pool and is allocated among the pool participants based on their respective participation interests.
The following discussion and analysis of EMC Insurance Group Inc. and its subsidiaries' financial condition and results of operations should be read in conjunction with the Consolidated Financial Statements and Notes to Consolidated Financial Statements included elsewhere herein.
On October 20, 2004, the Company successfully completed a follow-on stock offering and sold 2.0 million new shares of its common stock to the public at a price of $18.75 per share. Employers Mutual participated in the stock offering as a selling shareholder and sold 2.1 million shares of the Company's common stock that it previously owned. As a result of these transactions, Employers Mutual's ownership of the Company was reduced from approximately 80.9 percent to 53.7 percent.
Net proceeds from the follow-on stock offering totaled $34,890,000. These proceeds were contributed to three of the Company's property and casualty insurance subsidiaries in late December to support a planned 6.5 percentage point increase in the Company's aggregate participation in the pooling agreement effective January 1, 2005. As a result of this change, the Company's aggregate participation in the pooling agreement will increase from the current 23.5 percent to 30.0 percent and Employers Mutual's participation will decrease from the current 65.5 percent to 59.0 percent. In connection with this change in the pooling agreement, the Company's liabilities will increase $115,042,000 and assets will increase $108,798,000. The Company will reimburse Employers Mutual $6,519,000 for expenses that were incurred to generate the additional business assumed by the Company, but this expense will be offset by an increase in deferred policy acquisition costs. The Company will also receive $275,000 in interest income from Employers Mutual as the actual cash transfer did not occur until February 15, 2005.
Insurance pricing has historically been cyclical in nature. Periods of excess capital and increased competition encourage price cutting and liberal underwriting practices (referred to as a soft market) as insurance companies compete for market share, while attempting to cover the inevitable underwriting losses from these actions with investment income. As capital decreases and competition begins to subside in the interest of strengthening the balance sheet, premium pricing rises, sometimes dramatically, and underwriting practices are tightened (referred to as a hard market). During the late 1990's the insurance industry had hit the depths of an extremely long soft market. High interest rates and a strong stock market allowed insurers to cover ever growing underwriting losses with investment income. As the year 2000 approached, declining interest rates and a weakening stock market prompted the insurance industry to begin a movement toward increased pricing. This movement was dramatically accelerated by the terrorist attacks of September 11, 2001, pushing the industry toward a hard market. The ensuing plunge in the stock market, a further decline in interest rates, high profile bankruptcies and rising concerns about reserve deficiencies lead the insurance industry to implement large premium rate increases in an effort to improve capitalization. This hard market continued through 2002, but began to level off somewhat during 2003 as premium rate increases slowed, or even flattened, in most lines of business. Premium rates were fairly stable during 2004, but
moderated slightly in certain lines of business and select territories due to an increase in price competition. Overall premium rate levels for 2005 are expected to remain steady or decline slightly due to improved industry capitalization and continued price competition.
Recent actions by New York Attorney General Eliot Spitzer have raised questions concerning the use of contingent commission arrangements whereby insurance companies provide agents with financial incentives in addition to the traditional commission structure. The arrangements targeted by Attorney General Spitzer are variously referred to as "placement service agreements" or "market service agreements" and, in essence, compensate an agent for directing business to a particular insurance company. The Company, like many others in the insurance industry, uses contingent compensation arrangements to compensate independent agents for the valuable services they provide to their clients.
In addition to an ongoing review of claim files in the normal course of business, the Company has for many years required each of its 16 branch offices to perform a complete inventory of its open claim files during the fourth quarter of each year and to review the adequacy of each carried reserve based on current information. This fourth quarter review process has not historically resulted in a significant increase in carried reserves; however, because of heightened emphasis placed on case reserve adequacy during 2004, the review performed in the fourth quarter of 2004 generated a significant and unanticipated increase in carried reserves and a corresponding increase in settlement expense reserves. In an effort to minimize the likelihood of this occurring in the future, beginning in the 2005 the branch offices will be required to perform a complete inventory and review of their open claim files semi-annually rather than annually as previously required. The first review is to be completed by the end of June and the second review is to be completed by the end of November each year. This new procedure is designed to help assure that necessary reserve adjustments are implemented on a timely basis.
The products offered by an insurance company must be priced so that they are competitive in the marketplace, yet offer the prospect of producing an underwriting profit. Management is keenly aware of the need to achieve an underwriting profit in today's marketplace and has implemented focused underwriting initiatives that stress profitability over production. Achieving an underwriting profit has become increasingly important during the last several years as investment income, which is used to supplement underwriting results and contribute to net earnings, has been negatively impacted by the lingering low interest rate environment.
The Company's consolidated financial statements are prepared on the basis of accounting principles generally accepted in the United States (also known as "GAAP"). The Company also prepares financial statements for each of its insurance subsidiaries based on statutory accounting principles that are filed with insurance regulatory authorities in the states in which they do business. Statutory accounting principles are designed to address the concerns of state regulators and stress the measurement of the insurer's ability to satisfy its obligations to its policyholders and creditors.
Management evaluates the Company's operations by monitoring key measures of growth and profitability. Management measures the Company's growth by examining direct premiums written and, perhaps more importantly, premiums written assumed from affiliates. Management generally measures the Company's operating results by examining the Company's net income, return on equity, and the loss and settlement expense, acquisition expense and combined ratios. The following provides further explanation of the key measures management uses to evaluate the Company's results:
Premiums Written Assumed From Affiliates. Premiums written assumed from affiliates reflects the Company's property and casualty insurance subsidiaries' 23.5 percent aggregate participation interest in the total direct premiums written by all the participants in the pooling arrangement and the premiums written assumed by the Company's reinsurance subsidiary from Employers Mutual under the quota share agreement. See note 3 of Notes to Consolidated Financial Statements. Management uses premiums written assumed from affiliates and non-affiliates, which excludes the impact of written premiums ceded to reinsurers, as a measure of the underlying growth of the Company's insurance business from period to period.
Net Premiums Written. Net premiums written is the sum of the premiums written assumed from affiliates plus premiums written assumed from non- affiliates less premiums written ceded to non-affiliates. Premiums written ceded to non-affiliates is the portion of the Company's direct and assumed premiums written that is transferred to reinsurers in accordance with the terms of the reinsurance contracts and based upon the risks they accept. See note 3 of Notes to Consolidated Financial Statements. Management uses net premiums written to measure the amount of business retained after cessions to reinsurers.
Loss and Settlement Expense Ratio. The loss and settlement expense ratio is the ratio (expressed as a percentage) of losses and settlement expenses to premiums earned and measures the underwriting profitability of a company's insurance business. The loss and settlement expense ratio is generally measured on both a gross (direct and assumed) and net (gross less ceded) basis. Management uses the gross loss and settlement expense ratio as a
GAAP Combined Ratio. The combined ratio is the sum of the loss and settlement expense ratio and the acquisition expense ratio and measures a company's overall underwriting profit. If the combined ratio is at or above 100, an insurance company cannot be profitable without investment income (and may not be profitable if investment income is insufficient). Management uses the GAAP combined ratio in evaluating the Company's overall underwriting profitability and as a measure for comparison of the Company's profitability relative to the profitability of its competitors who prepare GAAP-basis financial statements.
The following accounting policies are considered by management to be critically important in the preparation and understanding of the Company's financial statements and related disclosures. The assumptions utilized in the application of these accounting policies are complex and require subjective judgment.
Liabilities for losses are based upon case-basis estimates of reported losses and estimates of incurred but not reported ("IBNR") losses. For direct insurance business, the Company's IBNR reserves are estimates of liability for accidents that have occurred, but have not yet been reported to the Company. For assumed reinsurance business, IBNR reserves are also used to record anticipated increases in reserves for claims that have previously been
reported. An estimate of the expected expenses to be incurred in the settlement of the claims provided for in the loss reserves is established as the liability for settlement expenses.
Property and Casualty Insurance Segment - --------------------------------------- The Company's claims department establishes case loss reserves for direct business. Branch claims personnel establish case reserves for individual claims, with mandatory home office claims department review of reserves that
exceed a specified threshold. This reserving process implicitly assumes a stable inflationary and legal environment. The Company's case loss reserve philosophy is exposure based and implicitly assumes a stable inflationary and legal environment. When claims department personnel establish loss reserves they take into account various factors that influence the potential exposure, such as the types of injuries being claimed, whether the insured is a target defendant, the jurisdiction in which a potential court case would be litigated and negligence of other parties. The goal of the claims department is to establish and maintain loss reserves that are sufficient, but not excessive. Most of the IBNR reserves for direct business are established through an actuarial analysis of IBNR claims that have emerged after the end of recent calendar years compared to the corresponding calendar year earned premiums (adjusted for changes in rate level adequacy). The methodology used in estimating these formula IBNR reserves assumes consistency in claims reporting patterns and immaterial changes in loss development patterns due to loss cost trends. From this analysis, IBNR factors are derived for each line of business and are applied to the latest twelve months of earned premiums to generate the formula IBNR reserves.
The methodology used for reserving settlement expenses is based on an analysis of historical ratios of paid expenses to paid losses. Assumptions underlying this methodology include stability in the mix of business, consistent claims processing procedures, immaterial impact of loss cost trends on development patterns, and a consistent philosophy regarding the defense of lawsuits. Based on this actuarial analysis, factors are derived for each line of business, which are applied to loss reserves to generate the settlement expense reserves.
As of December 31, 2004, IBNR loss reserves accounted for $55,720,000, or 18.0 percent, of the property and casualty insurance segment's total loss and settlement expense reserves, compared to $49,259,000, or 19.6 percent at December 31, 2003. IBNR reserves are, by nature, less precise than case reserves. A five percent change in IBNR reserves at December 31, 2004 would equate to a $2,786,000 change in loss reserves, which would represent 13.7 percent of net income and 0.8 percent of stockholders' equity.
The Company's direct IBNR reserves are established by applying factors to the latest twelve months premiums earned. These factors are developed using a methodology that compares (1) 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. Included in the rate adequacy adjustment 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. This methodology assumes that future emerged IBNR claims relative to IBNR claims that have emerged after 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 reserves.
To address the underlying cause of the indicated deficiency in case reserves, the home office claims department in early 2004 instructed each of the 16 branch offices to review and carefully reevaluate all claim reserves for adequacy. As a result of these reviews, case reserves were strengthened significantly in both the second and third quarters of 2004 and the third quarter actuarial review indicated that case reserves, as well as total loss and settlement expense reserves, were adequate. However, during the required fourth quarter inventory and review process, the branch offices further strengthened their case reserves, generating a significant amount of adverse development on prior years' reserves. With this additional strengthening, carried loss and settlement expense reserves are toward the high end of the range of actuarial reserve indications at December 31, 2004.
Reinsurance Segment - ------------------- The reinsurance book of business is comprised of two major components. The first is Home Office Reinsurance Assumed Department ("HORAD"), which is the reinsurance business that is underwritten by Employers Mutual. The second is the Mutual Reinsurance Bureau pool ("MRB"), which is a voluntary reinsurance pool in which Employers Mutual participates with other unaffiliated insurers.
At December 31, 2004, there was no backlog in the processing of assumed reinsurance information. Approximately $72,525,000 or 61 percent of the reinsurance segment's carried reserves were reported by the ceding companies. Employers Mutual receives loss reserve and paid loss data from the 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. Unearned premiums are generally reported on pro rata accounts, but are usually calculated by Employers Mutual on excess-of-loss business.
Employers Mutual's actuarial department annually reviews the MRB reserves for reasonableness. These analyses use a variety of actuarial techniques, which are applied at a line-of-business level. MRB staff supplies the reserve analysis data, which is verified for accuracy by Employers Mutual's actuaries. This review process is replicated by certain other MRB member companies, using actuarial techniques they deem appropriate. Based on these reviews, Employers Mutual and the other MRB member companies have consistently found the MRB reserves to be appropriate.
For long-tail lines of business, unreliable estimates of unreported losses can result from the application of loss projection factors to reported losses. To some extent, this is also true for short-tail lines of business in the early stages of a policy year's development. Therefore, in addition to loss-based projections, we generate estimates of unreported losses based on earned premiums. The latter estimates are sometimes more stable and reliable than projections based on losses.
Toxic tort (primarily asbestos), environmental and other uncertain exposures - ---------------------------------------------------------------------------- Toxic tort claims include those claims where the claimant seeks compensation for harm allegedly caused by exposure to a toxic substance or substance that increases the risk of contracting a serious disease, such as cancer. Typically the injury is caused by latent effects of direct or indirect exposure to a substance or combination of substances through
absorption, contact, ingestion, inhalation, implantation or injection. Examples of toxic tort claims include injuries arising out of exposure to asbestos, silica, mold, drugs, carbon monoxide, chemicals or lead.
During 2003, as a direct result of proposed federal legislation in the areas of asbestos and class action reform, the Company was presented with several hundred additional lawsuits filed against three former policyholders representing approximately 40,500 claims related to exposure to asbestos or asbestos containing products. These claims are based upon nonspecific asbestos exposure and nonspecific injuries. As a result, management did not establish a significant amount of loss reserves associated with these claims. The vast majority of the 40,500 claims are multi-plaintiff suits filed in Mississippi. One lawsuit lists multiple named plaintiffs of approximately 2,000 individuals. While the expense of handling these lawsuits is higher than what the Company has averaged in the past, it is not proportional based upon the number of plaintiffs, and is mitigated to some extent through cost sharing agreements reached with other insurance companies. The Company believes its settlement expense reserve adequately accounts for these additional expenses.
While proposed federal asbestos legislation was not successful in 2004, plaintiffs' attorneys have already altered their pleadings across the country to anticipate the enactment of federal legislation. Specifically, asbestos plaintiffs' attorneys are pleading "silica" and "pnuemoconisis dust" exposure for new clients, as well as former asbestos plaintiffs. The Company is defending approximately 200 such claims in Texas and Mississippi jurisdictions, some of which involve multiple plaintiffs. The plaintiffs allege employment exposure to "airborne respirable silica dust," causing "serious and permanent lung injuries," i.e., silicosis. Silicosis injuries are identified in the upper lobes of the lungs while asbestos injuries are localized in the lower lobes.
Examples include, but are not limited to: chemical waste; hazardous waste treatment, storage and/or disposal facilities; industrial waste disposal facilities; landfills; superfund sites; toxic waste spills; and underground storage tanks. Widespread use of pollution exclusions since 1970 in virtually all lines of business, except personal lines, has resulted in limited exposure to environmental claims. Absolute pollution exclusions have been used since the 1980's. The Company's exposure to environmental claims is therefore limited primarily to accident years preceding the 1980s. The pre-1980's exposures include municipality exposures for closed landfills, small commercial businesses involved with disposing waste at landfills or leaking underground storage tanks. During 2002, the Company re-evaluated the estimated ultimate losses for direct environmental exposures. Based on this re-evaluation, the Company reallocated $576,000 of bulk IBNR reserves and $191,000 of settlement expense reserves to direct environmental exposures. No additional IBNR reserves were established for these exposures.
In 2004, the Company was presented with eight contamination claims filed against four of its petroleum marketers in Iowa and Indiana. The claims arise out of alleged contamination of municipal public water systems by the gasoline additive Methyl Tertiary Butyl Ether ("MTBE"). All MTBE lawsuits initiated in California, Connecticut, Florida, Indiana, Iowa, Massachusetts, New Hampshire, New Jersey and New York were moved to their respective federal courts and were then transferred to the United States District Court for the Southern District of New York where they were consolidated under the caption, In re: Methyl Tertiary Butyl Ether ("MTBE") Products Liability Litigation. The Company is defending these claims under commercial auto policies which afford broadened pollution liability coverage for overfills. These defenses are subject to express reservations of rights based upon the lack of property damage within the policy periods because these lawsuits do not specifically allege dates of property damage or contamination or any contamination that is the result of an overfill.
At December 31, 2004, the Company carried asbestos and environmental reserves for direct insurance and assumed reinsurance business totaling $5,460,000, which represents 1.3% of total loss and settlement expense reserves. The asbestos and environmental reserves include $1,662,000 of case reserves, $2,836,000 of IBNR reserves and $962,000 of bulk settlement expense reserves.
The Company has exposure to construction defect claims arising from general liability policies issued to contractors. Most of the Company's construction defect claims are concentrated in a limited number of states, and the Company has 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. The Company has recently implemented additional coding to identify and monitor construction defect claims. Newly reported construction defect claims numbered 685, 668, and 555 in 2004, 2003, and 2002, respectively, and produced incurred losses and paid settlement expenses of approximately $2,498,000, $3,200,000, and $1,913,000 in each respective period. Incurred losses and paid settlement expenses on all construction defect claims totaled approximately $3,895,000 in 2004. At year- end 2004, the Company carried case reserves of approximately $6,075,000 on 982 open construction defect claims.
Reserves at 12/31/03 Asbestos ...........$ 1,138 $ 991 $ 756 $ 86 $ 646 $ - Environmental ...... 13 836 316 52 750 - Products(1) ........ 4,235 2,557 4,657 - - - Casualty excess(2) - - - 18,959 24,834 1,866
Paid during 2003 Asbestos ...........$ 14 $ 83 $ 93 $ 2 Environmental ...... 5 6 33 - Products(1) ........ 705 959 - - Casualty excess(2) - - 4,523 386
Paid during 2002 Asbestos ...........$ 18 $ 97 $ 8 $ - Environmental ...... 44 10 12 - Products(1) ........ 577 586 - - Casualty excess(2) - - 5,019 498
(1) Products includes the portion of asbestos and environmental claims reported above that are non-premises/operations claims. (2) Casualty excess includes the asbestos and environmental claims reported above.
Environ- Asbestos mental Products -------- -------- -------- Open claims, 12/31/04 ... 39,738 6 1,721 Reported in 2004 ........ 9,655 2 295 Disposed of in 2004 ..... 10,993 3 358
After-Tax Impact Range of Reserve Estimates on Earnings -------------------------- ------------------ Reserves Reserves ($ in thousands) High Low Carried at High at Low -------- -------- ------- -------- -------- Property and casualty insurance segment .........$294,723 $248,453 $285,962 $ (5,694) $ 24,381 Reinsurance segment ......... 119,880 102,484 119,721 (104) 11,204 -------- -------- -------- -------- -------- $414,603 $350,937 $405,683 $ (5,798) $ 35,585 ======== ======== ======== ======== ========
Workers' compensation claim severity has increased significantly over the past five years, with the projected ultimate average claim amount increasing approximately 72 percent over the five year period. An increase of this magnitude has made the establishment of adequate case reserves challenging. A review of claim data indicates that claims adjusters have recently underestimated medical costs and the length of time injured workers are away from work. In addition, partial disability benefits have been underestimated or unanticipated. Large increases in drug costs and the availability and utilization of new and costly medical procedures have contributed to rapidly escalating medical costs.
In response to an indicated deficiency in case reserves at December 31, 2004, the home office claims department in early 2004 instructed each of the 16 branch offices to review and carefully reevaluate all claim reserves for adequacy. As a result of these reviews, case reserves were strengthened in both the second and third quarters of 2004. However, during the required fourth quarter inventory and review process, the branch offices further strengthened their case reserves, generating a significant amount of adverse development on prior years' reserves.
Amortization of deferred policy acquisition costs is calculated as the difference between the beginning and ending amounts of deferred policy acquisition costs plus the amount of costs deferred during the current year. 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 their 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, 2004, and management does not anticipate future limitations to be likely due to the improved premium rate environment in both the insurance and reinsurance marketplaces.
Segment information and consolidated net income for the three years ended December 31, 2004 are as follows:
($ in thousands) 2004 2003 2002 -------- -------- -------- REINSURANCE Premiums earned .......................... $ 95,444 $ 89,386 $ 72,030 Losses and settlement expenses ........... 53,346 58,266 50,906 Acquisition and other expenses ........... 26,870 24,403 23,150 -------- -------- -------- Underwriting income (loss) ............... $ 15,228 $ 6,717 $ (2,026) ======== ======== ======== Loss and settlement expense ratio ........ 55.9% 65.2% 70.7% Acquisition expense ratio ................ 28.1 27.3 32.1 -------- -------- -------- Combined ratio ........................... 84.0% 92.5% 102.8% ======== ======== ======== Losses and settlement expenses: Insured events of current year ....... $ 56,946 $ 59,805 $ 48,553 (Decrease) increase in provision for insured events of prior years ...... (3,600) (1,539) 2,353 -------- -------- -------- Total losses and settlement expenses ....................... $ 53,346 $ 58,266 $ 50,906 ======== ======== ======== Catastrophe and storm losses ............. $ 5,011 $ 3,411 $ 249 ======== ======== ========
CONSOLIDATED REVENUES Premiums earned .......................... $345,479 $330,623 $297,043 Net investment income .................... 29,900 29,702 32,778 Realized investment gains (losses) ....... 4,379 1,170 (3,159) Other income ............................. 601 862 866 -------- -------- -------- 380,359 362,357 327,528 -------- -------- -------- LOSSES AND EXPENSES Losses and settlement expenses ........... 249,806 226,505 207,058 Acquisition and other expenses ........... 112,707 104,896 95,633 Interest expense ......................... 1,112 1,320 1,639 Other expense ............................ 1,163 1,654 1,306 -------- -------- -------- 364,788 334,375 305,636 -------- -------- -------- Income before income tax expense ......... 15,571 27,982 21,892 Income tax expense ....................... 2,386 7,633 5,790 -------- -------- -------- Net income ............................... $ 13,185 $ 20,349 $ 16,102 ======== ======== ======== Earnings per share ....................... $ 1.10 $ 1.78 $ 1.42 ======== ======== ======== Loss and settlement expense ratio ........ 72.3% 68.5% 69.7% Acquisition expense ratio ................ 32.6 31.7 32.2 -------- -------- --------
Year ended December 31, 2004 compared to year ended December 31, 2003 - --------------------------------------------------------------------- Net income decreased 35.2 percent to $13,185,000 ($1.10 per share) in 2004 from $20,349,000 ($1.78 per share) in 2003. This decrease is attributed to a significant increase in the amount of adverse development experienced on prior years' reserves. The majority of this adverse development occurred during the fourth quarter and is attributed to a diligent review and reevaluation of the individual case reserves carried by the property and casualty insurance segment. In addition to an ongoing review of claims files in the normal course of business, the Company has for many years required each of its 16 branch office to perform a complete inventory of its open claim files during the fourth quarter of each year and to review the adequacy of each carried reserve based on current information. This review process has not historically resulted in a significant increase in case reserves; however, because of heightened emphasis placed on case reserve adequacy during 2004, the review performed in the fourth quarter of 2004 generated a significant and unanticipated increase in carried reserves and a corresponding increase in settlement expense reserves. Catastrophe and storm losses declined 11.7 percent in 2004 but remained at an unusually high level due to the four hurricanes that hit the Southern United States in August and September.
Premiums earned for the reinsurance segment increased 6.8 percent to $95,444,000 in 2004 from $89,386,000 in 2003 due to increased participation in the MRB reinsurance pool. For 2004, Employers Mutual's participation in the MRB reinsurance pool (which is ceded to the reinsurance segment under the terms of the quota share agreement) increased to 33 percent from 25 percent in 2003, producing $8,176,000 of additional premiums earned. The increase in the MRB premiums earned was partially offset by a decline in the HORAD book of business because Employers Mutual was unsuccessful in its attempt to renew several accounts during the January 1 and July 1, 2004 renewal seasons due to its current "A-" (Excellent) A.M. Best rating. Employers Mutual is attempting to replace this business with new accounts and increased participation on existing accounts. Following large across-the-board rate increases implemented in 2002, premium rate increases on excess-of-loss contracts moderated during 2003 and 2004 due to the influx of new capital into the reinsurance marketplace; however, contracts with poor loss experience continued to receive large rate increases. The rate increases implemented during the last several years have been realized in conjunction with moderate declines in the related exposure base due to increased retention levels and coverage exclusions for terrorist activities. In addition, both excess-of- loss and pro rata contracts have benefited from improved industry-wide rate levels at the primary company level. Premiums earned in 2004 reflect a decrease in the estimate of earned but not reported premiums of $190,000, compared to an increase of $3,575,000 in 2003.
The board of directors of the MRB reinsurance pool, of which Employers Mutual is a member, recently authorized management to pursue the addition of one or two new assuming companies to the pool. If additional assuming companies are added to the pool, Employers Mutual's participation would be reduced and the reinsurance segment's premium volume would decline in the short-term; however, this action will strengthen MRB's surplus base and should favorably impact their ability to attract new business.
Acquisition and other expenses increased 7.4 percent to $112,707,000 in 2004 from $104,896,000 in 2003. The expense ratio (acquisition and other expenses expressed as a percentage of premiums earned) increased to 32.6 percent in 2004 from 31.7 percent in 2003, primarily due to increases in contingent commission and policyholder dividend expenses.
Net investment income remained relatively flat at $29,900,000 in 2004 compared to $29,702,000 in 2003, despite an increase in invested assets. This is primarily attributed to the lingering low interest rate environment, which has negatively impacted the rate of return earned on the Company's investments. During this prolonged period of low interest rates, many of the Company's higher yielding securities have been called. The proceeds from these called securities, and from maturing securities, have been reinvested at the current lower interest rates, resulting in less investment income. In addition, until the second quarter of 2004 the Company had been reluctant to invest in long-term securities due to the low interest rate environment, and had therefore accumulated a significant amount of short-term and cash equivalent investments. Since these investments carry lower interest rates than long-term securities, the decline in the Company's rate of return was magnified. However, during the second quarter of 2004 interest rates became more attractive and the Company began investing in long-term securities.
The Company reported net realized investment gains of $4,379,000 in 2004 and $1,170,000 in 2003. The large amount of realized investment gains in 2004
includes $2,558,000 of net gain recognized during the second quarter on the Company's investment in MCI Communications Corporation bonds in conjunction with a payout award received under a bankruptcy court approved "Plan of Reorganization." The MCI bonds had previously been determined to be other- than-temporarily impaired during the second quarter of 2002. The new MCI bonds were sold during the third quarter, resulting in an additional realized gain of $187,000. Reflected in the gains of 2003 are $1,567,000 of other- than-temporary impairment losses recognized in the Company's equity portfolio during the first quarter, $2,689,000 of net losses recognized by the Company's equity managers during the first quarter as they rebalanced the Company's portfolios to enhance future returns, and $4,342,000 of losses recognized on the sale of American Airlines and United Airlines bonds during the first quarter. These losses were more than offset by gains recognized on the sale of certain bond and equity investments during the remainder of 2003. The Company has not recognized any additional other-than-temporary impairment losses since the first quarter of 2003, and all the impaired equity securities were sold before year-end 2003, generating gross realized gains of $619,000 and gross realized losses of $48,000.
On December 8, 2003, the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (the "Act") was signed into law. The Act expanded Medicare to include, for the first time, coverage for prescription drugs. In January 2004, the Financial Accounting Standards Board (FASB) issued Staff Position FAS No. 106-1 "Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003." Because of various uncertainties, including Employers Mutual's response to this legislation and the appropriate accounting methodology for this event, the Company elected to defer financial recognition of this legislation as permitted under FAS 106-1. In May 2004, the FASB issued Staff Position FAS No. 106-2, which became effective for interim and annual periods beginning after June 15, 2004. FAS No. 106-2 provides accounting guidance and disclosure requirements for the prescription drug subsidy established under the Act. The effect of the subsidy on the measurement of the Employers Mutual postretirement benefit plan resulted in a decrease in the accumulated projected benefit obligation of $9,899,000 and the net periodic postretirement benefit cost for 2004 was reduced by $1,537,000. Adoption of FAS 106-2 resulted in a $344,000 reduction in the Company's share of the net periodic postretirement benefit cost for 2004.
Year ended December 31, 2003 compared to year ended December 31, 2002 - --------------------------------------------------------------------- Net income increased 26.4 percent to a record $20,349,000 ($1.78 per share) in 2003 from $16,102,000 ($1.42 per share) in 2002. This increase was attributed to improved premium rate adequacy, an improvement in the quality of the Company's book of business and strong second half earnings in the reinsurance segment. The improvement in 2003 net income was achieved even though the Company experienced an unusually high level of catastrophe and storm losses and performed some necessary reserve strengthening in the property and casualty insurance segment.
Premiums earned increased 11.3 percent to $330,623,000 in 2003 from $297,043,000 in 2002. This increase was attributed to rate increases that were implemented in the property and casualty insurance segment during the preceding two years as well as significant growth and improved pricing in the reinsurance segment. The market for property and casualty insurance softened somewhat during 2003 but was considered to be firm at year-end.
producing $7,262,000 of additional earned premium. In addition to these factors, the growth in earned premiums for 2003 reflected an increase in the estimate of earned but not reported premiums of $3,575,000, compared to a decrease in this estimate of approximately $1,135,000 in 2002.
Losses and settlement expenses increased 9.4 percent to $226,505,000 in 2003 from $207,058,000 in 2002. The loss and settlement expense ratio (losses and settlement expenses expressed as a percentage of premiums earned) decreased to 68.5 percent in 2003 from 69.7 percent in 2002, despite an unusually high level of catastrophe and storm losses that was second only to the record amount reported in storm-plagued 2001, and some necessary reserve strengthening. This decline in the loss and settlement expense ratio was attributed to improved premium rate adequacy, an improvement in the quality of the Company's book of business and unusually good loss experience in the reinsurance segment during the second half of the year.
The loss and settlement expense ratio for the property and casualty segment increased slightly to 69.7 percent in 2003 from 69.4 percent in 2002. Despite an unusually high level of catastrophe and storm losses ($17,531,000 in 2003 compared to $8,055,000 in 2002) and some necessary reserve strengthening, the loss and settlement expense ratio did not increase appreciably during 2003. This is due to management's diligent efforts over the last several years to improve both premium rate adequacy and the quality of the risks insured. Loss frequency continued to trend downward in 2003 while loss severity continued to increase. The reserve strengthening performed in 2003 amounted to approximately $12,825,000, which represented only 5.6 percent of the property and casualty insurance segment's carried reserves at December 31, 2002.
For the reinsurance segment, the expense ratio decreased to 27.3 percent in 2003 from 32.1 percent in 2002. The decrease in 2003 was attributed to a decline in contingent commission expense and a shift in the mix of business towards property excess, which carries a lower commission rate. The decline in contingent commission expense was attributed to several sources, including a decline of approximately $413,000 associated with the MRB pool and a marine syndicate account, a decline of approximately $400,000 associated with the commutation of a retrocession contract related to the World Trade Center catastrophe, and a general trend toward a reduction in the number of contracts with contingent commission provisions. The asset for deferred acquisitions costs increased in 2003 and 2002 in connection with the increased participation in the MRB pool. These increases offset commission expense of $782,000 and $379,000 recorded for statutory purposes in those respective years with the increased participation in the MRB pool.
Net investment income decreased 9.4 percent to $29,702,000 in 2003 from $32,778,000 in 2002, despite an increase in invested assets. This decrease was primarily attributed to the lingering low interest rate environment, which negatively impacted the rate of return earned on the Company's investments, but also reflected an increase in investment expenses. During this period of low interest rates, many of the Company's higher yielding securities were called. The proceeds from those called securities, and from maturing securities, were reinvested at the current lower interest rates, resulting in less investment income. In addition, until the latter half of 2003 the
Realized investment gains totaled $1,170,000 in 2003 compared to a loss of $3,159,000 in 2002. Reflected in the gains of 2003 were $1,567,000 of other-than-temporary impairment losses recognized in the Company's equity portfolio during the first quarter of 2003, $2,689,000 of net losses recognized by the Company's equity managers during the first quarter as they rebalanced the Company's portfolios to enhance future returns, and $4,342,000 of losses recognized on the sale of American Airlines and United Airlines bonds during the first quarter. These bonds were collateralized by aircraft with an appraised value sufficient to recover the Company's investment at December 31, 2002; however, during the first quarter of 2003 the value of the collateral declined below the Company's investment as a result of the war with Iraq, a significant decline in air travel, and the prospects of a bankruptcy filing by American Airlines and a liquidation of United Airlines. The losses recognized in the first quarter were more than offset by gains recognized on the sale of certain bond and equity investments during the remainder of 2003. The Company did not recognize any additional other-than-temporary impairment losses during 2003 and all the impaired equity securities were sold before year-end, generating gross realized gains of $619,000 and gross realized losses of $48,000. The realized investment loss for 2002 primarily reflected a $3,821,000 impairment loss on the Company's investment in MCI Communications Corporation bonds.
Mutual effective April 1, 2003 at an interest rate of 3.09 percent, resulting in a 19.4 percent decline in interest expense in 2003.
Prior to 2002, the Company had concluded that it was not subject to the accounting requirements of Accounting Principles Board (APB) Opinion No. 25, "Accounting for Stock Issued to Employees", and related interpretations, since it received the current fair value for any common stock issued under Employers Mutual's stock option plans. As a result, the Company was recognizing as compensation expense its pool participation share of the stock option expense recorded by Employers Mutual for these plans. During 2002, the Company concluded that it was subject to the accounting requirements of APB 25 and, accordingly, should not be recognizing compensation expense from Employers Mutual's stock option plans since the exercise price of the options was equal to the fair value of the stock at the date of grant. Accordingly, during 2002 the Company reversed the accrual for stock option expense allocated to it by Employers Mutual, resulting in $349,000 of pre-tax income.
The Company's insurance subsidiaries reimburse Employers Mutual for their share of the statutory-basis compensation expense associated with stock option exercises under the terms of the pooling and quota share agreements. Beginning in 2003, the statutory-basis compensation expense that was paid by the Company's subsidiaries to Employers Mutual ($505,000 in 2003) was reclassified as a dividend payment to Employers Mutual in these GAAP-basis financial statements. Since the corresponding amounts for 2002 were not material, the financial statements for that year were not restated.
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 can be variable because of uncertainties regarding settlement dates for unpaid losses and because of the potential for large losses, either individually or in the aggregate. Accordingly, the insurance company subsidiaries maintain investment and reinsurance programs generally intended to provide adequate funds to pay claims without forced sales of investments.
The majority of the Company's assets are invested in fixed maturity securities. These investments provide a substantial amount of investment income that supplements underwriting results and contributes to net earnings. As these investments mature, or are called, the proceeds will be reinvested at current rates, which may be higher or lower than those now being earned; therefore, more or less investment income may be available to contribute to net earnings depending on the interest rate level.
The Company held $5,550,000 and $4,758,000 in minority ownership interests in limited partnerships and limited liability companies at December 31, 2004 and 2003, respectively. The Company does not hold any other unregistered securities.
The Company's cash balance was $61,000 and ($14,069,000) at December 31, 2004 and 2003, respectively. The balance at December 31, 2003 reflects a $14,346,000 transfer of funds out of the cash account on December 31, 2003 to purchase a fixed maturity security; however, due to timing, the account does not reflect the corresponding transfer of cash into the account to fund the purchase. This timing difference resulted in the negative balance in the account.
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 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 3 to 1. All of the Company's insurance subsidiaries were well under this guideline at December 31, 2004.
The Company's insurance subsidiaries are required to maintain certain minimum surplus on a statutory basis and are subject to regulations under which payment of dividends from statutory surplus is restricted and may require prior approval of their domiciliary insurance regulatory authorities. The Company's insurance subsidiaries are also subject to Risk Based Capital (RBC) requirements that may further impact their ability to pay dividends. RBC requirements attempt to measure minimum statutory capital needs based upon the risks in a company's mix of products and investment portfolio. At December 31, 2004, the Company's insurance subsidiaries had total adjusted statutory capital of $216,868,000, which is well in excess of the minimum RBC requirement of $43,485,000.
December 31, 2003 ----------------------------------- Percent of Amortized total at ($ in thousands) cost Fair value fair value --------- ---------- ---------- Fixed maturities, held-to-maturity .... $ 49,845 $ 53,854 7.9% Fixed maturities, available-for-sale .. 499,511 523,786 76.9 Equity securities, available-for-sale 38,998 49,008 7.2 Cash .................................. (14,069) (14,069) (2.0) Short-term investments ................ 63,568 63,568 9.3 Other long-term investments ........... 4,758 4,758 0.7 -------- -------- ----- $642,611 $680,905 100.0% ======== ======== =====
The amortized cost and estimated fair value of fixed maturity and equity securities at December 31, 2004 were as follows:
Held-to maturity ---------------------------------------------- Gross Gross Estimated Amortized unrealized unrealized fair ($ in thousands) cost gains losses value --------- ---------- ---------- --------- U.S. treasury securities and obligations of U.S. government corporations and agencies ............. $ 28,037 $ 1,280 $ - $ 29,317 Mortgage-backed securities 1,169 108 - 1,277 --------- ---------- ---------- --------- Total securities held-to-maturity ..... $ 29,206 $ 1,388 $ - $ 30,594 ========= ========== ========== =========
Available-for sale ---------------------------------------------- Gross Gross Estimated Amortized unrealized unrealized fair ($ in thousands) cost gains losses value --------- ---------- ---------- --------- U.S. treasury securities and obligations of U.S. government corporations and agencies ............. $ 137,274 $ 413 $ 148 $ 137,539 Obligations of states and political subdivisions ... 257,483 10,329 136 267,676 Mortgage-backed securities 11,136 715 - 11,851 Public utilities ........... 8,687 1,181 - 9,868 Debt securities issued by foreign governments ...... 7,178 321 - 7,499 Corporate securities ....... 174,033 11,226 38 185,221 ---------- ---------- ---------- -------- Total fixed maturity securities ........... 595,791 24,185 322 619,654 ---------- ---------- ---------- -------- Equity securities .......... 59,589 19,225 121 78,693 ---------- ---------- ---------- -------- Total securities available-for-sale $ 655,380 $ 43,410 $ 443 $ 698,347 ========== ========== ========== =========
Gross Book Fair unrealized ($ in thousands) value value loss ------- ------- ---------- Due in one year or less ................. $ - $ - $ - Due after one year through five years ... 2,000 1,990 10 Due after five years through ten years .. 27,491 27,384 107 Due after ten years ..................... 27,787 27,582 205 ------- ------- ----
The Company has no fixed maturity securities available-for-sale that are non-investment grade and have unrealized losses at December 31, 2004. As previously noted, the Company does not invest in junk bonds. Any non-investment grade securities held by the Company are the result of rating downgrades that occurred subsequent to their purchase.
Following is a schedule of gross realized losses recognized in 2004 along with the associated book values and sales prices 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 Company's equity portfolio is managed on a "tax-aware" basis, which generally results in sales of securities at a loss to offset sales of securities at a gain, thus minimizing the Company's income tax expense. Fixed maturity securities are generally held until maturity.
The realized losses recognized on fixed maturity securities that were in an unrealized loss position for three months or less reflects the $1,268,000 other-than-temporary impairment loss recognized during the second quarter of 2004 on a new series of bonds issued by MCI Communications Corporation in conjunction with a bankruptcy court approved payout award. The bonds were sold at a gain during the third quarter of 2004.
The following table reflects the contractual obligations of the Company as of December 31, 2004. Included in the table are the estimated payments that the Company expects to make in the settlement of its loss reserves and with respect to its long-term debt. One of the Company's property and casualty insurance subsidiaries leases office facilities in Bismarck, North Dakota with lease terms expiring in 2014. Hamilton Mutual Insurance Company, an affiliate of Employers Mutual and a pool participant, leases office facilities for the Cincinnati branch office with lease terms expiring in 2005. Employers Mutual has entered into various leases for branch and service office facilities with lease terms expiring through 2013. Employers Mutual also leases computer software under various operating lease agreements expiring through 2005. All lease costs are included as expenses under the pooling agreement after allocation of the portion of these expenses to the subsidiaries that do not participate in the pool. The table reflects the Company's current 23.5 percent aggregate participation in the pooling agreement. As discussed further under the caption "Company Overview," the Company's aggregate participation in the pooling agreement will increase to 30.0 percent effective January 1, 2005.
The main objectives in managing the investment portfolios of the Company are to maximize after-tax investment income and total 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 and the Company's resulting tax position, 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 board of directors for each of the Company's subsidiaries.
Interest rate risk includes the price sensitivity of a fixed maturity security to changes in interest rates, and the affect on future earnings from short-term investments and maturing long-term investments given a change in interest rates. The following analysis illustrates the sensitivity of the Company's financial instruments to selected changes in market rates and prices. A hypothetical one percent increase in interest rates as of December 31, 2004 would result in a corresponding pre-tax decrease in the fair value of the fixed maturity portfolio of approximately $39,229,000, or 5.6 percent. In addition, a hypothetical one percent decrease in interest rates at December 31, 2004 would result in a corresponding decrease in pre-tax income over the next twelve months of approximately $1,463,000, assuming the current maturity and prepayment patterns. The Company monitors interest rate risk through the analysis of interest rate simulations, and adjusts the average duration of its fixed maturity portfolio by investing in either longer or shorter term instruments given the results of interest rate simulations and judgments of cash flow needs. The effective duration of the Company's fixed maturity portfolio at December 31, 2004 was 5.19 years.
The valuation of the Company's marketable equity portfolios 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, 2004 would result in a corresponding pre-tax decrease in the fair value of the Company's equity portfolio of approximately $8,980,000.
Securities Securities held-to-maturity available-for-sale (at amortized cost) (at fair value) ------------------- ------------------ ($ in thousands) Amount Percent Amount Percent -------- ------- -------- ------- Rating: AAA ..................... $ 29,206 100.0% $349,176 56.3% AA ...................... - - 90,847 14.7 A ....................... - - 134,837 21.7 BAA ..................... - - 40,046 6.5 B ....................... - - 4,748 0.8 -------- ----- -------- ----- Total fixed maturities $ 29,206 100.0% $619,654 100.0% ======== ===== ======== =====
In 2003, the Emerging Issues Task Force (EITF) of the FASB reached a consensus on certain disclosures required by EITF Issue 03-1, "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments," which was effective for fiscal years ending after December 15, 2003. The Company adopted this EITF in 2003, which only required additional disclosures and did not have any effect on the operating results of the Company. In March of 2004, the EITF reached a consensus on the guidance provided to determine whether an investment is within the scope of Issue 3-1. Under EITF Issue 03-1, an investment is impaired if the fair value of the investment is less than its cost including adjustments for amortization, accretion, foreign exchange and hedging. An impairment would be considered other-than-temporary unless a) the investor has the ability and intent to hold an investment for a reasonable period of time sufficient for the recovery of the fair value up to (or beyond) the cost of the investment, and b) evidence indicating that the cost of the investment is recoverable within a reasonable period of time outweighs evidence to the contrary. This new guidance for determining whether the decline in the fair value of the investment is other-than-temporary was to be effective for reporting periods beginning after June 15, 2004. On September 30, 2004, the FASB issued EITF Issue 03-1-1 "Effective Date of Paragraphs 10-20 of EITF Issue 3-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments," which delayed the effective date for the measurement and recognition guidance included in EITF Issue 03-1 until additional implementation guidance is provided. Pending adoption of the final rule, the Company continues to apply existing accounting guidance for determining when a decline in fair value is other-than-temporary.
The NAIC has taken initial steps toward adopting selected provisions of the Sarbanes-Oxley Act of 2002 into its model audit rule. The provisions most likely to be adopted include the provisions on audit committees and auditor independence, as well as the requirements that insurers include in their annual statutory financial statements a statement of management's responsibility for establishing and maintaining adequate internal control over financial reporting, a report of management's assessment of the company's internal control over financial reporting, and an attestation report by the external auditor on the assessment. A working group is holding a series of meetings to further study the implications of revising the model audit rule to incorporate the Sarbanes-Oxley Act of 2002 Section 404-type requirements. Adoption of these requirements into the model audit rule is expected to have little consequence to either the Company or the EMC Insurance Companies, as the Company is already subject to the provisions of the Sarbanes-Oxley Act of 2002.
The Private Securities Litigation Reform Act of 1995 provides issuers the opportunity to make cautionary statements regarding forward-looking statements. Accordingly, any forward-looking statement contained in this report is based on management's current beliefs, assumptions and expectations of the Company's future performance, taking into account all information currently available to management. These beliefs, assumptions and expectations can change as the result of many possible events or factors, not all of which are known to management. If a change occurs, the Company's business, financial condition, liquidity, results of operations, plans and objectives may vary materially from those expressed in the forward-looking statements. The risks and uncertainties that may affect the actual results of the Company include, but are not limited to, the following: catastrophic events and the occurrence of significant severe weather conditions; the adequacy of loss and settlement expense reserves; state and federal legislation and regulations; changes in the Company's industry, interest rates or the performance of financial markets and the general economy; rating agency actions and other risks and uncertainties inherent to the Company's business. When the Company uses the words "believe", "expect", "anticipate", "estimate" or similar expressions, the Company intends to identify forward-looking statements. You should not place undue reliance on these forward-looking statements.
The Company's financial statements have been audited by Ernst & Young LLP, Independent Registered Public Accounting Firm. Management has made available to Ernst & Young LLP all of the Company's financial records and related data, as well as the minutes of the stockholders' and directors' meetings. Furthermore, management believes that all representations made to Ernst & Young LLP during its audit were valid and appropriate. Their report appears elsewhere in this annual report.
Management of the Company has established and continues to maintain a system of internal controls that are designed to provide assurance as to the integrity and reliability of the financial statements, the protection of assets from unauthorized use or disposition, and the prevention and detection of fraudulent financial reporting. The system of internal controls provides for appropriate division of responsibility. Certain aspects of these systems and controls are tested periodically by the Company's internal auditors. Management considers the recommendations of its internal auditors and the independent auditors concerning the Company's internal controls and takes the necessary actions that are cost-effective in the circumstances to respond appropriately to the recommendations presented. Although management is not required to issue an annual report on internal control over financial reporting until December 31, 2005, management believes that as of December 31, 2004, the Company's system of internal controls was adequate to accomplish the above objectives.
/s/ Bruce G. Kelley /s/ Mark E. Reese - ------------------------ -------------------------
We have audited the accompanying consolidated balance sheets of EMC Insurance Group Inc. and Subsidiaries as of December 31, 2004 and 2003, 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, 2004. 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.
Balances resulting from related party transactions with Employers Mutual: Reinsurance receivables ..................... 26,316,358 21,720,789 Prepaid reinsurance premiums ................ 3,682,676 3,297,228 Deferred policy acquisition costs ........... 27,940,583 26,737,784 Intangible asset, pension plan .............. - 1,016,492 Pension plan prepaid asset .................. 2,684,463 - Other assets ................................ 1,877,564 1,857,284
Income taxes payable ............................. - 2,780,500 Securities lending obligation .................... 70,122,695 154,556,758 ------------ ------------ Total liabilities ........................ 706,342,900 724,820,459 ------------ ------------ STOCKHOLDERS' EQUITY Common stock, $1 par value, authorized 20,000,000 shares; issued and outstanding, 13,568,945 shares in 2004 and 11,501,065 shares in 2003 .......... 13,568,945 11,501,065 Additional paid-in capital ....................... 103,467,293 69,113,228 Accumulated other comprehensive income ........... 27,928,463 22,285,668 Retained earnings ................................ 83,508,331 77,850,590 ------------ ------------ Total stockholders' equity ................. 228,473,032 180,750,551 ------------ ------------ Total liabilities and stockholders' equity $934,815,932 $905,571,010 ============ ============
Year ended December 31, ---------------------------------------- 2004 2003 2002 ------------ ------------ ------------ REVENUES Premiums earned .................... $345,478,461 $330,622,810 $297,043,033 Investment income, net ............. 29,900,203 29,702,461 32,778,133 Realized investment gains (losses) 4,379,314 1,169,698 (3,159,201) Other income ....................... 600,732 862,070 865,819 ------------ ------------ ------------ 380,358,710 362,357,039 327,527,784 ------------ ------------ ------------
LOSSES AND EXPENSES Losses and settlement expenses ..... 249,806,210 226,504,550 207,057,856 Dividends to policyholders ......... 4,478,169 3,011,433 2,977,154 Amortization of deferred policy acquisition costs ......... 75,444,837 71,959,232 65,727,016 Other underwriting expenses ........ 32,783,686 29,924,942 26,928,972 Interest expense ................... 1,112,400 1,320,266 1,638,716 Other expenses ..................... 1,162,411 1,654,320 1,306,034 ------------ ------------ ------------ 364,787,713 334,374,743 305,635,748 ------------ ------------ ------------ Income before income tax expense (benefit) ...... 15,570,997 27,982,296 21,892,036 ------------ ------------ ------------ INCOME TAX EXPENSE (BENEFIT) Current .......................... 4,583,505 8,336,381 5,061,093 Deferred ......................... (2,197,191) (703,208) 729,205 ------------ ------------ ------------ 2,386,314 7,633,173 5,790,298 ------------ ------------ ------------ Net income ................... $ 13,184,683 $ 20,349,123 $ 16,101,738 ============ ============ ============ Net income per common share - basic and diluted .............. $ 1.10 $ 1.78 $ 1.42 ============ ============ ============ Average number of shares outstanding - basic and diluted .............. 11,948,710 11,453,324 11,375,779 ============ ============ ============
Reclassification adjustment for (gains) losses included in net income, before income tax expense (benefit) .......... (4,370,215) (1,168,918) 3,159,201 Income tax expense (benefit) ..... 1,529,575 409,121 (1,105,720) ------------ ------------ ------------ (2,840,640) (759,797) 2,053,481 ------------ ------------ ------------ Adjustment for minimum liability associated with Employers Mutual's pension plan .......... - 289,639 (289,639) Deferred income tax expense (benefit) ...................... - 101,373 (101,373) ------------ ------------ ------------ - 188,266 (188,266) ------------ ------------ ------------ Other comprehensive income ... 5,642,795 8,067,338 6,710,658 ------------ ------------ ------------ Total comprehensive income ... $ 18,827,478 $ 28,416,461 $ 22,812,396 ============ ============ ============
Year ended December 31, -------------------------------------- 2004 2003 2002 ------------ ------------ ------------ COMMON STOCK Beginning of year .................. $ 11,501,065 $ 11,399,050 $ 11,329,987 Issuance of common stock through follow-on stock offering ......... 2,000,000 - - Issuance of common stock through Employers Mutual's stock option plans ............................ 67,880 102,015 69,063 ------------ ------------ ------------ End of year ........................ 13,568,945 11,501,065 11,399,050 ------------ ------------ ------------ ADDITIONAL PAID-IN CAPITAL Beginning of year .................. 69,113,228 67,270,591 66,013,203 Issuance of common stock through follow-on stock offering ......... 32,890,085 - - Issuance of common stock through Employers Mutual's stock option plans ............................ 1,463,980 1,842,637 1,257,388 ------------ ------------ ------------ End of year ........................ 103,467,293 69,113,228 67,270,591 ------------ ------------ ------------ ACCUMULATED OTHER COMPREHENSIVE INCOME Beginning of year .................. 22,285,668 14,218,330 7,507,672 Unrealized gains on available-for-sale securities .... 5,642,795 7,879,072 6,898,924 Minimum liability associated with Employers Mutual's pension plan .. - 188,266 (188,266) ------------ ------------ ------------ End of year ........................ 27,928,463 22,285,668 14,218,330 ------------ ------------ ------------ RETAINED EARNINGS Beginning of year .................. 77,850,590 64,880,393 55,606,761 Net income ......................... 13,184,683 20,349,123 16,101,738 Dividends paid to public stockholders ($.60 per share in 2004, 2003 and 2002) ............. (1,941,181) (1,350,736) (1,405,064) Dividends paid to Employers Mutual ($.60 per share in 2004, 2003 and 2002) ............................ (5,292,178) (5,522,994) (5,423,042) Dividends paid to Employers Mutual (reimbursement for non-GAAP expenses) ........................ (293,583) (505,196) - ------------ ------------ ------------ End of year ........................ 83,508,331 77,850,590 64,880,393 ------------ ------------ ------------ Total stockholders' equity ....... $228,473,032 $180,750,551 $157,768,364 ============ ============ ============
Adjustments to reconcile net income to net cash provided by operating activities: Balances resulting from related party transactions with Employers Mutual: Losses and settlement expenses .................. 55,894,386 42,556,163 16,708,165 Unearned premiums ........... 6,756,758 9,085,793 16,364,638 Other policyholders' funds .. 1,435,215 354,972 562,670 Indebtedness of related party 3,883,730 (1,129,421) 620,121 Employee retirement plans ... (2,885,657) 636,114 774,079 Reinsurance receivables ..... (4,595,569) (10,138,653) 2,919,200 Prepaid reinsurance premiums (385,448) (854,329) (167,668) Commission payable .......... 2,594,243 2,470,516 2,732,425 Interest payable ............ 278,100 (1,003,066) 1,641,205 Prepaid assets .............. 8,029 (87,676) 27,894
Year ended December 31, ---------------------------------------- 2004 2003 2002 ------------ ------------ ------------ CASH FLOWS FROM INVESTING ACTIVITIES Maturities of fixed maturity securities held-to-maturity .... $ 20,635,775 $ 5,293,717 $ 11,074,685 Purchases of fixed maturity securities available-for-sale .. (830,263,629) (791,156,969) (229,504,732) Disposals of fixed maturity securities available-for-sale .. 737,364,629 753,004,136 180,717,143 Purchases of equity securities available-for-sale ............. (52,518,206) (34,283,972) (43,930,432) Disposals of equity securities available-for-sale ............. 32,685,028 31,151,627 33,884,190 Purchase of other long-term investments .................... (3,078,000) (2,040,000) (4,057,004) Disposals of other long-term investments .................... 2,285,926 338,981 1,000,004 Net sales (purchases) of short-term investments ......... 17,329,211 (33,917,835) (11,925,773) ------------ ------------ ------------ Net cash used in investing activities ............. (75,559,266) (71,610,315) (62,741,919) ------------ ------------ ------------
Issuance of common stock through follow-on stock offering ....... 34,890,085 - - Dividends paid to public stockholders ................... (1,941,181) (1,350,736) (1,405,064) ------------ ------------ ------------ Net cash provided by (used in) financing activities 28,895,003 (5,434,274) 5,498,345 ------------ ------------ ------------ Net increase (decrease) in cash .... 14,130,190 (13,950,005) (677,170) Cash at beginning of year .......... (14,069,102) (119,097) 558,073 ------------ ------------ ------------ Cash at end of year ................ $ 61,088 $(14,069,102) $ (119,097) ============ ============ ============ Income taxes paid .................. $ 10,957,163 $ 5,400,010 $ 4,755,010 Interest paid ...................... $ 884,310 $ 615,709 $ 19,232
EMC Insurance Group Inc., a 53.7 percent owned subsidiary of Employers Mutual Casualty Company (Employers Mutual), is an insurance holding company with operations in property and casualty insurance and reinsurance. Both commercial and personal lines of insurance are written, with a focus on medium-sized commercial accounts. Approximately 38 percent of the premiums written are in Iowa and contiguous states. The term "Company" is used interchangeably to describe EMC Insurance Group Inc. (Parent Company only) and EMC Insurance Group Inc. and its subsidiaries.
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 49 percent of the Company's total net premiums written in 2004. Policyholder dividends are accrued over the terms of the underlying policies.
Deferred income taxes are provided for temporary differences between the tax basis of assets and liabilities and the reported amounts of those assets and liabilities for financial reporting purposes. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Income tax expense provisions increase or decrease in the same period in which a change in tax rates is enacted. A valuation allowance is established to reduce deferred tax assets to their net realizable value if it is "more likely than not" that a tax benefit will not be realized.
2004 2003 2002 -------- -------- -------- Dividend yield .......................... 2.69% 3.56% 3.28% Expected volatility ..................... .239 .247 .218 Risk-free interest rate ................. 3.12% 2.99% 4.37% Expected term (years) ................... 5.75 5.35 5.00
The Company's basic and diluted net income per share is computed by dividing net income by the weighted average number of common shares outstanding during each period. As previously noted, the Company receives the current fair value for any shares issued under Employers Mutual's stock plans. As a result, the Company had no potential common shares outstanding during 2004, 2003 and 2002 that would have been dilutive to net income per share.
The Company's four 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. The aggregate participation of the Company's property and casualty insurance subsidiaries is 23.5 percent. Employers Mutual negotiates reinsurance agreements that provide protection to the pool and each of its participants, including protection against losses arising from catastrophic events.
Ceded reserves at beginning of year (20,666,429) (10,367,624) (11,848,597) ------------ ------------ ------------ Net reserves at beginning of year .. 353,116,487 320,859,129 302,669,991
Losses and settlement expenses attributable to insured events of prior years ................. 115,072,988 108,175,065 107,744,442 ------------ ------------ ------------ Total payments ............. 198,603,715 194,247,192 188,868,718 ------------ ------------ ------------
Ceded reserves at end of year ...... 25,358,320 20,666,429 10,367,624 ------------ ------------ ------------ Gross reserves at end of year ...... $429,677,302 $373,782,916 $331,226,753 ============ ============ ============
2004 Development - ---------------- For the property and casualty insurance segment, the December 31, 2004 estimate of loss and settlement expense reserves for accident years 2003 and prior increased $23,738,375 from the estimate at December 31, 2003. This increase represents 9.4 percent of the December 31, 2003 carried reserves and is attributed to a combination of newly reported claims in excess of carried IBNR reserves ($14,758,000), development on case reserves of previously reported claims ($11,037,000), bulk reserve strengthening ($2,350,000), and settlement expense reserve increases resulting from increases in case reserves ($6,209,000). This adverse development was partially offset by $10,437,000 of reinsurance recoveries associated with the case reserve development and IBNR emergence. Substantial case reserve strengthening performed at the Company's branch offices, primarily in the workers' compensation and other liability lines of business, is the underlying reason for the adverse reserve development that occurred during 2004. The economic factors behind this case reserve strengthening include, most notably, an increase in workers' compensation claim severity, increases in construction defect claim activity, the recent occurrence of several large umbrella claims and increasing legal expenses in the other liability line of business.
For the reinsurance segment, the December 31, 2004 estimate of loss and settlement expense reserves for accident years 2003 and prior decreased $3,599,941 from the estimate at December 31, 2003. This decrease represents 3.1 percent of the December 31, 2003 carried reserves and is primarily from reported policy year 2003 losses for property, casualty and multi-line classes that were below 2003 implicit projections.
2003 Development - ---------------- For the property and casualty insurance segment, the December 31, 2003 estimate of loss and settlement expense reserves for accident years 2002 and prior increased $9,014,984 from the estimate at December 31, 2002. This increase represents 3.9 percent of the December 31, 2002 carried reserves and is attributed to a combination of bulk reserve strengthening, development on case reserves of previously reported claims and newly reported claims in excess of carried incurred but not reported (IBNR) reserves. Included in the reserve strengthening actions taken during 2003 was an increase of approximately $6,055,000 in formula IBNR reserves, an increase of approximately $3,245,000 in settlement expense reserves and a $3,525,000 bulk reserve established for the workers' compensation line of business. The remaining adverse development of approximately $4,521,000 came from case reserve development and IBNR claim emergence.
For the reinsurance segment, the December 31, 2002 estimate of loss and settlement expense reserves for accident years 2001 and prior increased $2,352,864 from the estimate at December 31, 2001. This increase represents 2.6% of the December 31, 2001 carried reserves. Virtually all of the increase arose from the MRB pool, for which the Company books the reserves established and reported by the pool. The carried MRB reserves at December 31, 2001 were above the midpoint of the actuarial range of estimates. However, reported losses and settlement expenses during pool year 2002 exceeded by approximately $1,249,792 the amounts predicted by the actuarial analysis. In addition, management of the MRB pool increased the IBNR reserves for prior years by $345,800. Finally, the losses and settlement expenses reported during January 2002 exceeded by $762,000 the IBNR reserve established at December 31, 2001 to cover the one-month reporting lag.
Statutory surplus of the Company's insurance subsidiaries was $216,868,207 and $170,232,871 at December 31, 2004 and 2003, respectively. Statutory net income of the Company's insurance subsidiaries was $11,878,844, $16,700,374 and $13,729,028 for 2004, 2003 and 2002, respectively.
The Company's operations consist of a property and casualty insurance segment and a reinsurance segment. The property and casualty insurance segment writes both commercial and personal lines of insurance, with a focus on medium sized commercial accounts. The reinsurance segment provides reinsurance for other insurers and reinsurers. The segments are managed separately due to differences in the insurance products sold and the business environment in which they operate. The accounting policies of the segments are described in note 1, Summary of Significant Accounting Policies.
Assets ................ $691,745,896 $242,694,389 $228,686,424 $1,163,126,709 Eliminations .......... - - (223,101,504) (223,101,504) Reclassifications ..... (62,040) (5,147,233) - (5,209,273) ------------ ------------ ------------ -------------- Net assets ....... $691,683,856 $237,547,156 $ 5,584,920 $ 934,815,932 ============ ============ ============ ==============
Assets ................ $639,366,058 $256,579,831 $180,961,286 $1,076,907,175 Eliminations .......... - - (176,087,397) (176,087,397) Reclassifications ..... (896,043) - (211,760) (1,107,803) ------------ ------------ ------------ -------------- Net assets ....... $638,470,015 $256,579,831 $ 4,662,129 $ 899,711,975 ============ ============ ============ ==============
Property Year ended and casualty Parent December 31, 2002 insurance Reinsurance company Consolidated - ----------------- ------------ ------------ ------------ ------------ Premiums earned ......... $225,013,076 $ 72,029,957 $ - $297,043,033
Underwriting loss ....... (3,621,656) (2,026,309) - (5,647,965) Net investment income ... 23,517,163 9,147,127 113,843 32,778,133 Realized gains (losses) (2,154,246) (1,010,268) 5,313 (3,159,201) Interest expense ........ (1,345,153) (293,563) - (1,638,716) Other income ............ 865,819 - - 865,819 Other expenses .......... (869,346) - (436,688) (1,306,034) ------------ ------------ ------------ ------------ Income (loss) before income tax expense (benefit) ........... $ 16,392,581 $ 5,816,987 $ (317,532)$ 21,892,036 ============ ============ ============ ============
Gross Gross Estimated Amortized unrealized unrealized fair cost gains losses value ------------ ----------- ----------- ------------ December 31, 2004 - ----------------- Securities held-to-maturity: Fixed maturity securities: U.S. treasury securities and obligations of U.S. government corporations and agencies ............. $ 28,037,203 $ 1,279,346 $ - $ 29,316,549 Mortgage-backed securities ........... 1,168,668 108,389 - 1,277,057 ------------ ----------- ----------- ------------ Total securities held-to-maturity $ 29,205,871 $ 1,387,735 $ - $ 30,593,606 ============ =========== =========== ============ Securities available-for- sale: Fixed maturity securities: U.S. treasury securities and obligations of U.S. government corporations and agencies ............. $137,273,717 $ 413,027 $ (148,047)$137,538,697 Obligations of states and political subdivisions ......... 257,483,428 10,329,065 (136,682) 267,675,811 Mortgage-backed securities ........... 11,136,193 714,925 - 11,851,118 Public utilities ....... 8,686,436 1,181,467 - 9,867,903 Debt securities issued by foreign governments 7,177,870 321,329 - 7,499,199 Corporate securities ... 174,033,352 11,225,843 (37,520) 185,221,675 ------------ ----------- ----------- ------------ Total fixed maturity securities ....... 595,790,996 24,185,656 (322,249) 619,654,403 ------------ ----------- ----------- ------------ Equity securities: Common stocks .......... 59,089,434 19,195,320 (120,861) 78,163,893 Non-redeemable preferred stocks ..... 500,000 29,000 - 529,000 ------------ ----------- ----------- ------------ Total equity securities ....... 59,589,434 19,224,320 (120,861) 78,692,893 ------------ ----------- ----------- ------------ Total securities available-for-sale $655,380,430 $43,409,976 $ (443,110)$698,347,296 ============ =========== =========== ============
In 2003, the Emerging Issues Task Force (EITF) of the FASB reached a consensus on certain disclosures required by EITF Issue 03-1, "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments," which was effective for fiscal years ending after December 15, 2003. The Company adopted this EITF in 2003, which only required additional disclosures and did not have any effect on the results of operations of the Company. In March of 2004, the EITF reached a consensus on the guidance provided to determine whether an investment is within the scope of Issue 03-1. Under EITF Issue 03-1 an investment is impaired if the fair value of the investment is less than its cost including adjustments for amortization, accretion, foreign exchange and hedging. An impairment would be considered other-than- temporary unless a) the investor has the ability and intent to hold an investment for a reasonable period of time sufficient for the recovery of the fair value up to (or beyond) the cost of the investment, and b) evidence indicating that the cost of the investment is recoverable within a reasonable period of time outweighs evidence to the contrary. This new guidance for determining whether the decline in the fair value of the investment is other- than-temporary was to be effective for reporting periods beginning after June 15, 2004. On September 30, 2004, the FASB issued EITF Issue 03-1-1 "Effective Date of Paragraphs 10-20 of EITF Issue 03-1, The Meaning of Other-Than- Temporary Impairment and Its Application to Certain Investments," which delayed the effective date for the measurement and recognition guidance included in EITF Issue 03-1 until additional implementation guidance is provided. Pending adoption of the final rule, the Company continues to apply existing accounting guidance for determining when a decline in fair value is other-than-temporary.
The following table sets forth the estimated fair value and unrealized losses of securities in an unrealized loss position as of December 31, 2004, listed by length of time the securities have been in an unrealized loss position. Less than twelve Twelve months or months or longer Total -------------------- ------------------- -------------------- Description of Fair Unrealized Fair Unrealized Fair Unrealized securities value losses value losses value losses - --------------- -------------------- ------------------- -------------------- U.S. Treasury securities and obligations of U.S. government corporations and agencies $35,342,656 $148,047 $ - $ - $35,342,656 $148,047 Obligations of states and political subdivisions 11,962,755 35,038 7,241,675 101,644 19,204,430 136,682 Corporate Securities 1,587,243 13,245 821,546 24,275 2,408,789 37,520 ----------- -------- ---------- -------- ----------- -------- Subtotal, debt securities 48,892,654 196,330 8,063,221 125,919 56,955,875 322,249 ----------- -------- ---------- -------- ----------- -------- Common stocks 7,394,774 120,861 - - 7,394,774 120,861 ----------- -------- ---------- -------- ----------- -------- Total temporarily impaired securities $56,287,428 $317,191 $8,063,221 $125,919 $64,350,649 $443,110 =========== ======== ========== ======== =========== ========
The amortized cost and estimated fair value of fixed maturity securities at December 31, 2004, 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. Estimated Amortized fair cost value ------------ ------------ Securities held-to-maturity: Due in one year or less ................... $ 8,999,646 $ 9,059,063 Due after one year through five years ..... 18,041,555 19,180,894 Due after five years through ten years .... 996,003 1,076,592 Due after ten years ....................... - - Mortgage-backed securities ................ 1,168,667 1,277,057 ------------ ------------ Totals ................................ $ 29,205,871 $ 30,593,606 ============ ============ Securities available-for-sale: Due in one year or less ................... $ 90,137,120 $ 90,176,150 Due after one year through five years ..... 52,831,899 56,265,211 Due after five years through ten years .... 118,069,601 125,200,014 Due after ten years ....................... 323,616,183 336,161,910 Mortgage-backed securities ................ 11,136,193 11,851,118 ------------ ------------ Totals ................................ $595,790,996 $619,654,403 ============ ============
Year ended December 31, ------------------------------------- 2004 2003 2002 ----------- ----------- ----------- Fixed maturity securities held-to-maturity: (1) Gross realized investment gains .. $ 9,099 $ 781 $ - Gross realized investment losses - - -
(1) Investment gains realized on fixed maturity securities held-to- maturity are the result of calls and prepayments.
(2) Investment losses realized on fixed maturity securities available- for-sale for the year ended December 31, 2004 and 2002 include other-than- temporary impairment write-downs totaling $1,323,475 and $3,821,466, respectively.
(3) Investment losses realized on equity securities for the year ended December 31, 2003 include other-than-temporary impairment write-downs totaling $1,566,985. All of the impaired equity securities were sold during 2003, generating gross realized gains of $619,069 and gross realized losses of $47,558.
Year ended December 31, ------------------------------------- 2004 2003 2002 ----------- ----------- ----------- Interest on fixed maturities .......... $28,305,693 $29,027,370 $31,909,946 Dividends on equity securities ........ 827,112 587,723 605,079 Interest on short-term investments .... 985,105 440,902 690,046 Interest on long-term investments ..... 518,793 371,340 103,763 Fees from securities lending .......... 104,953 92,671 120,489 ----------- ----------- ----------- Total investment income ........... 30,741,656 30,520,006 33,429,323 Investment expenses ................... (841,453) (817,545) (651,190) ----------- ----------- ----------- Net investment income ............. $29,900,203 $29,702,461 $32,778,133 =========== =========== ===========
securities .................. $ 5,642,795 $ 7,879,072 $ 6,898,924 ============ ============ ============
At December 31, 2004, the Company has $6,936,214 of net operating loss carry forwards which will expire, if unused, in 2024.
Based upon anticipated future taxable income and consideration of all other available evidence, management believes that it is "more likely than not" that the Company's net deferred income tax asset will be realized.
Year ended December 31, ------------------------------------- 2004 2003 2002 ----------- ----------- ----------- Computed "expected" tax expense ....... $ 5,449,848 $ 9,793,804 $ 7,662,213 Increases (decreases) in tax resulting from: Tax-exempt interest income ........ (3,430,616) (2,079,465) (1,441,502) Pro-ration of tax-exempt interest and dividends received deduction 544,317 334,243 163,770 Other, net ........................ (177,235) (415,409) (594,183) ----------- ----------- ----------- Income tax expense .............. $ 2,386,314 $ 7,633,173 $ 5,790,298 =========== =========== ===========
Year ended December 31, ------------------------------------- 2004 2003 2002 ----------- ----------- ----------- Income tax expense on: Operations .......................... $ 2,386,314 $ 7,633,173 $ 5,790,298 Unrealized holding gains on revaluation of securities available-for-sale ................ 3,038,428 4,242,578 3,714,799 Minimum pension liability ........... - 101,373 (101,373) ----------- ----------- ----------- Comprehensive income tax expense $ 5,424,742 $11,977,124 $ 9,403,724 =========== =========== ===========
On December 8, 2003, the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (the "Act") was signed into law. The Act expanded Medicare to include, for the first time, coverage for prescription drugs. In January 2004, the Financial Accounting Standards Board (FASB) issued Staff Position FAS No. 106-1 "Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003", which permitted a sponsor of a postretirement health care plan that provides prescription drug benefits to make a one-time election to defer accounting for the effects of the Act. In May 2004, the FASB issued Staff Position FAS No. 106-2 which superseded FAS 106-1 and was effective for interim and annual periods beginning after June 15, 2004. FAS No. 106-2 provides accounting guidance and disclosure requirements for the prescription drug subsidy established under the Act.
Postretirement benefit plans: Service cost ........................ $ 580,952 Interest cost ....................... 494,956 Expected return on plan assets ...... - Amortization of net loss ............ 460,727 ---------- Total reduction in net periodic postretirement benefit cost ..... $1,536,635 ==========
Postretirement Pension plan benefit plans -------------------------- -------------------------- 2004 2003 2004 2003 ------------ ------------ ------------ ------------ Change in projected benefit obligation: Benefit obligation at beginning of year ...$120,616,776 $111,790,069 $ 72,787,471 $ 66,309,000 Service cost .......... 6,818,518 6,161,019 3,995,559 4,401,000 Interest cost ......... 7,020,887 6,992,656 3,819,081 4,263,000 Actuarial (gain) loss 4,929,150 5,316,003 (10,254,086) (5,157,878) Benefits paid ......... (5,223,965) (9,642,971) (1,402,273) (1,481,498) Acquisition ........... - - - 4,453,847 ------------ ------------ ------------ ------------ Projected benefit obligation at end of year ......... 134,161,366 120,616,776 68,945,752 72,787,471 ------------ ------------ ------------ ------------
Change in plan assets: Fair value of plan assets at beginning of year ............. 93,676,748 82,198,366 15,974,241 12,737,000 Actual return on plan assets .............. 9,897,006 11,252,353 1,047,459 418,739 Employer contributions 21,600,000 9,869,000 3,835,000 4,300,000 Benefits paid ......... (5,223,965) (9,642,971) (1,402,273) (1,481,498) ------------ ------------ ------------ ------------ Fair value of plan assets at end of year ......... 119,949,789 93,676,748 19,454,427 15,974,241 ------------ ------------ ------------ ------------
The accumulated benefit obligation for the pension plan amounted to $109,635,159 and $98,508,176 for the years ended December 31, 2004 and 2003, respectively.
The weighted average assumptions used to measure the benefit obligations are as follows:
Year ended December 31, ----------------------- 2004 2003 ---------- ---------- Pension plan: Discount rate ...................... 6.00% 6.00% Rate of compensation increase ..... 4.81% 4.82%
Postretirement benefit plans: Discount rate ...................... 6.00% 6.50% 7.00% Expected long-term rate of return on plan assets ....................... 5.00% 5.00% 6.00%
The weighted average asset allocations of the Employers Mutual pension plan as of the measurement dates of November 1, 2004 and 2003 are as follows:
Employers Mutual has hired Principal Financial Advisors, Inc. to manage the asset allocation strategy for its pension plan (herein referred to as Fund Selection Service). The asset allocation strategy and process of the Fund Selection Service consists of a long-term, risk-controlled approach using diversified investment options with a minimal exposure to volatile investment options like derivatives. The long-term strategy of the Fund Selection Service is foremost preserving plan assets from downside market risk while secondarily out-performing its peers over a full market cycle. The investment process of Fund Selection Service uses a diversified allocation of equity, debt, and real estate exposures that are customized to each plan's cash flow needs.
The Fund Selection Service reviews a plan's assets and liabilities with an emphasis on forecasting a plan's cash flow needs. This forecast calculates the allocation percentage of fixed income assets needed to cover the liabilities of each plan. The model is quantitatively based and evaluates the plan's current assets plus five years of deposit projections and compares it to the current monthly benefit payments and the emerging benefit liabilities for the next ten years. The data for the deposits and emerging liabilities is provided from the plan's actuarial valuation while the current assets and monthly benefit payments data is provided from Principal Life Insurance Company's retirement plan account system.
The weighted average asset allocations of the Employers Mutual postretirement benefit plan as of the measurement dates of November 1, 2004 and 2003 are as follows:
Plan assets for Employers Mutual's postretirement benefit plans are primarily invested in universal life insurance policies issued by EMCNL, an affiliate of Employers Mutual. The assets supporting these universal life insurance policies are invested in S&P 500 mutual funds and debt securities and have a guaranteed interest rate of 4.50 percent.
The Senior Executive Compensation and Stock Option Committee (the "Committee") of Employers Mutual's Board of Directors (the "Board") is the administrator of the plans. Options granted are initially determined by the Committee and subsequently approved by the Board. In 2004, the Company's Board of Directors established its own Compensation Committee (the "Company Compensation Committee") and, commencing in 2005, the Company Compensation Committee will consider and approve all stock options granted to the Company's executive officers.
A total of 500,000 shares of the Company's common stock have been reserved for issuance under the Employers Mutual Casualty Company 1993 Employee Stock Purchase Plan. Any employee who is employed by Employers Mutual or its subsidiaries on the first day of the month immediately preceding any option period is eligible to participate in the plan. Participants pay 85 percent of the fair market value of the stock purchased, which is fully vested on the date purchased. 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 this plan totaled $9,752, $13,214 and $6,817 in 2004, 2003 and 2002, respectively.
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, 2004.
Estimated guaranty fund assessments of $1,206,984 and $1,252,564, which are used by states to pay claims of insolvent insurers domiciled in that state, have been accrued as of December 31, 2004 and 2003, respectively. The guaranty fund assessments are expected to be paid over the next two years with premium tax offsets of $1,543,735 expected to be realized within ten years of the payments. Estimated second injury fund assessments of $1,389,590 and $1,108,605, which are designed to encourage employers to employ a worker with a pre-existing disability, have been accrued as of December 31, 2004 and 2003, 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.
Three months ended, ----------------------------------------------------- March 31 June 30 September 30 December 31 ----------- ----------- ------------ ----------- - ---- Total revenues ........ $91,209,265 $94,296,170 $96,455,388 $98,397,887 =========== =========== =========== =========== Income (loss) before income tax expense (benefit) ........... $12,363,360 $ 3,775,979 $ 1,641,750 $(2,210,092) Income tax expense (benefit) ........... 4,014,265 310,043 (216,710) (1,721,284) ----------- ----------- ----------- ----------- Net income (loss) $ 8,349,095 $ 3,465,936 $ 1,858,460 $ (488,808) =========== =========== =========== =========== Net income (loss) per share - basic and diluted* $ .72 $ .30 $ .16 $ (.04) =========== =========== =========== ===========
REPORT OF ERNST & YOUNG LLP, INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM, ON SCHEDULES
In our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.
/s/ Ernst & Young LLP March 11, 2005 Des Moines, Iowa
Securities available-for-sale: Fixed maturities: United States Government and government agencies and authorities .............. 137,273,717 137,538,697 137,538,697 States, municipalities and political subdivisions ....... 257,483,428 267,675,811 267,675,811 Mortgage-backed securities ..... 11,136,193 11,851,118 11,851,118 Public utilities ............... 8,686,436 9,867,903 9,867,903 Debt securities issued by foreign governments .......... 7,177,870 7,499,199 7,499,199 Corporate securities ........... 174,033,352 185,221,675 185,221,675 ------------- ------------ ------------ Total fixed maturity securities ............. 595,790,996 619,654,403 619,654,403 ------------- ------------ ------------
Equity securities: Common stocks Banks, trusts and insurance companies .................. 10,242,918 16,019,824 16,019,824 Industrial, miscellaneous and all other .................. 48,846,516 62,144,069 62,144,069 Non-redeemable preferred stocks ..................... 500,000 529,000 529,000 ------------- ------------ ------------ Total equity securities .. 59,589,434 78,692,893 78,692,893 ------------- ------------ ------------ Other long-term investments ........ 5,550,093 5,550,093 5,550,093
LIABILITIES Accounts payable ................................ $ 208,252 $ 199,015 Indebtedness to related party ................... 5,140 11,720 ------------ ------------ Total liabilities .......................... 213,392 210,735 ------------ ------------
Years ended December 31, ------------------------------------- 2004 2003 2002 ----------- ----------- ----------- REVENUES Dividends received from subsidiaries .. $ 7,028,641 $ 7,255,228 $ 6,250,016 Investment income ..................... 164,936 30,368 113,843 Realized investment gains ............. - - 5,313 ----------- ----------- ----------- 7,193,577 7,285,596 6,369,172 Operating expenses .................... 666,628 609,563 436,688 ----------- ----------- ----------- Income before income tax benefit and equity in undistributed net income of subsidiaries ............ 6,526,949 6,676,033 5,932,484
Income tax benefit .................... (175,591) (195,932) (101,747) ----------- ----------- ----------- Income before equity in undistributed net income of subsidiaries ....... 6,702,540 6,871,965 6,034,231
Equity in undistributed net income of subsidiaries ..................... 6,482,143 13,477,158 10,067,507 ----------- ----------- ----------- Net income .............. $13,184,683 $20,349,123 $16,101,738 =========== =========== ===========
Years ended December 31, ---------------------------------------- 2004 2003 2002 ------------ ------------ ------------ Net income ......................... $ 13,184,683 $ 20,349,123 $ 16,101,738 ------------ ------------ ------------ Other Comprehensive Income: Unrealized holding gains arising during the period, net of deferred income tax expense .... 8,483,435 8,638,869 4,845,443
Cash flows from financing activities Balances resulting from related party transactions with Employers Mutual: Issuance of common stock through Employers Mutual stock option plans .................. 1,531,860 1,944,652 1,326,451 Dividends paid to Employers Mutual ........................ (5,292,178) (5,522,994) (5,423,042) Dividends paid to Employers Mutual (reimbursement for non-GAAP expense) ............. (293,583) (505,196) -
Issuance of common stock through follow-on stock offering .......... 34,890,085 - - Dividends paid to public stockholders (1,941,181) (1,350,736) (1,405,064) ----------- ----------- ----------- Net cash provided by (used in) financing activities .......... 28,895,003 (5,434,274) (5,501,655) ----------- ----------- -----------