew from the reinsurance business in November 2003 and from the excess and surplus lines business in May 2002.
A. Basis of Presentation - The consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). All significant intercompany accounts and transactions have been eliminated in consolidation. The preparation of consolidated financial statements in conformity with GAAP requires management to make certain estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the period. Actual results could differ from those estimates.
Certain prior year amounts have been reclassified to conform to the current year classification. In 2007, the Company determined that the results of its Run-off Operations should be reported as discontinued operations. In accordance with Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-lived Assets” (“SFAS 144”), the Balance Sheets have been presented with the gross assets and liabilities of discontinued operations in separate lines and the Statements of Operations have been presented with the net results from discontinued operations, shown after the results from continuing operations. For comparative purposes, the Company has reclassified its prior period financial presentation to conform to these changes. See Note 4 for additional information regarding the Company’s discontinued operations.
C. Premiums - Premiums, including estimates of premiums resulting from audits of insureds’ records are earned principally on a pro rata basis over the terms of the policies. Any changes occurring or reported to the Company after the policy term are recorded as earned premiums in the period in which the adjustment is made. With respect to policies that provide for premium adjustments, such as experience-rated or exposure-based adjustments, such premium adjustments may be made subsequent to the end of the policy’s coverage period and will be recorded as earned premiums in the period in which the adjustment is made. Premiums applicable to the unexpired terms of policies in force are reported as unearned premiums. The estimated premiums receivable on experience-rated or exposure-based policies are reported as a component of premiums receivable. For reinsurance premiums assumed at the Company’s discontinued operations, management must estimate the subject premiums associated with the treaties in order to determine the level of written and earned premiums for a reporting period. Such estimates are based on information from brokers and ceding companies, which can be subject to change as new information becomes available.
D. Unpaid Losses and Loss Adjustment Expenses - Unpaid losses and loss adjustment expenses (“LAE”), which are stated net of estimated salvage and subrogation, are estimates of losses and LAE on known claims and estimates of losses and LAE incurred but not reported (“IBNR”). IBNR reserves are calculated utilizing various actuarial methods. Unpaid losses on certain workers’ compensation claims are discounted to present value using the Company’s payment experience and mortality and interest assumptions in accordance with statutory accounting practices prescribed by the Pennsylvania Insurance Department. The Company also discounts unpaid losses and LAE for certain other claims at rates permitted by domiciliary regulators or if the timing and amount of such claims are fixed and determinable. The methods of making such estimates and establishing the resulting reserves are continually reviewed and updated and any adjustments resulting there from are reflected in earnings in the period identified. See Note 6 for additional information.
E. Reinsurance - In the ordinary course of business, PMA Capital’s insurance subsidiaries assume and cede premiums with other insurance companies and are members of various insurance pools and associations. The Company’s insurance subsidiaries cede business in order to limit the maximum net loss and limit the accumulation of many smaller losses from a catastrophic event. The insurance subsidiaries remain primarily liable to their clients in the event their reinsurers are unable to meet their financial obligations. Reinsurance receivables include claims paid by the Company and estimates of unpaid losses and LAE that are subject to reimbursement under reinsurance and retrocessional contracts. The method for determining the reinsurance receivable for unpaid losses and LAE involves reviewing actuarial estimates of unpaid losses and LAE to determine the Company’s ability to cede unpaid losses and LAE under its existing reinsurance contracts. This method is continually reviewed and updated and any adjustments resulting there from are reflected in earnings in the period identified. Under certain of the Company’s reinsurance and retrocessional contracts, additional premium and interest may be required if predetermined loss and LAE thresholds are exceeded.
F. Deferred Acquisition Costs - Costs that directly relate to and vary with the acquisition of new and renewal business are deferred and amortized over the period during which the related premiums are earned. Such direct costs include commissions or brokerage and premium taxes, as well as other policy issuance costs and underwriting expenses. The
Company determines whether acquisition costs are recoverable considering future losses and LAE, maintenance costs and anticipated investment income. To the extent that acquisition costs are not recoverable, the deficiency is charged to income in the period identified.
G. Derivatives - The derivative component of the Company’s 6.50% Senior Secured Convertible Debt due 2022 (“6.50% Convertible Debt”) is bifurcated and recorded at fair value in long-term debt on the Balance Sheet. Changes in fair value are recorded in net realized investment gains (losses) on the Statement of Operations. See Note 8 for additional information.
H. Dividends to Policyholders - The Company sells certain workers’ compensation insurance policies with dividend payment features. These policyholders share in the underwriting results of their respective policies in the form of dividends. Dividends to policyholders are accrued during the period in which the related premiums are earned and are determined based on the terms of the individual policies.
I. Income Taxes - The Company records deferred tax assets and liabilities to the extent of the tax effect of differences between the financial statement carrying values and tax bases of assets and liabilities. A valuation allowance is recorded for deferred tax assets where it appears more likely than not that the Company will not be able to recover the deferred tax asset. See Note 14 for additional information.
K. Commission Income - Commission income primarily includes income related to managing general agency and program administrator services provided by the Company’s Fee-based Business. Commission income, which is generally reported gross of sub-producer fees, is recognized at the later of the date billed or the effective date of the related insurance policy. Adjustments due to payroll, audits, cancellations, and endorsements are recorded in the period in which they occur.
In December 2007, the FASB issued Statement of Financial Accounting Standards No. 141 (revised 2007), “Business Combinations” (“SFAS 141R”). SFAS 141R replaces Statement of Financial Accounting Standards No. 141, “Business Combinations” (“SFAS 141”), although it retains the fundamental requirement in SFAS 141 that the purchase method of accounting be used for all business combinations. SFAS 141R establishes principles and requirements for how the acquirer in a business combination (a) recognizes and measures the assets acquired, liabilities assumed and any non-controlling interest in the acquiree, (b) recognizes and measures the goodwill acquired in a business combination or a gain from a bargain purchase and (c) determines what information to disclose regarding the business combination. SFAS 141R applies prospectively to business combinations for which the acquisition date is on or after the beginning of the Company’s 2009 fiscal year, and therefore, has no impact on the accounting for the Company’s 2007 acquisition of Midlands.
On October 1, 2007, the Company entered into a Stock Purchase Agreement with the shareholders of Midlands Holding Corporation, pursuant to which the Company acquired all of the stock of Midlands Holding Corporation. Under the Stock Purchase Agreement, the Company paid cash of $19.8 million for the stock of Midlands Holding Corporation on the closing date. The ultimate purchase price for the stock, which could range from $22.8 million to $44.5 million, will be
The value of the non-contractual customer relationships was calculated using a 15% annual attrition rate. The non-contractual customer relationships will be amortized on a straight-line basis over 10 years. In 2007, the Company recognized $167,000 of expenses related to the amortization of non-contractual customer relationships. The Company expects to recognize $669,000 of amortization expense per year over the next five years and $3.2 million thereafter.
In 2007, the Company announced that it was actively pursuing the sale of its Run-off Operations. The Company’s Run-off Operations include its reinsurance and excess and surplus lines businesses which were placed into run-off in 2003 and 2002, respectively. In February 2008, the Company announced that it entered into a non-binding letter of intent with a third party and expects to execute a definitive stock purchase agreement in the first quarter of 2008. The transfer of ownership will be subject to regulatory approval. Because of the expected divestiture, the Company has determined that its Run-off Operations should be reflected as discontinued operations in accordance with SFAS 144. As such, the Company recognized an after-tax impairment loss of $40.0 million in 2007, as the book value of its Run-off Operations was greater than the estimated net proceeds it expects to receive in a sale.
At December 31, 2007, the Company recorded an income tax benefit on the impairment loss as it believes it will be able to use the loss to offset future operating earnings.
Includes write-down of net assets of Run-off Operations to fair value less cost to sell.
The amortized cost and fair value of the discontinued operations’ investment portfolio were as follows:
In February 2007, the FASB issued SFAS 159. The objective of SFAS 159 is to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently. This Statement permits entities to choose, at specified election dates, to measure eligible items at fair value (i.e., the fair value option). Items eligible for the fair value option include certain recognized financial assets and liabilities, rights and obligations under certain insurance contracts that are not financial instruments, host financial instruments resulting from the separation of an embedded non-financial derivative instrument from a non-financial hybrid instrument, and certain commitments. Business entities are required to report unrealized gains and losses on items for which the fair value option has been elected in net income. The fair value option may be applied instrument by instrument, with certain exceptions, is irrevocable (unless a new election date occurs), and is applied only to entire instruments and not to portions of instruments.
Because reinsurers rely on their ceding companies to provide them with information regarding incurred losses, it takes longer for reinsurers to find out about reported claims than for primary insurers and such claims are subject to more unforeseen development and uncertainty. See Note 6 for additional information regarding management estimates included in unpaid losses and LAE.
Unpaid losses and LAE for the Company’s discontinued operations’ workers’ compensation claims, net of reinsurance, at December 31, 2007 and 2006 were $48.8 million and $47.8 million, net of discount of $19.5 million and $22.2 million, respectively. The discount rate used was approximately 5% at December 31, 2007 and 2006.
At December 31, 2007, 2006 and 2005, the discontinued operations’ gross reserves for environmental-related losses were $877,000, $1.5 million and $1.3 million, respectively ($364,000, $1.1 million and $900,000, net of reinsurance, respectively). Of the net environmental reserves, approximately $373,000 related to IBNR losses at December 31, 2006 and 2005, respectively. All incurred asbestos and environmental losses were for accident years 1986 and prior.
At December 31, 2007, of the 71 securities that have been in an unrealized loss position for more than 12 months, 70 securities have a total fair value of 99% of the amortized cost basis at December 31, 2007, and the average unrealized loss per security is approximately $22,000. The one security with an unrealized loss greater than 20% of its amortized cost at
December 31, 2007 has a fair value of $545,000 and an amortized cost of $1.4 million. This security, which matures in 2033, is rated AAA, and its $1.4 million principal is backed and guaranteed at maturity by discounted agency securities. The Company has both the ability and intent to hold this security until it matures.
available for sale to the trading category in conjunction with the Company’s adoption of SFAS 159, effective January 1, 2007.
Management believes that its unpaid losses and LAE are fairly stated at December 31, 2007. However, estimating the ultimate claims liability is necessarily a complex and judgmental process inasmuch as the amounts are based on management’s informed estimates, assumptions and judgments using data currently available. As additional experience and data become available regarding claims payment and reporting patterns, legal and legislative developments, judicial theories of liability, the impact of regulatory trends on benefit levels for both medical and indemnity payments, changes in social attitudes and economic conditions, the estimates are revised accordingly. If the Company’s ultimate losses, net of reinsurance, prove to differ substantially from the amounts recorded at December 31, 2007, then the related adjustments could have a material adverse impact on the Company’s financial condition, results of operations and liquidity.
At December 31, 2007, the Company had reinsurance receivables due from the following unaffiliated reinsurers in excess of 5% of shareholders’ equity:
The PMA Insurance Group had recorded reinsurance receivables of $13.9 million at December 31, 2006, related to certain umbrella policies covering years prior to 1977. The reinsurer had previously disputed the extent of coverage under these policies. The Company settled this dispute with the reinsurer in 2007.
The Company’s largest reinsurer is Trabaja Reinsurance Company (“Trabaja”). Reinsurance receivables from Trabaja were $167.6 million at December 31, 2007, of which 98% were collateralized.
The remaining junior subordinated debt of $43.8 million matures in 2033 and is redeemable, in whole or in part, in 2008 at the stated liquidation amount plus accrued and unpaid interest. The weighted average interest rates on this junior subordinated debt equal the three-month LIBOR plus 4.12%, and interest on this debt is also payable on a quarterly basis. At December 31, 2007, the weighted average interest rate on all of the junior subordinated securities was 8.90%.
The 6.50% Convertible Debt is secured equally and ratably with the Company’s $54.9 million 8.50% Monthly Income Senior Notes due 2018 (“8.50% Senior Notes”) by a first lien on 20% of the capital stock of the Company’s principal operating subsidiaries. This lien is released if the 6.50% Convertible Debt is no longer outstanding. The indenture governing the 6.50% Convertible Debt contains restrictive covenants with respect to limitations on the Company’s ability to incur indebtedness, enter into transactions with affiliates or engage in a merger or sale of all or substantially all of the Company’s assets. Subsequent to December 31, 2007, the Company retired the remaining $1.3 million principal amount of its 6.50% Convertible Debt for which it paid $1.5 million, exclusive of accrued interest. The Company is currently in the process of releasing the lien and restrictive covenants.
In June 2007, the Company entered into new interest rate swaps that it has designated as cash flow hedges to manage interest costs and cash flows associated with the variable interest rates on a portion of its junior subordinated debt and its Surplus Notes. There was no consideration paid or received for these swaps. The swaps will effectively convert $10.0 million of the junior subordinated debt and $10.0 million of Surplus Notes to fixed rate debt with interest rates of 9.40% and 9.93%, respectively.
During 2006, the Company retired $28.7 million principal amount of its 6.50% Convertible Debt through open market purchases. The Company paid $32.3 million for these bond purchases, exclusive of accrued interest. In 2006, the Company also retired $2.6 million principal amount of its 8.50% Senior Notes through open market purchases. The Company paid $2.6 million for these bond purchases, exclusive of accrued interest. The Company has the right to call its 8.50% Senior Notes beginning in June 2008.
The put premium and conversion features of the 6.50% Convertible Debt constitute a derivative which requires bifurcation. Any change in the fair value of the derivative component of the 6.50% Convertible Debt is recognized in net realized investment gains (losses). The Company recorded realized investment losses of $483,000, gains of $466,000 and losses of $3.7 million in 2007, 2006 and 2005, respectively, resulting from changes in the fair value of the derivative component of the 6.50% Convertible Debt.
In the event a property and casualty insurer operating in a jurisdiction where the Company’s insurance subsidiaries also operate becomes or is declared insolvent, state insurance regulations provide for the assessment of other insurers to fund any capital deficiency of the insolvent insurer. Generally, this assessment is based upon the ratio of an insurer’s voluntary premiums written to the total premiums written for all insurers in that particular jurisdiction. As of December 31, 2007 and 2006, the Company had recorded liabilities of $6.7 million and $5.5 million for these assessments, which are included in accounts payable, accrued expenses and other liabilities on the Balance Sheet.
See Note 7 for information regarding the terms of the sale of PMA Cayman in 1998.
The Company is frequently involved in numerous lawsuits arising, for the most part, in the ordinary course of business, either as a liability insurer defending third-party claims brought against its insureds, or as an insurer defending coverage claims brought against it by its policyholders or other insurers. While the outcome of all litigation involving the Company, including insurance-related litigation, cannot be determined, such litigation is not expected to result in losses that differ from recorded reserves by amounts that would be material to the Company’s financial condition, results of operations or liquidity. For additional information about our liability for unpaid losses and loss adjustment expenses, see Note 6. In addition, reinsurance recoveries related to claims in litigation, net of the allowance for uncollectible reinsurance, are not expected to result in recoveries that differ from recorded receivables by amounts that would be material to the Company’s financial condition, results of operations or liquidity.
On December 11, 2007, the U.S. District Court for the Eastern District of Pennsylvania approved the settlement of the securities class action, In re PMA Capital Corporation Securities Litigation (Civil Action No. 03-6121), against the Company and certain of its officers and directors. The settlement made no admission of liability or wrongdoing by the Company or its officers and directors. The amounts necessary to fund this settlement have been paid on the Company’s behalf by insurance carriers.
In May 2007, the Company’s Board of Directors authorized the Company and its subsidiaries to repurchase up to $10.0 million of its Class A Common Stock from time to time in the open market at prevailing prices or in privately negotiated transactions. During the year, the Company repurchased 986,522 shares of its Class A Common Stock at a cost of $10.0 million under this authorization. Decisions regarding share repurchases are subject to prevailing market conditions and an evaluation of the costs and benefits associated with alternative uses of capital.
In 2006, the Company completed the redemption of $35 million principal amount of its 6.50% Convertible Debt. Under the original terms of this debt, the Company was required to pay a premium to the holders of the debt. The premium was due in cash, or at the election of the holder, in shares of the Company’s Class A Common Stock. As a result of this redemption, the Company issued 307,990 shares of Class A Common Stock. This issuance of shares in lieu of cash resulted in an increase in Shareholders’ equity of $3.1 million. See Note 8 for additional information regarding this redemption.
In a 2004 order (the “2004 Order”) approving the transfer of the Pooled Companies from PMACIC to PMA Capital Corporation, the Pennsylvania Insurance Department (the “Department”) prohibited PMACIC from declaring or paying any dividends, return of capital or other types of distributions to PMA Capital Corporation prior to 2006. Under the terms of
Information regarding the Company’s stock option plans for the year ended December 31, 2007 was as follows:
Stock options outstanding and options exercisable at December 31, 2007 were as follows:
In 2007, the Company issued 3,000 and 5,000 shares of restricted Class A Common Stock to employees under the Company’s 2002 and 2007 Equity Incentive Plans, respectively, and 48,533 shares of restricted Class A Common Stock to its Directors under the 2004 Directors Plan. In 2006, the Company issued 101,013 shares of restricted Class A Common Stock to employees under the Company’s 2002 Equity Incentive Plan and 56,100 shares of restricted Class A Common Stock to its Directors under the 2004 Directors Plan. In 2005, the Company issued 52,754 shares of restricted Class A Common Stock to its Directors. Restricted stock issued to the Company’s Directors under the 2004 Directors Plan includes shares granted to new Directors and shares awarded to all Directors in lieu of a portion of their retainer. The restricted stock vests (restrictions lapse) between one and three years.
Upon vesting of a restricted stock award, employees may remit cash or shares of Class A Common Stock to satisfy their tax obligations relating to the award. During 2007, 2006 and 2005, employees remitted 31,525 shares, 8,831 shares and 54,694 shares, respectively, to the Company to satisfy their payment of withholding taxes for vested awards.
In March 2006 and 2007, the Compensation Committee approved the 2006 and 2007 Officer Long Term Incentive Plans, pursuant to which stock may be awarded to all officers in 2009 and 2010 if the return on equity (“ROE”) in 2008 and 2009 is within a specified range. Award amounts are calculated as a percentage of the participants’ base salaries. The 2006 and 2007 Officer Long Term Incentive Plans link compensation to performance under the Company’s three-year strategic plan and recognize the long-term nature of improvement in ROE and the value ROE growth creates for shareholders. The Company recognized expenses related to these plans of $1.0 million in 2007 and $500,000 in 2006.
Shares used as the denominator in the computations of basic and diluted earnings per share were as follows:
As of December 31, 2007 and 2006, the carrying amounts for the Company’s financial instruments approximated their estimated fair value. The Company measures the fair value of fixed maturities, the Convertible Debt and the Senior Notes based upon quoted market prices or by obtaining quotes from dealers. Certain financial instruments, specifically amounts relating to insurance and reinsurance contracts, are excluded from this disclosure.
The Company recognized pre-tax net realized losses of $483,000 in 2007, gains of $466,000 in 2006 and losses of $3.7 million in 2005, resulting from changes in the fair value of the derivative component of its 6.50% Convertible Debt.
At December 31, 2007, the Company had a net operating loss (“NOL”) carryforward of $250.5 million, which will expire in years 2018 through 2027, and a $9.6 million tax credit carryforward primarily related to alternative minimum tax (“AMT”) credits, which do not expire. The NOL carryforward, which produces a gross deferred tax asset of $87.7 million, will be applied to reduce taxable income of the Company.
Prior to 2005, the Company established a valuation allowance in the amount of $57 million. This was based upon management’s assessment that it was more likely than not that a portion of the gross deferred tax assets related to the NOL carryforward and all of the deferred tax asset related to the AMT credit carryforward would not be realized. During 2005, the Company reassessed the valuation allowance previously established against its net deferred tax assets. Factors considered by management in this reassessment included historical earnings, scheduled reversal of deferred tax liabilities and revised projections of future earnings. Based upon management’s consideration of these factors in conjunction with the current level of valuation allowance recorded, the Company increased the valuation allowance with respect to its net deferred tax asset by $3.5 million in 2005. The increase was primarily due to the future earnings projections for the Company’s discontinued operations which were revised downward from previous projections.
The Company was required to adopt SFAS 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans,” in 2006. SFAS 158 requires that an employer recognize the overfunded or underfunded status of each defined benefit postretirement plan as an asset or liability on the Balance Sheet. Changes in the funded status during any given period of time shall be recognized as a change in comprehensive income. The statement has no impact on the recognition of benefit costs. The Company’s 2006 adoption of this statement resulted in a $13.5 million decrease in Other assets, a $15.2 million decrease in Accounts payable, accrued expenses and other liabilities, and a $1.1 million increase in Accumulated other comprehensive income.
For the measurement of other postretirement benefits, an 8% annual rate of increase in the per capita cost of covered health care benefits was assumed for 2007. The rate was assumed to decrease gradually to 5% by 2014 and remain at that level thereafter. A one percentage point change in assumed health care cost trend rates would have an immaterial impact on the total service and interest cost components of the net periodic benefit cost and the postretirement benefit obligation.
Benefits paid in the table above include only those amounts paid directly from plan assets.
As a result of the Company’s acquisition of Midlands in 2007, the combined operating results of PMA Management Corp. and Midlands have been reported in a new reporting segment, Fee-based Business. The results of PMA Management Corp. were previously included in The PMA Insurance Group segment. In 2007, the Company also reported the results of its Run-off Operations as discontinued operations. For comparative purposes, the Company has reclassified its prior period financial presentation to conform to these changes.
Operating income (loss), which is GAAP net income (loss) excluding net realized investment gains (losses) and results from discontinued operations, is the financial performance measure used by the Company’s management and Board of Directors to evaluate and assess the results of its businesses. Net realized investment activity is excluded because (i) net realized investment gains and losses are unpredictable and not necessarily indicative of current operating fundamentals or future performance of the business segments and (ii) in many instances, decisions to buy and sell securities are made at the holding company level, and such decisions result in net realized gains and losses that do not relate to the operations of the individual segments. Operating income (loss) does not replace net income (loss) as the GAAP measure of the Company’s consolidated results of operations.
The Company incurred legal and consulting expenses aggregating approximately $810,000, $3.0 million and $3.3 million in 2007, 2006 and 2005, respectively, from firms in which directors of the Company are partners or principals.
These consolidated financial statements vary in certain respects from financial statements prepared using statutory accounting practices (“SAP”) that are prescribed or permitted by the Pennsylvania Insurance Department. Prescribed SAP includes state laws, regulations and general administrative rules, as well as a variety of NAIC publications. Permitted SAP encompasses all accounting practices that are not prescribed. The Codification of Statutory Accounting Principles guidance is the NAIC’s primary guidance on statutory accounting. The principal differences between GAAP and SAP are in the treatment of acquisition expenses, reinsurance, deferred income taxes, fixed assets and investments.
SAP net income (loss) and capital and surplus for PMA Capital’s domestic insurance subsidiaries were as follows:
PMA Capital Insurance Company paid “extraordinary” dividends in the amounts of $37.5 million and $73.5 million in 2007 and 2006, respectively, to its parent, PMA Capital Corporation.
We have audited the accompanying consolidated balance sheets of PMA Capital Corporation and subsidiaries (the Company) as of December 31, 2007 and 2006, and the related consolidated statements of operations, cash flows, shareholders’ equity and comprehensive income (loss) for each of the years in the three-year period ended December 31, 2007. The Company’s management is responsible for these consolidated financial statements. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We have audited PMA Capital Corporation’s (the Company) internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). PMA Capital Corporation’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets and the related consolidated statements of operations, cash flows, shareholders’ equity, comprehensive income (loss) and financial statement schedules of PMA Capital Corporation, and our reports dated March 10, 2008 expressed an unqualified opinion.