The Company does not own any real property; however, one of the property and casualty insurance subsidiaries, Dakota Fire, leases from EMC National Life Company (an affiliate of Employers Mutual) approximately 18,000 square feet of office space in which the Bismarck, North Dakota branch office is located. The Company’s home office, which also serves as the home office of Employers Mutual, is located in three office buildings containing approximately 437,000 square feet of space in Des Moines, Iowa, all of which are owned by Employers Mutual. Employers Mutual also owns office buildings in which the Minneapolis, Milwaukee and Lansing branch offices operate. Employers Mutual leases approximately 230,000 square feet of office space in 17 other locations where other branch offices and service centers are located.
Property and casualty insurance operations are conducted through three subsidiaries and represent the most significant segment of the Company’s business, totaling approximately 80 percent of consolidated premiums earned in 2009. The Company’s three property and casualty insurance subsidiaries and two subsidiaries and an affiliate of Employers Mutual are parties to reinsurance pooling agreements with Employers Mutual (collectively the “pooling agreement”). Under the terms of the pooling agreement, each company cedes to Employers Mutual all of its insurance business, with the exception of any voluntary reinsurance business assumed from nonaffiliated insurance companies, and assumes from Employers Mutual an amount equal to its participation in the pool. All premiums, losses, settlement expenses, and other underwriting and administrative expenses, excluding the voluntary reinsurance business assumed by Employers Mutual from nonaffiliated insurance companies, are prorated among the parties on the basis of participation in the pool. Employers Mutual negotiates reinsurance agreements that provide protection to the pool and each of its participants, including protection against losses arising from catastrophic events. The aggregate participation of the Company’s property and casualty insurance subsidiaries is 30 percent.
Liabilities for losses and settlement expenses are estimates at a given point in time of what an insurer expects to pay to settle claims, based on facts and circumstances then known. It can be expected that the insurer’s ultimate liability for losses and settlement expenses may either exceed or be less than such estimates.
The Company has implemented specific line-of-business guidelines that are used to establish the individual case loss reserve estimates. These guidelines, which are used for both short-tail and long-tail claims, require the claims department personnel to reserve for the probable (most likely) exposure for each claim. Probable exposure is defined as what is likely to be awarded if the case were to be decided by a civil court in the applicable venue or, in the case of a workers’ compensation case, by that state’s workers’ compensation commission. This evaluation process is repeated throughout the life of the claim at regular intervals, and as additional information becomes available. While performing these regular reviews, the branch claims personnel are able to make adjustments to the case loss reserves for location and time specific factors, such as legal venue, severity of claim, inflation, and changes in applicable laws.
The Company’s automated claims system utilizes an automatic diary process that helps ensure that case loss reserve estimates are reviewed on a regular basis. The claims system requires written documentation each time a case loss reserve is established or modified, and provides management with the information necessary to perform individual reserve reviews and monitor reserve development. In addition, the claims system produces monthly reports that allow management to analyze case loss reserve development in the aggregate, by branch, by line of business, or by claims adjuster.
The goal of the Company’s claims department is to establish and maintain case loss reserves that are sufficient, but not excessive. Since specific guidelines are utilized for establishing case loss reserves, the Company does not incorporate a provision for uncertainty (either implicitly or explicitly) when setting individual case loss reserve estimates. The Company’s actuaries do, however, review the adequacy of the aggregate case loss reserves on a quarterly basis and, if deemed appropriate, make recommendations for adjustments to management. Management reviews all recommendations submitted by the Company’s actuaries and considers such recommendations in the determination of its best estimate of the Company’s overall liability. Adjustments to the case loss reserves, when approved by management, are accomplished through the implementation of bulk case loss reserves in the applicable line(s) of business, which supplement the individual case loss reserves. For financial reporting purposes, bulk case loss reserves are included in case loss reserves.
The property and casualty insurance segment’s formula IBNR loss reserves are established for each line of business by applying actuarially derived “IBNR factors” to the latest twelve months premiums earned. These factors are developed using a methodology that utilizes historical ratios of (1) actual IBNR claims that have emerged after prior year-ends to (2) corresponding prior years’ premiums earned that have been adjusted to the current level of rate adequacy. In order to minimize the volatility that naturally exists in the early stages of IBNR claims emergence, IBNR claims are not utilized in this process until 18 months after the end of a respective calendar year. For example, during 2009 the actual IBNR claims reported in the 18 months following year-end 2007 were compared to the adjusted 2007 premiums earned. The 2007 ratios, together with the ratios for several prior years, were then used to develop the 2009 “IBNR factors” that were applied to premiums earned for each line of business. Included in the rate adequacy adjustment noted above is consideration of current frequency and severity trends compared to the trends underlying prior years’ calculations. The selected trends are based on an analysis of industry and Company loss data.
The methodology used in estimating formula IBNR loss reserves assumes consistency in claims reporting patterns and immaterial changes in loss development patterns. Implicit in this assumption is that future IBNR claims emergence, relative to IBNR claims that have emerged following prior year-ends, will reflect the change in frequency and severity trends underlying the rate adequacy adjustments. If this projected relationship proves to be inaccurate, future IBNR claims may differ substantially from the estimated IBNR loss reserves. The following table displays the impact that a five percent variance in IBNR emergence from the projected level reflected in the December 31, 2009 IBNR factors would have on the Company’s results of operations. This variance in IBNR emergence could occur in one year or over multiple years, depending when the claims were reported. A variance in IBNR emergence would also affect the Company’s financial position in that the Company’s equity would be impacted by an amount equivalent to the change in net income. A variance of this type would typically be recognized in loss and settlement expense reserves and, accordingly, would not have a material effect on liquidity because the claims have not been paid. A five percent variance in IBNR emergence is considered reasonably likely based on the range of actuarial indications developed during the analysis of the property and casualty insurance segment’s carried reserves.
One assumption underlying aggregate reserve estimation methods is that the claims inflation trends implicitly built into the historical loss and settlement expense development patterns will continue into the future. To estimate the sensitivity of the estimated ultimate loss and settlement expense payments to an unexpected change in inflationary trends, the actuarial department derived expected payment patterns separately for each major line of business. These patterns were applied to the December 31, 2009 loss and settlement expense reserves to generate estimated annual incremental loss and settlement expense payments for each subsequent calendar year. Then, for the purpose of sensitivity testing, an explicit annual inflationary variance of one percent was added to the inflationary trend that is implicitly embedded in the estimated payment pattern, and revised incremental loss and settlement expense payments were calculated. This unexpected claims inflation trend could arise from a variety of sources including a change in economic inflation, social inflation and, especially for the workers’ compensation line of business, the introduction of new medical technologies and procedures, changes in the utilization of procedures and changes in life expectancy. The estimated cumulative impact that this unexpected one percent variance in the inflationary trend would have on the Company’s results of operations over the lifetime of the underlying claims is shown below. A variance in the inflationary trend would also affect the Company’s financial position in that the Company’s equity would be impacted by an amount equivalent to the change in net income. A variance of this type would typically be recognized in loss and settlement expense reserves and, accordingly, would not have a material effect on liquidity because the claims have not been paid. A one percent variance in the projected inflationary trend is considered reasonably likely based on the range of actuarial indications developed during the analysis of the property and casualty insurance segment’s carried reserves.
The property and casualty insurance subsidiaries have exposure to environmental and asbestos claims arising primarily from the other liability line of business. This exposure is closely monitored by management, and the IBNR loss reserves have been established to cover estimated ultimate losses. Currently, asbestos reserves are based on the results of an independent consultant’s ground-up study of the pool participants’ asbestos exposures that was completed in 2006. These reserves were increased in 2008 and again in 2009 based on examinations of the implied three-year survival ratio (ratio of loss reserves to the three-year average of loss payments). Environmental reserves are established in consideration of the implied three-year survival ratio. Estimation of ultimate liabilities for these exposures is unusually difficult due to unresolved issues such as whether coverage exists, the definition of an occurrence, the determination of ultimate damages and the allocation of such damages to financially responsible parties. Therefore, any estimation of these liabilities is subject to greater than normal variation and uncertainty, and ultimate payments for losses and settlement expenses for these exposures may differ significantly from the carried reserves.
The reinsurance book of business is comprised of two major components. The first is the Home Office Reinsurance Assumed Department (“HORAD”), which is the reinsurance business that is underwritten by Employers Mutual. The second is the MRB pool, which is a voluntary reinsurance pool in which Employers Mutual participates with four other unaffiliated insurers.
At December 31, 2009, the carried reserves for HORAD and MRB combined were in the upper quartile of the range of actuarial reserve indications. This selection reflects the fact that there are inherent uncertainties involved in establishing reserves for assumed reinsurance business. Such uncertainties reflect the fact a reinsurance company generally has less knowledge than the ceding company about the underlying book of business and the ceding company’s reserving practices. Because of these uncertainties, there is a risk that the reinsurance segment’s reserves for losses and settlement expenses could prove to be inadequate, with a consequent adverse impact on the Company’s future earnings and stockholders’ equity.
At December 31, 2009, there was no backlog in the processing of assumed reinsurance information. Approximately $79,374,000, or 55 percent, of the reinsurance segment’s carried reserves were reported by the ceding companies. Employers Mutual receives loss reserve and paid loss data from its ceding companies on individual excess-of-loss business. If a claim involves a single or small group of claimants, a summary of the loss and claim outlook is normally provided. Summarized data is provided for catastrophe claims and pro rata business, which is subject to closer review if inconsistencies are suspected.
Carried reserves established in addition to those reported by the ceding companies totaled approximately $66,313,000 at December 31, 2009. Since many ceding companies in the HORAD book of business do not report IBNR loss reserves, Employers Mutual establishes a bulk IBNR loss reserve to cover the lag in reporting. For the few ceding companies that do report IBNR loss reserves, Employers Mutual carries them as reported. These reported IBNR loss reserves are subtracted from the total IBNR loss reserve calculated by Employers Mutual’s actuaries, with the difference carried as bulk IBNR loss reserves. Except for the small IBNR loss reserve established to cover the one-month lag in reporting, the MRB IBNR loss reserve is established by the management of MRB. Employers Mutual rarely records additional case loss reserves.
Following is a summary of the carried loss and settlement expense reserves for the reinsurance segment at December 31, 2009 and 2008.
During 2003, the pool participants were presented with several hundred plaintiff lawsuits filed against three former policyholders representing approximately 66,500 claimants related to exposure to asbestos or products containing asbestos. The vast majority of the 66,500 claims are the result of multi-plaintiff lawsuits. These claims are based upon nonspecific asbestos exposure and nonspecific injuries. As a result, management did not establish a significant amount of case loss reserves for these claims. During the period 2006 through 2009, several of the multi-plaintiff lawsuits (including the vast majority of those associated with one former policyholder) were dismissed. During 2009, approximately 3,000 additional claims against one former policyholder were reported to the pool participants. As of December 31, 2009, approximately 5,500 of the claims remain open. During 2006, the pool participants received notice that another former policyholder was a named defendant in approximately 33,000 claims nationwide. As of December 31, 2009, approximately 27,000 of these claims remain open.
Prior to 2008, actual losses paid for asbestos-related claims had been minimal due to the plaintiffs’ failure to identify an exposure to any asbestos-containing products associated with the pool participants’ current and former policyholders. However, paid losses increased significantly during 2008 and 2009 as a result of claims attributed to two former policyholders. One of these former policyholders, a broker of various products, including asbestos, settled a claim for approximately $450,000 (the Company’s share) in 2008. Prior to 2008, the asbestos exposure associated with this former policyholder had been thought to be relatively small. At December 31, 2009, one additional claim associated with this former policyholder remains open, though similar exposure on that claim is not anticipated. The other former policyholder, a furnace manufacturer, had multiple claims settle for a total of approximately $514,000 (the Company’s share) in 2008 and 2009. The asbestos exposure associated with this former policyholder increased during this time period, and this trend may possibly continue into the future with increased per plaintiff settlements. Approximately 170 asbestos exposure claims associated with this former policyholder remain open. Defense costs for asbestos-related claims continue to be rather significant due to the large number of parties involved in the litigation proceedings and the length of time required to obtain judgments. Whenever possible, the pool participants have participated in cost sharing agreements with other insurance companies to reduce overall asbestos claim expenses.
The plaintiffs in the silicosis lawsuits are sandblasters, gravel and concrete workers, ceramic workers and road construction workers. All of these lawsuits are subject to express reservation of rights based upon the lack of an injury within the applicable policy periods because many silica lawsuits, like asbestos lawsuits, do not specifically allege dates of exposure or dates of injury. The pool participants’ policyholders (a refractory product manufacturer, small local concrete and gravel companies and a concrete cutting machine manufacturer) that have been named as defendants in these silica lawsuits have had little or no exposure and are routinely dismissed from silica litigation with nominal or no payment. While the expense of handling these lawsuits is high, it is not proportional to the number of plaintiffs, and is mitigated through cost sharing agreements with other insurance companies.
During 2009 the Company completed a comprehensive policy search and coverage review, and began defending (pursuant to policies issued 1969-1975) a lawsuit filed against a municipalities’ sewerage commission in United States District Court in Wisconsin in 2008. The company has a joint defense agreement with two other companies but currently retains the majority share. The lawsuit is potentially one of the largest CERCLA actions pending against numerous parties in the United States and seeks in excess of $1.5 billion from the defendants. The Company has established reserves equal to policy limits for each of the six years of alleged liability (approximately $90,000 in aggregate as the Company’s share) along with associated settlement expenses. While the insured’s summary judgment motion was successful, future appeals are anticipated.
The pool participants’ non-asbestos direct product liability claims are considered to be highly uncertain exposures due to the many uncertainties inherent in determining the loss, and the significant periods of time that can elapse between the occurrence of the loss and the ultimate settlement of the claim. The majority of the pool participants’ product liability claims arise from small to medium-sized manufacturers, contractors, petroleum distributors, and mobile home and auto dealerships. No specific claim trends are evident from the pool participants’ manufacturers, as the claims activity on these policies is generally isolated and can be severe. Specific product liability coverage is provided to the pool participants’ mobile home and auto dealership policyholders, and the claims from these policies tend to be relatively small. Certain construction defect claims are also reported under product liability coverage. During 2009, 48 of these claims were reported to the pool participants.
The Company has exposure to construction defect claims arising from general liability policies issued by the pool participants to contractors. Most of the pool participants’ construction defect claims are concentrated in a limited number of states, and the pool participants have taken steps to mitigate this exposure. Construction defect is a highly uncertain exposure due to such issues as whether coverage exists, definition of an occurrence, determination of ultimate damages, and allocation of such damages to financially responsible parties. Newly reported construction defect claims numbered 415, 373 and 345 in 2009, 2008 and 2007, respectively, and produced incurred losses and paid settlement expenses of approximately $2,913,000, $2,855,000 and $2,755,000 in each respective period. Incurred losses and paid settlement expenses on all construction defect claims totaled approximately $4,604,000 in 2009. At December 31, 2009, the Company carried case loss reserves of approximately $5,210,000 on 623 open construction defect claims.
As previously noted, assumed reinsurance business carries a high risk of volatility and uncertainty which, in management’s opinion, warrants a high degree of conservatism. Therefore, management’s objective is to carry reinsurance segment reserves in the upper quarter of the range of actuarial reserve estimates.
Prior to the fourth quarter of 2009, the Company held Class B shares of Insurance Services Office Inc. (now known as Verisk Analytics, Inc. (“Verisk”) following its Initial Public Offering on October 7, 2009). The Company was reporting this investment as a Level 3 fair value measurement at the fair value obtained from applying a 20 percent marketability discount to the quarterly valuations of the Class A shares produced by a nationally recognized independent financial advisory firm. This resulted in a fair value of $14,966,000 for the Class B shares held at December 31, 2008. In conjunction with the Verisk Initial Public Offering, the Company sold its entire holding of Verisk common stock in the fourth quarter for proceeds of $22,474,000, resulting in a realized capital gain in the same amount (before tax).
Effective April 1, 2009, the Company adopted the requirements for recognition, presentation, and disclosure of “other-than-temporary” impairments on fixed maturity securities from Investments-Debt and Equity Securities Topic 310 of the Financial Accounting Standards Board (FASB) FASB Accounting Standards Codification TM (ASC). This provision was a part of the originally issued Staff Position FAS 115-2 and FAS 124-2, “Recognition and Presentation of Other-Than-Temporary Impairments,” which was effective for interim and annual reporting periods ending after June 15, 2009. Under these requirements, the evaluation of an impaired fixed maturity security includes an assessment of whether the entity has the intent to sell the security and if it is more likely than not to be required to sell the security before recovery of its amortized cost basis. In addition, if the present value of cash flows expected to be collected is less than the amortized cost of the security, a credit loss is deemed to exist and the security is considered “other-than-temporarily” impaired. The portion of the impairment related to a credit loss is recognized through earnings and the portion of the impairment related to other factors is recognized through “other comprehensive income”.
Deferred policy acquisition costs and related amortization are calculated separately for the property and casualty insurance segment and the reinsurance segment. The method followed in computing deferred policy acquisition costs limits the amount of such deferred costs to the estimated realizable value, which gives effect to the premium to be earned, related investment income, losses and settlement expenses and certain other costs expected to be incurred as the premium is earned. Deferred policy acquisition costs were not subject to limitation at December 31, 2009, and management does not anticipate future limitations to be likely due to the current adequacy of premium rates in both the insurance and reinsurance marketplaces.
The discount rate utilized in the valuations is based on an analysis of the total rate of return that could be generated by a hypothetical portfolio of high-quality bonds created to generate cash flows that match the plans’ expected benefit payments. No callable bonds are used in this analysis and the discount rate produced by this analysis is compared to interest rates of applicable published indices for reasonableness. The discount rates used in the pension benefit valuations at December 31, 2009, 2008 and 2007 were 5.75 percent, 6.25 percent and 6.00 percent, respectively. The discount rates used in the postretirement benefit valuations at December 31, 2009, 2008 and 2007 were 6.00 percent, 6.25 percent and 6.25 percent, respectively. A 0.25 percentage point decrease in the discount rates used in the 2009 valuations would increase the Company’s net periodic pension and postretirement benefit costs for 2010 by approximately $91,000. Conversely, a 0.25 percentage point increase in the 2009 discount rates would decrease the Company’s net periodic pension and postretirement benefit costs for 2010 by approximately $87,000.
The health care cost trend rate assumption represents the anticipated change in the cost of health care benefits due to factors outside of the plan. These factors include health care inflation, changes in health care utilization and delivery patterns, technological advances, and the overall health of the plan participants. The health care cost trend rate assumption is based on published information and general economic conditions. The health care cost trend rate assumption for 2009 was 9 percent, and is assumed to decrease gradually to 5 percent in 2018 and remain at that level thereafter.
In accordance with GAAP, actuarial gains/losses contained in the valuations that result from (1) actual experience that differs from that assumed, or (2) a change in actuarial assumptions, is accumulated and, if in excess of a specified corridor, amortized to expense over future periods. As of December 31, 2009, the supplemental retirement and defined benefit pension plans, as well as the postretirement benefit plans, had accumulated actuarial losses in excess of the corridor and thus will be amortized into expense in 2010. The Company’s share of the accumulated actuarial losses that will be amortized into expense during 2010 amounted to $1,614,000. Prior service costs/credits for plan amendments are also contained in the valuations, and are amortized into expense/income over the future service periods. As of December 31, 2009, the postretirement benefit plans have prior service credits that are being amortized into income in future periods, while the defined benefit pension plan has prior service costs that are being amortized into expense in future periods. The net amount of prior service credit being amortized into income during 2010 is $480,000.
In accordance with GAAP, the funded status of defined benefit retirement or other postretirement plans is recognized as a net asset or liability on the balance sheet. Changes in the funded status of the plans is recognized through other comprehensive income. Beginning in 2008, the pension and postretirement benefit plans’ assets and obligations are measured as of the end of the Company’s fiscal year.
The Company reported net income of $45,371,000 ($3.44 per share) in 2009 compared to a net loss of $1,705,000 ($0.13 per share) in 2008. This improvement is attributed to several factors: a record amount of catastrophe and storm losses in 2008, a record amount of “other-than-temporary” investment impairment losses recognized in 2008 as a result of the financial crisis, and a realized investment gain of $22,474,000 recognized in 2009 from the sale of the Company’s holdings of Verisk common stock. Another contributing factor to the improvement in net income was an improved underwriting performance by the Company’s reinsurance subsidiary in 2009.
Premiums earned for the property and casualty insurance segment decreased 2.4 percent to $308,079,000 in 2009 from $315,598,000 in 2008, primarily due to a 4.1 percent decline in premium rate levels implemented in 2008. Premium rates did improve somewhat in the personal lines of business during the second half of the year, but the commercial lines of business, which account for more than 80 percent of the property and casualty insurance segment’s premiums, remained very competitive. Filed rates for 2009 were up a modest 0.4 percent, representing the first positive change in four years. The competitiveness in the commercial lines of business is being driven, at least in part, by the weak economy. Companies know that any proposed rate increases on good business will likely be challenged by the insured and could result in the loss of the account. As a result, most companies are content to retain their good business at current pricing levels and wait for the economy to improve. New business premium increased approximately 13 percent in 2009 and accounted for approximately 13 percent of net written premiums, but was insufficient to cover premium declines resulting from prior year rate reductions and policies not retained. Approximately 39 percent of the new business came from the pool participants’ Premier and Leading agents (representing about 18 percent of the total agency force), which once again emphasizes the importance of building and strengthening agency relationships. Policy retention rates for the year declined slightly to approximately 86 percent in both commercial and personal lines, but continued to exceed industry averages. This decline is attributed to management’s willingness to walk away from underpriced business, efforts to limit exposures in coastal regions, and management’s decision to exit from personal lines in some regions of the country. Policy counts increased slightly in both the commercial and personal lines of business in 2009.
For the property and casualty insurance segment, the acquisition expense ratio increased to 38.8 percent in 2009 from 34.8 percent in 2008. This increase is attributed to increases in net periodic pension benefit cost, executive bonuses, contingent salaries, and policyholder dividends. The increase in executive bonuses and contingent salaries is due to the improved underwriting results in 2009 (no expense for these items was incurred in 2008). The increase in net periodic pension benefit cost is due to a significant increase in the amount of actuarial losses being amortized and a decrease in the expected return on plan assets, both resulting from the severe decline in the financial markets during 2008. The increase in policyholder dividend expense is largely due to an increase in the estimated dividend payable on several safety dividend groups, as well as an increase in the estimated aggregate amount of dividends payable on individual workers’ compensation policies as a result of good loss experience.
Other expense increased 32.3 percent to $2,173,000 in 2009 from $1,642,000 in 2008. This increase primarily reflects an increase in uncollectible premiums allocated to the property and casualty insurance subsidiaries through the pooling agreement, and a decrease in foreign currency exchange gains associated with the reinsurance subsidiary’s foreign currency denominated reinsurance business.
Premiums earned for the property and casualty insurance segment decreased 1.6 percent to $315,598,000 in 2008 from $320,836,000 in 2007 as new business premium was not sufficient to offset the premium lost from declining rate levels and business not retained. New business policy counts were up in 2008, and helped generate a slight increase in total policy count in both the commercial and personal lines of business. However, while personal lines new business premium increased 9.9 percent, commercial lines new business premium declined 8.9 percent. The decline in commercial lines new business premium was attributed to a combination of declining rates (rate declines are larger in commercial lines of business) and reduced exposures on new business (with a corresponding reduction in premium). The growth in personal lines new business premium was occurring in selected territories which management had identified as having greater profit potential. Retention rates remained above industry standards, with commercial lines declining slightly to 86.2 percent, personal auto remaining steady at 87.5 percent, and personal property increasing slightly to 86.6 percent.
Acquisition and other expenses declined 6.1 percent to $127,385,000 in 2008 from $135,693,000 in 2007. The acquisition expense ratio declined to 32.7 percent in 2008 from 34.5 percent in 2007. These declines were attributed to the property and casualty insurance segment and reflected reductions in the amount of expense related to policyholder dividends, agents’ profit share, executive bonuses and contingent salaries, and postretirement benefits.
For the property and casualty insurance segment, the acquisition expense ratio declined to 34.8 percent in 2008 from 37.1 percent in 2007. This decrease was attributed to declines in the amount of expense related to policyholder dividends, contingent commissions (in the form of agents’ profit share), executive bonuses and contingent salaries, and postretirement benefits. The decline in policyholder dividend expense was largely due to a decrease in the estimated dividend payable on several of the Company’s safety dividend groups. The declines in executive bonuses and contingent salaries, as well as agents’ profit share expenses, reflected the large decline in underwriting profitability that occurred during 2008. The decline in postretirement benefits expense reflected a decrease in the service cost component and the amortization of a prior service credit resulting from a plan amendment that became effective in the first quarter.
For the reinsurance segment, the acquisition expense ratio increased to 23.8 percent in 2008 from 22.9 percent in 2007. This increase was primarily associated with an increase in contingent commission expense in the MRB business, and, to a lesser extent, an increase in estimated commission expense on earned but not reported premiums.
Interest expense declined 20.1 percent in 2008 due to the redemption of the reinsurance subsidiary’s $11,000,000 of surplus notes on December 31, 2007. This decline in interest expense was partially offset by an increase in the interest rate on the surplus notes issued by the property and casualty insurance subsidiaries to 3.60 percent from 3.09 percent effective February 1, 2008. The 26.9 percent decrease in other expense was primarily due to fluctuations in foreign currency exchange rates recognized by the reinsurance subsidiary on its foreign contracts.
The Company is a holding company whose principal asset is its investment in its insurance subsidiaries. As a holding company, the Company is dependent upon cash dividends from its insurance company subsidiaries to meet all obligations, including cash dividends to stockholders and the funding of the Company’s stock repurchase program. State insurance regulations restrict the maximum amount of dividends insurance companies can pay without prior regulatory approval. See note 6 of Notes to Consolidated Financial Statements for additional information regarding dividend restrictions. The maximum amount of dividends that the insurance company subsidiaries can pay to the Company in 2010 without prior regulatory approval is approximately $44,986,000. The Company received $12,500,000, $25,005,000 and $4,750,000 of dividends from its insurance company subsidiaries and paid cash dividends to its stockholders totaling $9,507,000, $9,731,000 and $9,497,000 in 2009, 2008 and 2007, respectively. The excess dividends received from the insurance company subsidiaries in 2008 and 2009 were used to partially fund the Company’s $25,000,000 stock repurchase program. At December 31, 2009, approximately $7,100,000 of the stock repurchase program remains available for the purchase of additional shares, which will necessitate the dividend of additional funds from the insurance company subsidiaries to the holding company.
At the insurance company subsidiary level, the primary sources of cash are premium income, investment income and maturing investments. The principal outflows of cash are payments of claims, commissions, premium taxes, operating expenses, income taxes, dividends, interest and principal payments on debt, and investment purchases. Cash outflows vary because of uncertainties regarding settlement dates for unpaid losses and the potential for large losses, either individually or in the aggregate. Accordingly, the insurance company subsidiaries maintain investment and reinsurance programs intended to provide adequate funds to pay claims without forced sales of investments. In addition, the insurance company subsidiaries have access to a line of credit maintained by Employers Mutual with the Federal Home Loan Bank to provide additional liquidity if needed.
The Company maintains a portion of its investment portfolio in relatively short-term and highly liquid investments to ensure the availability of funds to pay claims and expenses. At December 31, 2009, approximately 18 percent of the Company’s fixed maturity securities were in U.S. government or U.S. government-sponsored agency securities. This is down from approximately 35 percent at December 31, 2008 due to a significant amount of call activity on the Company’s U.S. government agency securities that occurred during 2009 due to the low interest rate environment. As of December 31, 2009, the majority of the proceeds received from the called securities had been reinvested. A variety of maturities are maintained in the Company’s investment portfolio to assure adequate liquidity. The maturity structure of the fixed maturity securities is also established by the relative attractiveness of yields on short, intermediate and long-term securities. The Company does not invest in high-yield, non-investment grade debt securities. Any non-investment grade securities held by the Company are the result of rating downgrades subsequent to their purchase.
The Company invest for the long term and generally purchases fixed maturity securities intending to hold them to maturity. Despite this intent, the Company currently classifies purchases of fixed maturity securities as available-for-sale to provide flexibility in the management of its investment portfolio. At December 31, 2009, the Company had a net unrealized holding gain, net of deferred taxes, on its fixed maturity securities available-for-sale of $17,541,000, compared to a net unrealized holding loss of $5,468,000 at December 31, 2008. The fluctuation in the fair value of these investments is primarily due to changes in the interest rate environment during this time period, but also reflects fluctuations in risk premium spreads over U.S. Treasuries for corporate and U.S. government-sponsored agency securities. Since the Company does not actively trade in the bond market, such fluctuations in the fair value of these investments are not expected to have a material impact on the operations of the Company, as forced liquidations of investments are not anticipated. The Company closely monitors the bond market and makes appropriate adjustments in its portfolio as conditions warrant.
The Company held $47,000 and $67,000 in minority ownership interests in limited partnerships and limited liability companies at December 31, 2009 and 2008, respectively. The Company does not hold any other unregistered securities.
The Company’s cash balance was $279,000 and $183,000 at December 31, 2009 and 2008, respectively.
Employers Mutual contributed $17,000,000, $15,000,000 and $3,500,000 to its pension plan in 2009, 2008 and 2007, respectively, and plans to contribute approximately $25,000,000 to the pension plan in 2010. The Company reimbursed Employers Mutual $5,204,000, $4,555,000 and $1,069,000 for its share of the pension contributions in 2009, 2008 and 2007, respectively. Employers Mutual contributed $2,550,000, $12,200,000 and $3,800,000 to its postretirement benefit plans in 2009, 2008 and 2007, respectively, and expects to contribute approximately $2,750,000 to the postretirement benefit plans in 2010. The Company reimbursed Employers Mutual $724,000, $3,495,000 and $1,083,000 for its share of the postretirement benefit plan contributions in 2009, 2008 and 2007, respectively.
Capital resources consist of stockholders’ equity and debt, representing funds deployed or available to be deployed to support business operations. For the Company’s insurance and reinsurance company subsidiaries, capital resources are required to support premium writings. Regulatory guidelines suggest that the ratio of a property and casualty insurer’s annual net premiums written to its statutory surplus should not exceed three to one. All of the Company’s property and casualty insurance subsidiaries were well under this guideline at December 31, 2009.
The amortized cost and estimated fair value of fixed maturity and equity securities at December 31, 2009 were as follows:
The Company’s property and casualty insurance subsidiaries have $25,000,000 of surplus notes issued to Employers Mutual. Effective February 1, 2008, the interest rate on these surplus notes was increased from 3.09 percent to 3.60 percent. Future reviews of the interest rate will be conducted by the Inter-Company Committees of the Boards of Directors of the Company and Employers Mutual every five years. Payment of interest and repayment of principal can only be made out of the applicable subsidiary’s statutory surplus and is subject to prior approval by the insurance commissioner of the respective state of domicile. The surplus notes are subordinate and junior in right of payment to all obligations or liabilities of the applicable insurance subsidiaries. Prior to December 31, 2007, the Company’s reinsurance subsidiary had $11,000,000 of surplus notes issued to Employers Mutual. These surplus notes were redeemed in the fourth quarter of 2007, along with accrued interest. Total interest expense incurred on these surplus notes was $900,000, $889,000 and $1,111,000 in 2009, 2008 and 2007, respectively. At December 31, 2009, the Company’s property and casualty insurance subsidiaries had received approval for the payment of interest accrued on the surplus notes during 2009.
The Company recorded “other-than-temporary” investment impairment losses totaling $10,108,000 on 34 equity securities and three fixed maturity securities during 2009, compared to $30,921,000 on 40 equity securities during 2008. Impairment losses on the three fixed maturity securities totaled $2,657,000 and is attributed to a bankruptcy filing made by Great Lakes Chemical Corporation, now known as Chemtura Corporation ($2,220,000), a planned disposal of US Freightways Corporation securities ($350,000), and the determination of a credit loss (all contractual cash flows are not expected to be collected) on a residential mortgage-backed security ($87,000). Included in the 2008 amount is $14,904,000 of impairment losses on the perpetual preferred stocks of Freddie Mac and Fannie Mae resulting from the U.S. government placing these companies under conservatorship. The Company sold these perpetual preferred stocks during the fourth quarter of 2008 and recognized an additional loss of $141,000.
At December 31, 2009, the Company had unrealized losses on available-for-sale securities as presented in the table below. The estimated fair value is based on quoted market prices, where available. In cases where quoted market prices are not available, fair values are based on a variety of valuation techniques depending on the type of security. None of these securities are considered to be in concentrations by either security type or industry. The Company uses several factors to determine whether the carrying value of an individual security has been “other-than-temporarily” impaired. Such factors include, but are not limited to, the security’s value and performance in the context of the overall markets, length of time and extent the security’s fair value has been below carrying value, key corporate events and collateralization of fixed maturity securities. Based on these factors, the absence of management’s intent to sell these securities prior to recovery or maturity, and the fact that management does not anticipate that it will be forced to sell these securities prior to recovery or maturity, it was determined that the carrying value of these securities were not “other-than-temporarily” impaired at December 31, 2009 (note, however, that this schedule does include a relatively small amount of unrealized losses on an “other-than-temporarily” impaired residential mortgage-backed security). Risks and uncertainties inherent in the methodology utilized in this evaluation process include interest rate risk, equity price risk, and the overall performance of the economy, all of which have the potential to adversely affect the value of the Company’s investments. Should a determination be made at some point in the future that these unrealized losses are “other-than-temporary”, the Company’s earnings would be reduced by approximately $6,674,000, net of tax; however, the Company’s financial position would not be affected because unrealized losses on available-for-sale securities are reflected in the Company’s financial statements as a component of stockholders’ equity, net of deferred taxes.
Following is a schedule of the length of time securities have continuously been in an unrealized loss position as of December 31, 2009.
Following is a schedule of gross realized losses recognized in 2009 from the sale of securities and from “other-than-temporary” investment impairments. The schedule is aged according to the length of time the underlying securities were in an unrealized loss position. This schedule does not include realized losses stemming from corporate actions such as calls, pay-downs, redemptions, etc.
The “other-than-temporary” impairment losses on fixed maturity securities are primarily from the impairment of Chemtura Corporation and US Freightways Corporation securities, both of which were subsequently sold during 2009 generating a net realized gain of $798,000. The realized losses associated with securities that had been in an urealized loss position for over twelve months are primarily from “other-than-temporary” impairment losses recognized on three equity securities.
The amounts presented are estimates of the dollar amounts and time period in which the Company expects to pay out its gross loss and settlement expense reserves. These amounts are based on historical payment patterns and do not represent actual contractual obligations. The actual payment amounts and the related timing of those payments could differ significantly from these estimates.
Interest expense on long-term debt reflects the interest expense on the surplus notes issued by the Company’s property and casualty insurance subsidiaries to Employers Mutual. Interest on the surplus notes is subject to approval by the issuing company’s state of domicile regulatory authority. The balance shown under the heading “More than 5 years” represents interest expense for years six through ten. Since the surplus notes have no maturity date, total interest expense could be greater than the amount shown.
The participants in the pooling agreement have purchased annuities from life insurance companies, under which the claimant is payee, to fund future payments that are fixed pursuant to specific claim settlement provisions. The Company’s share of case loss reserves eliminated by the purchase of these annuities was $1,712,000 at December 31, 2009. The Company has a contingent liability of $1,712,000 at December 31, 2009 should the issuers of these annuities fail to perform. The probability of a material loss due to failure of performance by the issuers of these annuities is considered remote. The Company’s share of the amount due from any one life insurance company does not equal or exceed one percent of its subsidiaries’ aggregate policyholders’ surplus.
The main objectives in managing the Company’s investment portfolios are to maximize after-tax investment return while minimizing credit risks, in order to provide maximum support for the underwriting operations. Investment strategies are developed based upon many factors including underwriting results, regulatory requirements, fluctuations in interest rates and consideration of other market risks. Investment decisions are centrally managed by investment professionals and are supervised by the investment committees of the respective boards of directors for each of the Company’s subsidiaries.
The valuation of the Company’s marketable equity portfolio is subject to equity price risk. In general, equities have more year-to-year price variability than bonds. However, returns from equity securities have been consistently higher over longer time frames. The Company invests in a diversified portfolio of readily marketable equity securities. A hypothetical 10 percent decrease in the S&P 500 index as of December 31, 2009 would result in a corresponding pre-tax decrease in the fair value of the Company’s equity portfolio of approximately $8,193,000.
Ratings for preferred stocks and fixed maturity securities with initial maturities greater than one year are assigned by nationally recognized statistical rating organizations (referred to generically as NRSROs, which includes such organizations as Moody’s Investor’s Services, Inc., Standard and Poor, etc.). The NRSROs’ rating processes seek to evaluate the quality of a security by examining the factors that affect returns to investors. NRSROs’ ratings are based on quantitative and qualitative factors, as well as the economic, social and political environment in which the issuing entity exists. The quantitative factors include debt coverage, sales and income growth, cash flows and liquidity ratios. Qualitative factors include management quality, access to capital markets and the quality of earnings and balance sheet items. Ratings for securities with initial maturities less than one year are based on ratings of NRSROs, or the credit rating of the issuer’s parent company. For further discussion of credit risk and related topics (impairment losses on equity securities, residential mortgage-backed securities, unrealized losses in the investment portfolios, and non-investment grade securities held by the Company) see the section entitled "Investment Impairments and Considerations” within this Management’s Discussion and Analysis of Financial Condition and Results of Operations.
In December 2008, the FASB updated its guidance related to the Compensation-Retirement Benefits Topic 715 of the FASB ASC (issued as FSP FAS 132(R)-1, “Employers’ Disclosures about Postretirement Benefit Plan Assets”). This pronouncement established guidance on employers’ disclosures about plan assets of defined benefit pension or other postretirement plans, and was intended to address a lack of transparency surrounding the types of assets and associated risks in an employer’s defined benefit pension or other postretirement plans. The plan asset disclosures required are effective for fiscal years ending after December 15, 2009. Adoption resulted in additional disclosures, but had no effect on the consolidated financial position or operating results of the Company.
In December 2007, the FASB updated its guidance related to the Business Combinations Topic 805 of the FASB ASC (issued as SFAS No. 141 (revised 2007), “Business Combinations,” a replacement of SFAS No. 141, “Business Combinations”). This pronouncement retained the fundamental requirements of the acquisition method of accounting (previously referred to as “purchase method”) to be used for all business combinations, and was to be applied prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. Adoption of this statement had no effect on the consolidated financial position or operating results of the Company.
We have audited the accompanying consolidated balance sheets of EMC Insurance Group Inc. and Subsidiaries as of December 31, 2009 and 2008, and the related consolidated statements of income, comprehensive income, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2009. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We also have audited, in accordance with standards of the Public Company Accounting Oversight Board (United States), EMC Insurance Group Inc. and Subsidiaries’ internal control over financial reporting as of December 31, 2009, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 15, 2010 expressed an unqualified opinion thereon.
All balances presented below, with the exception of net investment income, realized investment gains (losses) and income tax expense (benefit), and other items specifically identified, are the result of related party transactions with Employers Mutual.
Certain commercial lines of business, primarily workers’ compensation, are eligible for policyholder dividends in accordance with provisions of the underlying insurance policies. Net premiums written subject to policyholder dividends represented approximately 60 percent of the Company’s total net premiums written in 2009. Policyholder dividends are accrued over the terms of the underlying policies.
Liabilities for losses are based upon case-basis estimates of reported losses supplemented with bulk case loss reserves, estimates of unreported losses based upon prior experience adjusted for current trends, and estimates of losses expected to be paid under assumed reinsurance contracts. Liabilities for settlement expenses are provided by estimating expenses expected to be incurred in settling the claims provided for in the loss reserves. Changes in estimates are reflected in current operating results (see note 4).
Securities classified as held-to-maturity are purchased with the intent and ability to be held to maturity and are carried at amortized cost. Unrealized holding gains and losses on securities held-to-maturity are not reflected in the financial statements. All other securities have been classified as securities available-for-sale and are carried at fair value, with unrealized holding gains and losses reported as a component of accumulated other comprehensive income (loss) in stockholders’ equity, net of deferred income taxes. Other long-term investments represent minor ownership interests in limited partnerships and limited liability companies and are carried at cost. Short-term investments represent money market funds, U.S. Treasury bills and commercial paper that are carried at cost, which approximates fair value.
In April 2009, the Financial Accounting Standards Board (FASB) updated its guidance related to the Investments-Debt and Equity Securities Topic 310 of the FASB Accounting Standards CodificationTM (Codification or ASC) (issued as Staff Position (FSP) FAS 115-2 and FAS 124-2, “Recognition and Presentation of Other-Than-Temporary Impairments”). This pronouncement established guidance for evaluating “other-than-temporary” impairments for fixed maturity securities, and required changes to the financial statement presentation and disclosure of fixed maturity and equity security “other-than-temporary” impairments. Included is a requirement that the evaluation of an impaired fixed maturity security include an assessment of whether the entity has the intent to sell the security and if it is more likely than not to be required to sell the security before recovery of its amortized cost basis. In addition, if the present value of cash flows expected to be collected is less than the amortized cost of the security, a credit loss is deemed to exist and the security is considered “other-than-temporarily” impaired. The portion of the impairment related to a credit loss is recognized through earnings and the impairment related to other factors is recognized through “other comprehensive income”. This pronouncement was effective for interim and annual reporting periods ending after June 15, 2009. A cumulative effect adjustment from retained earnings to “accumulated other comprehensive income” was required for previously “other-than-temporarily” impaired fixed maturity securities still owned that had a non-credit component of the loss as of the date of adoption. Adoption resulted in a cumulative effect adjustment to increase retained earnings and decrease “accumulated other comprehensive income” by $643,500, net of tax. Adoption also resulted in additional disclosures for fixed maturity and equity securities.
The Company has no stock-based compensation plans of its own; however, Employers Mutual has several stock plans that utilize the common stock of the Company. The Company receives the current fair value for all shares issued under these plans. Employers Mutual also has a stock appreciation rights (SAR) agreement in effect with an executive officer of the Company. The SAR agreement is based upon the market price of the Company’s common stock, and because it will be settled in cash it is considered to be a liability-classified award. A portion of the compensation expense recognized by Employers Mutual, as the requisite service period for granted options and SARs is rendered, is allocated to the Company’s property and casualty insurance subsidiaries though their participation in the pooling agreement (see note 2). Because a portion of Employers Mutual’s stock compensation expense is reflected in the Company’s financial statements and issuances of the Company’s stock under Employers Mutual’s stock option plans have an impact on the Company’s capital accounts, the disclosures required by FASB ASC Topic 718 are included in the Company’s consolidated financial statements.
Employers Mutual has various employee retirement plans including a defined benefit retirement plan, a supplemental retirement plan, and two postretirement benefit plans that provide retiree healthcare and life insurance coverage. Although the Company has no employees of its own, it is responsible for its share of the expenses and related prepaid assets and liabilities of these plans as determined under the terms of the pooling agreement, and the costs allocated by Employers Mutual to subsidiaries that do not participate in the pooling agreement (see note 2). Accordingly, the Company recognizes its share of the funded status of Employers Mutual’s defined benefit retirement and other postretirement plans as a net asset or liability on the balance sheet, with changes in the funded status of the plans recognized through “other comprehensive income.”
Included in the underlying reinsurance business assumed by Employers Mutual and EMC Reinsurance Company are reinsurance transactions conducted with foreign cedants denominated in their local functional currencies. In accordance with the terms of the quota share agreement (see note 2), the reinsurance subsidiary assumes all foreign currency exchange gains/losses associated with contracts incepting on January 1, 2006 and thereafter that are subject to the quota share agreement. The assets and liabilities resulting from these foreign reinsurance transactions are reported in U.S. dollars based on the foreign currency exchange rates that existed at the balance sheet dates. The foreign currency exchange rate gains/losses reported in the consolidated statements of income that resulted from these foreign reinsurance transactions are reported in U.S. dollars measured at the foreign currency exchange rates that existed at the inception of each reinsurance contract. The foreign currency exchange rate gains/losses resulting from these re-measurements to U.S. dollars are reported as other income/expense in the consolidated statements of income.
Goodwill represents the excess of cost over the fair value of net assets of acquired subsidiaries. Goodwill is not amortized, but is subject to annual impairment testing to determine if the carrying value of the goodwill exceeds the estimated fair value of net assets. If the carrying amount of the subsidiary (including goodwill) exceeds the computed fair value, an impairment loss is recognized through earnings equal to the excess amount, but not greater than the balance of the goodwill. An annual impairment test is completed in the fourth quarter of each year and goodwill was not deemed to be impaired in 2009, 2008 or 2007.
In April 2009, the FASB updated its guidance related to the Financial Instruments Topic 825 of the FASB ASC (issued as FSP FAS 107-1 and APB 28-1, “Interim Disclosures about Fair Value of Financial Instruments”). This pronouncement established quarterly disclosure requirements in interim financial statements of the fair value disclosures that were previously only required annually. This pronouncement was effective for interim and annual reporting periods ending after June 15, 2009. Adoption resulted in the addition of quarterly fair value disclosures, but had no effect on the consolidated financial position or operating results of the Company.
Under the terms of the quota share agreement, the reinsurance subsidiary receives reinstatement premium income that is collected by Employers Mutual from the ceding companies when reinsurance coverage is reinstated after a loss event; however, the cap on losses assumed per event contained in the quota share agreement is automatically reinstated without cost. This arrangement can produce unusual underwriting results for the reinsurance subsidiary when a large event occurs because the reinstatement premium income received by the reinsurance subsidiary may approximate, or even exceed, the amount of losses retained.
Employers Mutual retains 10.5 percent of the net assumed premiums written subject to cession to the reinsurance subsidiary as compensation for the $2,000,000 cap on losses assumed per event, which totaled $8,471,152, $8,636,718 and $8,329,929 in 2009, 2008 and 2007, respectively. Employers Mutual retained losses and settlement expenses in excess of the $2,000,000 cap totaling ($7,467) in 2009, $11,195,887 in 2008 and ($52,664) in 2007.
Investment expenses are based on actual expenses incurred by the Company plus an allocation of other investment expenses incurred by Employers Mutual, which is based on a weighted average of total invested assets and number of investment transactions. Investment expenses allocated to the Company by Employers Mutual amounted to $1,217,193, $1,464,337 and $1,455,808 in 2009, 2008 and 2007, respectively.
As of December 31, 2009, reinsurance ceded to two nonaffiliated reinsurers totaled $16,900,107, which represents a significant portion of the total prepaid reinsurance premiums and reinsurance receivables for losses and settlement expenses. These amounts reflect the property and casualty insurance subsidiaries’ aggregate pool participation percentage of amounts ceded by Employers Mutual to these organizations on a mandatory basis. Credit risk associated with these amounts is minimal, as all companies participating in these organizations are responsible for the liabilities of such organizations on a pro rata basis.
The effect of reinsurance on premiums written and earned, and losses and settlement expenses incurred, for the three years ended December 31, 2009 is presented below.
“Ceded to affiliates” represents the cession of the property and casualty insurance subsidiaries’ direct business to Employers Mutual under the terms of the pooling agreement.
For the property and casualty insurance segment, the December 31, 2009 estimate of loss and settlement expense reserves for accident years 2008 and prior decreased $34,641,246 from the estimate at December 31, 2008. This decrease represents 8.1 percent of the December 31, 2008 gross carried reserves and is primarily attributed to decreased severity associated with the final settlement of closed claims, lower than expected IBNR emergence, as well as favorable development on settlement expense reserves.
For the reinsurance segment, the December 31, 2009 estimate of loss and settlement expense reserves for accident years 2008 and prior decreased $13,981,046 from the estimate at December 31, 2008. This decrease represents 9.7 percent of the December 31, 2008 gross carried reserves and is largely attributed to the 2008 accident year in the Home Office Reinsurance Assumed Department (also known as “HORAD”) book of business. During the fourth quarter, the reinsurance segment experienced $4,160,000 of favorable development associated with a reduction in bulk IBNR reserves and the winding down of the MAERP Reinsurance Association (formerly known as Mutual Atomic Energy Reinsurance Pool).
For the property and casualty insurance segment, the December 31, 2008 estimate of loss and settlement expense reserves for accident years 2007 and prior decreased $21,564,256 from the estimate at December 31, 2007. This decrease represented 5.3 percent of the December 31, 2007 gross carried reserves and is primarily attributed to lower than expected emergence during 2008 of losses estimated to have been incurred but not reported (IBNR) at December 31, 2007, as well as favorable development on settlement expense reserves and decreased severity associated with the final settlement of closed claims.
For the property and casualty insurance segment, the December 31, 2007 estimate of loss and settlement expense reserves for accident years 2006 and prior decreased $27,976,811 from the estimate at December 31, 2006. This decrease represented 6.8 percent of the December 31, 2006 gross carried reserves and is primarily attributed to decreased severity associated with the final settlement of closed claims.
For the reinsurance segment, the December 31, 2007 estimate of loss and settlement expense reserves for accident years 2006 and prior decreased $10,761,217 from the estimate at December 31, 2006. This decrease represented 7.8 percent of the December 31, 2006 gross carried reserves and is largely attributed to the 2004, 2005 and 2006 accident years in the HORAD book of business.
The Company has exposure to asbestos and environmental related claims associated with the insurance business written by the parties to the pooling agreement and the reinsurance business assumed from Employers Mutual by the reinsurance subsidiary. These exposures are not considered to be significant. Asbestos and environmental losses paid by the Company have averaged only $946,458 per year over the past five years, but have increased during the past two years. Reserves for asbestos and environmental related claims for direct insurance and assumed reinsurance business totaled $6,526,964 and $6,853,100 ($6,219,546 and $6,788,975 net of reinsurance) at December 31, 2009 and 2008, respectively.
Prior to 2008, actual losses paid for asbestos-related claims had been minimal due to the plaintiffs’ failure to identify an exposure to any asbestos-containing product associated with the pool participants’ current and former policyholders. However, paid losses increased significantly during 2008 and 2009 as a result of claims attributed to two former policyholders. One of these former policyholders, a broker of various products, including asbestos, settled a claim for approximately $450,000 (the Company’s share) in 2008. Prior to 2008, the asbestos exposure associated with this former policyholder had been thought to be relatively small. At December 31, 2009, one additional claim associated with this former policyholder remains open, though similar exposure on that claim is not anticipated. The other former policyholder, a furnace manufacturer, had multiple claims settle for a total of approximately $514,000 (the Company’s share) in 2008 and 2009. The asbestos exposure associated with this former policyholder increased during this time period, and this trend may possibly continue into the future with increased per plaintiff settlements. Approximately 170 asbestos exposure claims associated with this former policyholder remain open. Defense costs for asbestos-related claims continue to be rather significant due to the large number of parties involved in the litigation proceedings and the length of time required to obtain judgments. Whenever possible, the pool participants have participated in cost sharing agreements with other insurance companies to reduce overall asbestos claim expenses.
Statutory surplus of the Company’s insurance subsidiaries was $327,244,159 and $284,492,170 at December 31, 2009 and 2008, respectively. Statutory net income (loss) of the Company’s insurance subsidiaries was $46,824,981, ($3,961,799) and $47,304,097 for 2009, 2008 and 2007, respectively.
The amount of retained earnings of the Company’s insurance subsidiaries available for distribution as dividends are limited by law to a percentage of the statutory unassigned surplus of each of the subsidiaries as of the previous December 31, as determined in accordance with accounting practices prescribed by insurance regulatory authorities of the state of domicile of each subsidiary. Subject to this limitation, the maximum dividend that may be paid within a 12 month period without prior approval of the insurance regulatory authorities is generally restricted to the greater of 10 percent of statutory surplus as regards policyholders as of the preceding December 31, or net income of the preceding calendar year on a statutory basis, not greater than earned statutory surplus. At December 31, 2009, $44,986,178 was available for distribution to the Company in 2010 without prior approval.
Other long-term investments, consisting primarily of holdings in limited partnerships and limited liability companies, are valued by the various fund managers. In management’s opinion, these values reflect fair value at December 31, 2009 and 2008.
On a quarterly basis, the Company receives from its independent pricing service a list of fixed maturity securities that were priced solely from broker quotes. Since this is not an observable input, any fixed maturity security in the Company’s portfolio that is on this list is classified as a Level 3 fair value measurement. At December 31, 2009, the Company did not hold any fixed maturity securities that were priced solely from broker quotes.
Prior to the fourth quarter of 2009, the Company held Class B shares of Insurance Services Office Inc. (now known as Verisk Analytics, Inc. (“Verisk”) following its Initial Public Offering on October 7, 2009). The Company was reporting this investment as a Level 3 fair value measurement at the fair value obtained from applying a 20 percent marketability discount to the quarterly valuations of the Class A shares produced by a nationally recognized independent financial advisory firm. This resulted in a fair value of $14,965,502 for the Class B shares at December 31, 2008. The Company sold its entire holding of Verisk during the fourth quarter of 2009 in conjunction with Verisk’s Initial Public Offering. This sale resulted in a realized capital gain of $22,473,792 (before tax).
Presented in the table below is a reconciliation of the assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the year ended December 31, 2009 and 2008. Any unrealized gains or losses on these securities would be recognized in other comprehensive income (loss). Any gains or losses from disposals or impairments of these securities would be reported as realized investment gains or losses in net income.
The amortized cost and estimated fair value of securities held-to-maturity and available-for-sale as of December 31, 2009 and 2008 are as follows. Securities classified as held-to-maturity are carried at amortized cost. All other securities have been classified as available-for-sale and are carried at fair value.
U.S. government-sponsored agency securities declined significantly in 2008 and 2009 due to a high level of call activity that resulted from the declining interest rate environment. The proceeds from these called securities were initially invested in short-term securities until suitable long-term investment opportunities were identified. During 2009, a portion of those proceeds were reinvested back into U.S. government-sponsored agency securities. The remaining proceeds were invested in obligations of states and political subdivisions, corporate securities, and commercial mortgage-backed securities.
The amortized cost and estimated fair value of fixed maturity securities at December 31, 2009, by contractual maturity, are shown below. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations, with or without call or prepayment penalties.
The amounts reported as “other-than-temporary” impairments on equity securities available-for-sale reflect the impairment of 34 equity securities for the year ended December 31, 2009, compared to 40 equity securities for the year ended December 31, 2008 and 14 equity securities for the year ended December 31, 2007. The large amount of impairment losses recognized during 2009 and 2008 is a result of the severe and prolonged turmoil in the financial markets. Included in the amount for 2008 is $14,904,000 of losses recognized on the perpetual preferred stocks of Freddie Mac and Fannie Mae when those companies were placed under conservatorship by the U.S. government.
During the first quarter of 2009, the Company recognized an “other-than-temporary” impairment loss on a fixed maturity security attributed to a bankruptcy filing made by Great Lakes Chemical Corporation, now known as Chemtura Corporation. At March 31, 2009, this security was trading at 26 percent of its par value, which was the amount established as the new cost basis ($780,000) after recognition of a $2,219,779 “other-than-temporary” impairment loss.
On April 1, 2009, the Company adopted updated guidance related to the Investments-Debt and Equity Securities Topic 310 of the FASB ASC (issued as FSP FAS 115-2 and FAS 124-2). This pronouncement required a cumulative effect adjustment from retained earnings to “accumulated other comprehensive income” for previously “other-than-temporarily” impaired fixed maturity securities that had a non-credit component of the loss as of the date of adoption. The only “other-than-temporarily” impaired fixed maturity security held by the Company as of the adoption date was the Chemtura Corporation securities. On the date of adoption the credit component of the loss amounted to $1,229,779, which was measured as the difference between the present value of the estimated cash flows ($1,770,000) and the original amortized cost basis ($2,999,779). The non-credit component of the loss ($990,000) was measured as the difference between the fair value ($780,000) and the present value of the estimated cash flows ($1,770,000). This non-credit component of the loss ($643,000 after taxes) was treated as a change in accounting principle, and was reclassified from retained earnings to “accumulated other comprehensive income” as of April 1, 2009. This security was subsequently sold during the third quarter of 2009 for proceeds of $2,617,500, resulting in a realized gain of $847,500.
During 2009, in anticipation of an expected default and management’s intention to sell, the Company recognized an “other-than-temporary” impairment loss on US Freightways Corporation fixed maturity securities. Due to management’s intent to sell these securities, the impairment was not bifurcated between credit loss and non-credit loss components, and the entire impairment was recognized in earnings ($350,000). This security was subsequently sold during the fourth quarter of 2009 for an additional loss of $50,000. The Company also recognized an “other-than-temporary” impairment loss on a residential mortgage-backed security. The total impairment on this security was $248,618, with $87,315 determined as the credit loss component (recognized in earnings) and the remainder ($161,303) recognized in other comprehensive income.
Following is a tabular roll forward of the amount of credit losses recognized in earnings from “other-than-temporary” impairments. Note that this table only includes the credit loss component of “other-than-temporary” impairments, and does not include the non-credit loss component (which is recognized through “other comprehensive income”) or impairments that are recognized through earnings in their entirety (not subject to bifurcation between credit and non-credit components).
The large increase in interest income on short-term securities and the corresponding decline in interest on fixed maturity securities during 2008 is the result of a significant amount of call activity on U.S. government-sponsored agency securities due to the declining interest rate environment. The proceeds from these called securities were initially invested in short-term securities, until suitable long-term investment opportunities were later identified.
Temporary differences between the consolidated financial statement carrying amount and tax basis of assets and liabilities that give rise to significant portions of the deferred income tax asset at December 31, 2009 and 2008 are as follows:
The Company’s property and casualty insurance subsidiaries have $25,000,000 of surplus notes issued to Employers Mutual. Effective February 1, 2008, the interest rate on these surplus notes was increased from 3.09 percent to 3.60 percent. Reviews of the interest rate will be conducted by the Inter-Company Committees of the Boards of Directors of the Company and Employers Mutual every five years. Payment of interest and repayment of principal can only be made out of the applicable subsidiary’s statutory surplus and is subject to prior approval by the insurance commissioner of the respective state of domicile. The surplus notes are subordinate and junior in right of payment to all obligations or liabilities of the applicable insurance subsidiaries. Prior to December 31, 2007, the Company’s reinsurance subsidiary had $11,000,000 of surplus notes issued to Employers Mutual. These surplus notes were redeemed in the fourth quarter of 2007, along with accrued interest. Total interest expense incurred on these surplus notes was $900,000, $889,375 and $1,111,469 in 2009, 2008 and 2007, respectively. At December 31, 2009, the Company’s property and casualty insurance subsidiaries had received approval for the payment of interest accrued on the surplus notes during 2009.
Effective January 1, 2008, Employers Mutual increased the minimum retirement age and length of service requirements to receive the full employer contribution amount in the postretirement health care benefit plan. This change did not affect current retirees. The Company also increased the level of coverage and service requirements for its postretirement life insurance benefit plan.
During 2010, the Company will amortize $1,233,747 of net actuarial loss and $138,957 of prior service cost associated with the pension plans into net periodic benefit cost. In addition, the Company will amortize $619,217 of prior service credit and $380,518 of net actuarial loss associated with the postretirement benefit plans into net periodic postretirement benefit cost in 2010.
Net periodic pension benefit cost allocated to the Company amounted to $4,888,759, $1,419,827 and $1,514,136 in 2009, 2008 and 2007, respectively. Net periodic postretirement benefit cost allocated to the Company for the years ended December 31, 2009, 2008 and 2007 was $732,969, $752,309 and $2,267,348, respectively.
Employers Mutual manages the VEBA trust assets internally. The trust is currently in the funding stage, with contributions sufficiently large enough to cover current year benefits, as well as establish a reserve to fund future benefits. As such, an emphasis is placed on asset accumulation, with current income generation secondary.
Insurance Contract: Valued at the cash accumulation value, which approximates fair value.
The fair values of Employers Mutual’s VEBA trust by asset category are as follows:
Following is a description of the valuation methodologies used for the assets classes of Employers Mutual’s defined benefit retirement plan.
Short-Term Funds - these portfolios are comprised of short term securities. Securities in a Money Market Fund, such as the Prudential Short-Term Fund, are valued initially at cost and thereafter adjusted for amortization of any discount or premium.
U.S. Bond Funds - are portfolios that contain domestic fixed-income securities. Securities are priced by Interactive Data using inputs such as benchmark yields, reported trades, broker/dealer quotes, and issuer spreads. Interactive Data also monitors market indices and industry and economic events. Prices are reviewed to ensure comfort and can be challenged with Interactive Data and/or overridden if Prudential believes the price would be more reflective of fair value.
The 1993 Plan and the 2003 Plan provide for awards of incentive stock options only, while the 2007 Plan provides for the awarding of performance shares, performance units, and other stock-based awards, in addition to qualified (incentive) and non-qualified stock options, stock appreciation rights, restricted stock and restricted stock units. All three plans provide for a ten-year time limit for granting awards. Options can no longer be granted under the 1993 Plan and no additional options will be granted under the 2003 Plan now that Employers Mutual is utilizing the 2007 Plan. Options granted under the plans generally have a vesting period of five years, with options becoming exercisable in equal annual cumulative increments commencing on the first anniversary of the option grant. Option prices cannot be less than the fair value of the common stock on the date of grant.
During 2009, 304,400 non-qualified options were granted under the 2007 Plan to eligible participants at a price of $18.865 and 37,271 options were exercised under the plans at prices ranging from $9.25 to $19.35. A summary of the activity under Employers Mutual’s stock option plans for 2009, 2008 and 2007 is as follows:
On May 30, 2008, the Company registered 500,000 shares of the Company’s common stock for use in the Employers Mutual Casualty Company 2008 Employee Stock Purchase Plan (2008 Plan). The 2008 Plan provides for any eligible employee to participate in the plan by delivering, during the first twenty days of the calendar month preceding the first day of an election period, a payroll deduction authorization to the plan administrator; or making a cash contribution. Participants pay 85 percent of the fair market value of the stock on the date of purchase. The plan is administered by the Board of Employers Mutual and the Board has the right to amend or terminate the plan at any time; however, no such amendment or termination shall adversely affect the rights and privileges of participants with unexercised options. Expenses allocated to the Company in connection with these plans totaled $25,892, $9,695 and $22,643 in 2009, 2008 and 2007, respectively.
During 2009, a total of 23,397 options were exercised at prices ranging from $17.84 to $18.39. Activity under the plans was as follows:
A total of 200,000 shares of the Company’s common stock have been reserved for issuance under the 2003 Employers Mutual Casualty Company Non-Employee Director Stock Option Plan. All non-employee directors of Employers Mutual and its subsidiaries and affiliates who are not serving on the “Disinterested Director Committee” of the Board of Employers Mutual as of the beginning of an option period are eligible to participate in the plan. Each eligible director can purchase shares of common stock at 75 percent of the fair value of the stock on the option exercise date in an amount equal to a minimum of 25 percent and a maximum of 100 percent of their annual cash retainer. The plan will continue through the option period for options granted at the 2012 annual meetings. The plan is administered by the Disinterested Director Committee of the Board. The Board may amend or terminate the plan at any time; however, no such amendment or termination shall adversely affect the rights and privileges of participants with unexercised options. Expenses allocated to the Company in connection with these plans totaled $15,326, $27,121 and $18,173 in 2009, 2008 and 2007, respectively.
The Company maintains a dividend reinvestment and common stock purchase plan which provides stockholders with the option of reinvesting cash dividends in additional shares of the Company’s common stock. Participants may also purchase additional shares of common stock without incurring broker commissions by making optional cash contributions to the plan, and may sell shares of common stock through the plan. Employers Mutual did not participate in this plan in 2009, 2008 or 2007. Activity under the plan was as follows:
On October 19, 2006, Employers Mutual entered into a stock appreciation rights (SAR) agreement with the Company’s Executive Vice President and Chief Operating Officer (Mr. Murray). This SAR agreement is a substitute for an incentive stock option grant Mr. Murray was initially authorized to receive as part of his 2006 compensation arrangement, but was not issued to him due to certain limitations contained in Employers Mutual’s incentive stock option plan. The grant-date fair value of this award was $546,300. Because the SAR agreement will be settled in cash, it is considered to be a liability-classified award under ASC Topic 718. As a result, the value of this agreement must be re-measured at fair value at each financial statement reporting date, subject to a minimum fair value of $318,825 stipulated in the SAR agreement. The fair value of this agreement at December 31, 2009, 2008 and 2007 was $318,825 ($95,648 as the Company’s portion from the pool). The full value of this agreement was expensed in 2006 because Mr. Murray is currently eligible for retirement and is entitled to keep the award at retirement. As a result, the award does not have any subsequent service requirements. Subsequent changes in the fair value of this agreement will be reflected as compensation expense until the agreement is ultimately settled in 2016. During 2009 and 2008, the Company did not recognize any compensation expense related to this award as the fair value of the award did not change. During 2007, the Company recognized negative compensation expense of $103,207 ($67,085 net of tax) related to this award.
The participants in the pooling agreement are subject to guaranty fund assessments by states in which they write business. Guaranty fund assessments are used by states to pay policyholder liabilities of insolvent insurers domiciled in those states. Many states allow assessments to be recovered through premium tax offsets. Estimated guaranty fund assessments of $1,236,315 and $1,505,808 and related premium tax offsets of $692,233 and $935,822 have been accrued as of December 31, 2009 and 2008, respectively. The guaranty fund assessments are expected to be paid over the next two years and the premium tax offsets are expected to be realized within ten years of the payments. The participants in the pooling agreement are also subject to second-injury fund assessments which are designed to encourage employers to employ a worker with a pre-existing disability. Estimated second-injury fund assessments of $1,709,015 and $1,575,905 have been accrued as of December 31, 2009 and 2008, respectively. The second-injury fund assessment accruals are based on projected loss payments. The periods over which the assessments will be paid is not known.