Through various wholly-owned subsidiaries, we also own and occupy additional office facilities in three other locations and rent additional office space for our insurance operations in 16 other locations. We believe that such owned and leased properties are suitable and adequate for our current business operations.
Operating income (loss), which is GAAP net income (loss) excluding net realized investment gains and losses, is the financial performance measure used by our management and Board of Directors to evaluate and assess the results of our insurance businesses because (i) net realized investment gains and losses are unpredictable and not necessarily indicative of current operating fundamentals or future performance of the business segments and (ii) in many instances, decisions to buy and sell securities are made at the holding company level, and such decisions result in net realized gains and losses that do not relate to the operations of the individual segments. Operating income (loss) does not replace net income (loss) as the GAAP measure of our consolidated results of operations. Accordingly, we report operating income by segment in Note 15 of our Consolidated Financial Statements.
Our business profile changed significantly in 2003 and 2004. On November 4, 2003, we announced a third quarter pre-tax charge of $150 million to increase the loss reserves for our reinsurance business for prior accident years. Following this announcement, A.M. Best Company, Inc. (“A.M. Best”) reduced the financial strength ratings of PMA Capital Insurance Company (“PMACIC”), our reinsurance subsidiary, and The PMA Insurance Group companies, our primary insurance subsidiaries, to B++ (Very Good). On November 6, 2003, we announced our decision to cease writing reinsurance business and to run off our existing reinsurance business. We also decided in November 2003 to suspend the payment of dividends on our Class A Common stock.
acquisition and operating expenses, which are direct and indirect costs of acquiring both new and renewal business. This includes commissions paid to agents and brokers, and the internal expenses to operate the business segment; and
dividends that are paid to policyholders of certain of our insurance products.
We recorded a net loss of $21.0 million in 2005, compared to net income of $1.8 million in 2004 and a net loss of $93.6 million in 2003. The net loss for 2005 included the after-tax charge of $23 million ($30 million pre-tax) for prior year loss development at our Run-off Operations.
Net income for 2004 was reduced by $6.4 million after-tax ($9.8 million pre-tax) for the loss on the exchange and sale of our 6.50% Convertible Debt. This loss included a loss on the debt exchange of $3.9 million after-tax ($6.0 million pre-tax) and a loss of $2.5 million after-tax ($3.8 million pre-tax) for the subsequent increase in the fair value of the derivative component of the 6.50% Convertible Debt.
Results for 2004 were also reduced by $3.9 million after-tax ($6.0 million pre-tax) which was attributable to our purchasing reinsurance that protects our statutory capital in the event of further adverse loss development at the
Run-off Operations. Also included in 2004 results was an after-tax gain of $4.3 million ($6.6 million pre-tax) on the sale of a partnership interest.
Consolidated revenues were $443.1 million, $612.7 million and $1,305.2 million in 2005, and 2003. The decrease in 2005 was primarily due to lower earned premiums at The PMA Insurance Group. The 2004 decrease was primarily due to lower earned reinsurance premiums due to our decision to place our reinsurance business into run-off in November 2003.
Direct writings of commercial lines of business other than workers’ compensation, such as commercial auto, general liability, umbrella, multi-peril and commercial property lines (collectively, “Commercial Lines”), increased by $4.4 million in 2005, compared to 2004, reflecting an increase in new business premium from $4.3 million in 2004 to $15.8 million in 2005. Our renewal retention rate on existing accounts was 80% for 2005 compared to 40% for 2004. We obtained overall price increases on other commercial lines averaging approximately 4% in 2005. Direct writings decreased by $60.6 million in 2004, compared to 2003, reflecting the impact of The PMA Insurance Group’s B++ A.M. Best financial strength rating, which was partially offset by a 19% average price increase.
The loss and LAE ratio improved 2.7 points in 2004, compared to 2003. The lower loss and LAE ratio in 2004, compared to 2003, primarily reflects the effects on the 2003 loss and LAE ratio of the higher than expected losses and LAE for workers’ compensation business written for accident years 2001 and 2002 as discussed below, partially offset by a higher current accident year loss and LAE ratio in 2004. Medical cost inflation was 11% for both 2004 and 2003.
The total expense ratio increased 0.9 points in 2005, compared to 2004, primarily due to lower earned premiums. Overall operating expenses decreased approximately $6.4 million in 2005 compared to 2004, primarily due to a reduction in head count. The 2004 total expense ratio increased 4.3 points compared to 2003. In addition to the 1.5 point impact in the total expense ratio for 2003 discussed above, the 2.8 point increase was due to the fact that we did not reduce our level of operating expenses as quickly as revenues decreased in order to be in a position to respond to anticipated market demand after the restoration of the A- financial strength rating.
Net investment income was $761,000 higher and $1.9 million lower in 2005 and 2004 respectively, compared to the immediately preceding years. The higher net investment income in 2005, compared to 2004, primarily reflects an increase in invested asset yields of approximately 10 basis points offset by an average invested asset base that decreased approximately 2% in 2005. The lower net investment income in 2004, compared to 2003, primarily reflects a reduction in invested asset yields of approximately 50 basis points, partially offset by an average invested asset base that increased approximately 5% in 2004.
The Run-off Operations recorded a pre-tax operating loss of $26.9 million in 2005, pre-tax operating income of $5.5 million in 2004, and a pre-tax operating loss of $80.4 million for 2003. Net premiums earned, net investment income, losses and LAE, and acquisition and operating expenses decreased significantly in and 2004, compared to 2003, due to our exit from the reinsurance business. Results for 2003 reflected the third quarter $150 million charge to increase loss reserves for our reinsurance business associated mainly with accident years 1997 to 2000. Results for the Run-off Operations of past periods will not be indicative of future results as we expect net premiums earned, net investment income, losses and LAE, and acquisition and operating expenses to continue to decrease as we run-off this business.
Premiums written and earned in 2005 were primarily attributable to retrospective adjustments of policies written prior to our exit from the reinsurance business. Premiums written and earned declined significantly in 2004, compared to 2003, due to our exit from the reinsurance business. In 2004, there were significant cancellations of policies in force resulting in both negative written and earned premiums. Net premiums written and earned for 2004 also reflect a charge of $6.0 million for a reinsurance agreement covering potential adverse loss development.
This analysis was enhanced by an extensive review of specific accounts, comprising about 40% of the carried reserves of the reinsurance business for accident years 1997 to 2000. Our actuaries visited a number of former ceding company clients, which collectively comprised about 25% of the reinsurance business’s total gross loss and LAE reserves from accident years 1997 to 2000, to discuss reserving and reporting experience with these ceding companies. Our actuaries separately evaluated an additional number of other ceding companies, representing approximately 15% of the reinsurance business’s total gross loss and LAE reserves from accident years 1997 to 2000, to understand and examine data trends.
approximately 23 basis points on an average invested asset base that decreased approximately 18%, partially offset by lower net interest credited of $1.7 million on funds held. In a funds held arrangement, the ceding company retains the premiums, and losses are offset against these funds in an experience account. Because the reinsurer is not in receipt of the funds, the reinsurer earns interest on the experience fund balance at a predetermined credited interest rate.
The results were impacted by the sale of a real estate partnership interest that resulted in a pre-tax gain of $6.6 million, which is included in other revenues. Partially offsetting this gain was a pre-tax loss of $6.0 million related to the convertible debt exchange, including $4.7 million to record the 6.50% Convertible Debt at fair value and $1.3 million to write off the unamortized issuance costs on the 4.25% Convertible Debt. Results for 2004 also reflect lower operating expenses, partially offset by higher interest expense. Operating expenses for 2003 included approximately $3 million of accrued costs associated primarily with the remaining salary obligations under employment contracts with certain of our former executive officers.
Management relies on various data in making its estimate of loss reserves for reinsurance. As described above, the reinsurer receives certain information from ceding companies through the reinsurance brokers. Management assesses the quality and timeliness of claims reporting by its ceding companies. The reinsurer also may supplement the reported information by requesting additional information and conducting reviews of certain of its ceding companies’ reserving and reporting practices. It also reviews its internal operations to assess its capabilities to timely receive and process reported claims information from ceding companies. It assesses its claims data and loss projections in light of historical trends of claims developments, claims payments, and also as compared to industry data as a means of noticing unusual trends in claims development or payment. Based on the data reported by ceding companies, the results of the reviews and assessments noted above, as well as actuarial analysis and judgment, management will develop its estimate of reinsurance reserves.
In the ordinary course of the claims review process, we independently verify that reported claims by ceding companies are covered under the terms of the reinsurance policy or treaty purchased by the ceding company. In the event that we do not believe coverage has been provided, we will refuse to pay such claims. Most contracts contain a dispute resolution process that relies on arbitration to resolve any contractual differences. At December 31, 2005, we did not have any material claims that were in the process of arbitration that have not been recorded as liabilities on the accompanying financial statements.
judicial interpretations; and (v) changing government standards. Management believes that its reserves for asbestos and environmental claims are appropriately established based upon known facts, existing case law and generally accepted actuarial methodologies. However, the potential exists for changes in federal and state standards for clean-up and liability and changing interpretations by courts resulting from the resolution of coverage issues. These coverage issues in cases in which the company is a party include disputes concerning proof of insurance coverage, questions of allocation of liability and damages among the insured and participating insurers, assertions that asbestos claims are not products or completed operations claims subject to an aggregate limit and contentions that more than a single occurrence exists for purposes of determining the available coverage. Therefore our ultimate exposure for these claims may vary significantly from the amounts currently recorded, resulting in a potential future adjustment that could be material to our financial condition and results of operations.
See “Critical Accounting Estimates - Unpaid Losses and Loss Adjustment Expenses” beginning on page 55 for additional information. In addition, see “Cautionary Statements” on page 62 and “Item 1A - Risk Factors” for a discussion of factors that may adversely impact our losses and LAE in the future.
The PMA Insurance Group has recorded reinsurance receivables of $13.9 million at December 31, 2005, related to certain umbrella policies covering years prior to 1977. The reinsurer has disputed the extent of coverage under these policies. The parties have commenced arbitration to resolve this dispute. The ultimate resolution of this dispute cannot be determined at this time. An unfavorable resolution of the dispute could have a material adverse effect on our financial condition and results of operations.
The PMA Insurance Group retains an aggregate $12.6 million deductible on the first layer of its workers' compensation reinsurance, which is $750,000 excess $250,000.
The PMA Insurance Group does not write a significant amount of natural catastrophe exposed business. We actively manage our exposure to catastrophes through our underwriting process, where we generally monitor the accumulation of insurable values in catastrophe-prone regions. The PMA Insurance Group maintains property catastrophe reinsurance protection of 95% of $18.0 million excess of $2.0 million per occurrence. Our loss and LAE ratios were not significantly impacted by catastrophes in 2005, 2004 or 2003.
Except as noted, with respect to the reinsurance and retrocessional protection shown in the table above, our treaties do not cover us for losses sustained from terrorist activities. Therefore, if future terrorist attacks occur, they may result in losses that have a material adverse effect on our financial condition, results of operations and liquidity.
In 2004, the Run-off Operations purchased reinsurance to protect its statutory capital from adverse loss development of its loss and LAE reserves. Under the agreement, we ceded $100 million in carried loss and LAE reserves and paid $146.5 million in cash. During 2004, the Run-off Operations incurred $6.0 million in ceded premiums for this agreement. During the first quarter of 2005, the Run-off Operations ceded $30 million in losses and LAE under this agreement. Because the coverage is retroactive, the Run-off Operations deferred the initial benefit of this cession, which will be amortized over the estimated settlement period of the losses using the interest
In addition, the contract requires an additional premium of $2.5 million if it is not commuted by December 2007. This additional premium as well as the additional premiums due for any future losses ceded have been prepaid as part of the original $146.5 million payment and are included in other assets on the Balance Sheet.
In January 2006, the Terrorism Risk Insurance Extension Act of 2005 ("TRIEA") became effective. TRIEA expires on December 31, 2007 and extends most of the original provisions of the Terrorism Risk Insurance Act of 2002 ("TRIA"). For terrorist acts to be covered under TRIEA, they must be certified as such by the United States Government and must be committed by individuals acting on behalf of a foreign person or interest. TRIEA contains a “make available” provision, which requires insurers subject to the Act, to offer coverage for acts of terrorism that does not differ materially from the terms (other than price), amounts and other coverage limitations offered to the policyholder for losses from events other than acts of terrorism. The “make available” provision permits exclusions for certain types of losses, if a state permits exclusions for such losses. For 2006, TRIEA requires insurers to pay a deductible equal to 17.5% of commercial line (as defined by TRIEA) direct earned premiums. The federal government covers 90% of the losses above the deductible, while a company retains 10% of the losses. TRIEA contains an annual limit of $100 billion of covered industry-wide losses. TRIEA applies to certain commercial lines of property and casualty insurance, including workers’ compensation insurance, offered by The PMA Insurance Group, but does not apply to reinsurance. The PMA Insurance Group would have a deductible of approximately $63 million in 2006 if a covered terrorist act were to occur.
Workers’ compensation insurers were not permitted to exclude terrorism from coverage prior to the enactment of TRIA, and continue to be subject to this prohibition. When underwriting existing and new commercial insurance business, The PMA Insurance Group considers the added potential risk of loss due to terrorist activity. This has lead it to decline to write or non-renew certain business. Additional rates may be charged for terrorism coverage, and as of January 1, 2004, The PMA Insurance Group had adopted premium charges for workers’ compensation insurance in all states. The PMA Insurance Group has also refined its underwriting procedures in consideration of terrorism risks.
As a result of our decision to exit from the reinsurance and excess and surplus lines of business, we expect that we will continue to use cash from the operating activities of our Run-off Operations into the foreseeable future. We believe that the cash used to support the run-off of our business will reduce the liabilities that currently exist in the business, and will allow us to reduce our capital commitment to the Run-off Operations. We expect to be able to use such capital to assist us in reducing our current debt and managing our capital. We monitor the expected payout of the liabilities associated with the Run-off Operations and generally adjust the duration of our invested assets to match the timing of expected payouts.
We expect that the cash flows generated from the operating activities of The PMA Insurance Group will be positive for the foreseeable future as we anticipate premium and other service revenue collections to exceed losses and LAE and operating expense payments. We intend to be able to invest these positive cash flows and earn investment income.
At the holding company level, our primary sources of liquidity are dividends and net tax payments received from subsidiaries and capital raising activities. We utilize cash to pay debt obligations, including interest costs; taxes to the federal government; corporate expenses; and dividends to shareholders. At December 31, 2005, we had $22.5 million of cash and short-term investments at the holding company and its non-regulated subsidiaries, which we believe combined with our other capital sources, will continue to provide us with sufficient funds to meet our foreseeable ongoing expenses and interest payments.
relating to the issuance of Surplus Notes in September 2005. PMA Capital received dividends from subsidiaries of $24.0 million in 2003.
Net tax payments received from subsidiaries were $5.6 million, $4.9 million and $5.6 million in 2005, 2004 and 2003, respectively.
Assumes holders of this debt require us to repurchase this debt on the first put date. Holders, at their option, may require the Company to repurchase all or a portion of their debt on September 30, 2006, 2008, 2010, 2012 and 2017. This debt may be converted at any time, at the holder’s option, at a current price of $16.368 per share.
See discussion below for the variable interest rates on the junior subordinated debt and Surplus Notes. The obligations related to the junior subordinated debt and the Surplus Notes have been calculated using the interest rates in effect at December 31, 2005.
The operating lease obligations referred to in the table above are primarily obligations of our insurance subsidiaries and are net of sublease rentals of $1.5 million in 2006, $1.6 million in 2007, 2008, 2009 and 2010, $1.7 million in 2011 and $4.5 million thereafter.
In 2005, we issued, through one of our insurance subsidiaries, $10 million of Surplus Notes. The Surplus Notes may be redeemed in whole or in part on or after November 2, 2010. The Surplus Notes bear an annual interest rate of London InterBank Offered Rate (“LIBOR”) plus 4.5%. At December 31, 2005, the interest rate on the Surplus Notes was 8.76%. All payments of interest and principal on these notes are subject to the prior approval of the Pennsylvania Insurance Department. We used the proceeds of $9.7 million to purchase, in the open market, $9.2 million principal amount of our 6.50% Convertible Debt.
In 2006, in the event we receive any extraordinary dividends from our subsidiaries, we will be required to use 50% of those amounts to redeem up to $35 million principal amount of our 6.50% Convertible Debt at 110% of the original principal amount. Holders may elect to receive any premium over the principal amount in either cash or Class A Common stock (with the number of shares determined based on a value of $8.00 per share).
In 2003, we issued $57.5 million of 8.50% Senior Notes due June 15, 2018, from which we realized net proceeds of $55.1 million. We used the proceeds from the offering to repay the remaining balance outstanding under our prior bank credit facility, to increase the statutory capital and surplus of our insurance subsidiaries, and for general corporate purposes. We have the right to call these securities beginning in June 2008.
We have the right to defer interest payments on the junior subordinated securities for up to twenty consecutive quarters but, if so deferred, we may not declare or pay cash dividends or distributions on our Class A Common stock. The obligations of the statutory trusts are guaranteed by PMA Capital with respect to distributions and payments of the trust preferred securities issued by the trusts.
In 2004, the Run-off Operations paid a $1.0 million fee to shorten the term of our Philadelphia office lease from fifteen years to seven years and reduce the leased space by approximately 75% effective October 1, 2004. This reduced our contractual obligations under the lease by $661,000 annually from 2005 through 2008, $870,000 in 2009 and $14.6 million thereafter. In addition to the reduced contractual obligations, we estimate that this change will also result in reduced related expenses of approximately $830,000 annually.
composed of 74% fixed maturities and 26% equities at December 31, 2005. We currently estimate that the pension plan’s assets will generate a long-term rate of return of 8.25%, which we believe is a reasonable long-term rate of return, in part, because of the historical performance of the broad financial markets. Pension expense in 2005, 2004 and 2003 was $5.4 million, $4.9 million and $4.4 million, respectively.
On October 27, 2005, we announced that we had decided to "freeze" our Qualified Pension Plan and Non-qualified Pension Plans as of December 31, 2005. Under the terms of the freeze, eligible employees retained all of the rights under these plans that they had vested as of December 31, 2005. Effective January 1, 2006, our 401(k) and 401(k) Excess Plans were renamed The PMA Capital Corporation Retirement Savings Plan and The PMA Capital Retirement Savings Excess Plan and were enhanced to include quarterly age-based employer contributions. As a result of the pension plan freeze, we incurred a one-time non-cash charge of $229,000 in 2005.
During 2003 we paid dividends to shareholders of $9.9 million. We did not declare a dividend in the fourth quarter of 2003 and we have suspended common stock dividends at the current time.
We have structured our investment portfolio to provide an appropriate matching of maturities with anticipated claims payments. If we decide or are required in the future to sell securities in a rising interest rate environment, we would expect to incur losses from such sales. As of December 31, 2005, the duration of our investments that support the insurance reserves was 3.7 years and the duration of our insurance reserves was 3.2 years. The difference in the duration of our investments and our insurance reserves reflects our decision to maintain longer asset duration in order to enhance overall yield.
Mortgage-backed and other asset-backed securities in the table above include collateralized mortgage obligations (“CMOs”) of $200.7 million and $170.1 million carried at fair value as of December 31, 2005 and 2004. CMO holdings are concentrated in securities with limited prepayment, extension and default risk, such as planned amortization class bonds.
We review the securities in our fixed income portfolio on a periodic basis to specifically identify individual securities for any meaningful decline in fair value below amortized cost. Our analysis addresses all securities whose fair value is significantly below amortized cost at the time of the analysis, with additional emphasis placed on securities whose fair value has been below amortized cost for an extended period of time. As part of our periodic review process, we utilize the expertise of our outside professional asset managers who provide us with an updated assessment of each issuer’s current credit situation based on recent issuer activities, such as quarterly earnings announcements or other pertinent financial news for the company, recent developments in a particular industry, economic outlook for a particular industry and rating agency actions. We do not believe there are credit related risks associated with our U.S. Treasury and agency securities.
During 2005, we recorded impairment losses for securities issued by two auto manufacturers and one retail department store, resulting in a pre-tax impairment charge of $1.0 million. Impairment charges for the year ended December 31, were $334,000 pre-tax related to one asset-backed security and a security issued by an airline. During 2003, we recorded other than temporary impairment charges for securities issued by four companies, resulting in impairment losses of $2.6 million, primarily related to securities issued by airline companies and one asset backed security. The write-downs were measured based on public market prices and our expectation of the future realizable value for the security at the time we determined the decline in value was other than temporary.
Results for 2004 include gross realized investment gains and losses of $20.1 million and $4.9 million, respectively. Included in 2004 net realized investment gains were realized losses of $3.8 million related to the increase in the fair value of the derivative component of our 6.50% Convertible Debt and $4.9 million of foreign exchange losses. Gross realized investment losses in 2004 reflected sales reducing our per issuer exposure and general duration management trades, impairment losses of $334,000 on fixed income securities and realized losses of $380,000 on sales of securities where we reduced and/or eliminated our positions in certain issuers due to credit concerns. Results for 2003 include gross realized gains and losses of $18.7 million and $4.9 million, respectively, on our invested asset portfolio. Included in the gross realized losses were impairment losses of $2.6 million on fixed income securities, primarily securities issued by airline companies and one asset backed security and realized losses of $800,000 on sales of securities where we reduced and/ or eliminated our positions in certain issuers due to credit concerns. Realized losses also include sales reducing our per issuer exposure and general duration management trades.
Results presented in accordance with GAAP vary in certain respects from results presented in accordance with statutory accounting practices prescribed or permitted by the Pennsylvania Insurance Department, (collectively “SAP”). Prescribed SAP includes state laws, regulations and general administrative rules, as well as a variety of National Association of Insurance Commissioners publications. Permitted SAP encompasses all accounting practices that are not prescribed. Our domestic insurance subsidiaries use SAP to prepare various financial reports for use by insurance regulators.
At December 31, 2005, we estimated that under all insurance policies and reinsurance contracts issued by our insurance businesses, our liability for all events that occurred as of December 31, 2005 is $1,820.0 million. This amount includes estimated losses from claims plus estimated expenses to settle claims. Our estimate also includes amounts for losses occurring on or prior to December 31, 2005 whether or not these claims have been reported to us.
The data generated by application of these various actuarial methods generally reflect various development patterns and trends that assume historical patterns will be predictive of future patterns. Our actuaries analyze the various sets of data generated by these actuarial methods and also consider the impact of legal and legislative developments, regulatory trends including state benefit levels, changes in social attitudes and economic conditions in order to develop various sets of assumptions that we believe are reasonable and valid and can be used to assist us in predicting future claim trends. These assumptions are used in conjunction with the various development patterns and trends generated by the actuarial methods described above to produce various reserve estimates. Our actuaries consider these estimates and, utilizing their judgment, select a reasonable range of possible outcomes of the ultimate claims to be paid by us in the future. Because reported claims and paid claims activity can vary significantly between periods, our actuaries do not routinely rely on the same actuarial techniques and assumptions to develop their range of reasonable outcomes; instead, they will use their judgment to understand the effect that paid and reported claim activity has on the various actuarial techniques in a particular accident year, and consider this effect in determining their reasonable range.
In estimating our reserves for unpaid losses and LAE, our actuaries also consider the fact that each of our business segments has a different potential for reserve development. We believe that the potential for adverse reserve
Our Run-off Operation’s loss reserves are comprised primarily of excess of loss and pro rata reinsurance reserves (89% of the segment loss reserves). The excess of loss and pro rata reinsurance reserves are primarily casualty reserves, as only 6% of such reserves are for property business at December 31, 2005. The Run-off Operations pro rata business is mainly quota share reinsurance of ceding companies’ excess or umbrella insurance. Therefore, our actuarial analysis of our excess of loss and pro rata reinsurance business is generally based upon similar assumptions and loss development patterns.
With respect to The PMA Insurance Group, our actuaries separately review the reserves for our workers’ compensation and integrated disability, commercial automobile and commercial multi-peril/general liability lines of business. The PMA Insurance Group’s loss reserves are comprised primarily of reserves for its workers’ compensation and integrated disability business (85% of the segment loss reserves). Commercial multi-peril/general liability reserves comprise 10% of this segment’s carried reserves, with 31% of such commercial multi-peril/general liability reserves being asbestos and environmental reserves (see page 43 of this Report on Form 10-K for more detail regarding asbestos and environmental loss reserves).
After our actuaries complete the analyses described above, management reviews the data along with various industry benchmarks, and using its informed judgment, selects its best estimate of the amounts needed to pay all pending and future claims and related expenses, including those not yet reported to us. This best estimate is recorded as a loss and LAE reserve on our balance sheet. Our practice is to establish reserves for unpaid losses and LAE at a level where we believe it is likely that such unpaid losses and LAE could ultimately settle at similar amounts either above or below management’s best estimate. At December 31, 2005 management’s best estimate reflects an estimate of loss and LAE reserves that is approximately the mid-point of our actuaries’ range of loss reserves.
We believe that the major factors that can cause actual results to vary from our estimates at the Run-off Operations are changes in the experience and case reserving methodologies of our various ceding companies. This would affect
For additional factors that could impact our reserve estimates please see the risk factor entitled “Reserves are estimates and do not and cannot represent an exact measure of liability. If our actual losses from insureds exceed our loss reserves, our financial results would be adversely affected” on page 21 of this Report on Form 10-K.
We have established a carried loss and LAE reserve for unpaid claims at December 31, 2005 that we believe is a reasonable and adequate provision based on the information then available to us and we believe such amounts are fairly stated at December 31, 2005. However, based upon our actuarial analysis at December 31, 2005, and as discussed in the previous paragraphs, there is a reasonable probability that the range of reserve estimates (which represents various estimations of the amount required to ultimately settle all losses and LAE for unpaid claims) at both The PMA Insurance Group and the Run-off Operations segments of our business could be approximately five percent (5%) greater or less than the loss and LAE reserve recorded for such segments on our financial statements at December 31, 2005, if significant assumptions, such as frequency, severity and medical cost inflation, which are components of our actuarial analysis develop differently than we currently anticipate. Because our carried reserves reflect management’s best estimate and are not determined by a formula that is automatically the direct product of the actuarial methods used to develop our range or reserves we are unable to quantify in any meaningful way the effect of a change to any one of these significant assumptions underlying our actuarial process on our carried reserves. It is also possible that the amount required to settle all losses and LAE for unpaid claims or our estimates in future periods could exceed or be less than the reasonable range of possible outcomes that we can currently estimate.
If our future estimate of ultimate unpaid losses is greater than the recorded amounts, we would have to increase our reserves in subsequent periods. Any increase in our net reserves would result in a charge to earnings in the period recorded. For example, in 2003 we increased net reserves for our Run-off Operations by $169 million and took earnings charges as a result. Accordingly, any reserve adjustment could have a material adverse effect on our financial condition, results of operations and liquidity.
The component’s of our (favorable) unfavorable development of reserves for losses and LAE for prior accident years by business segment, excluding accretion of discount, are as follows:
During 2003, The PMA Insurance Group recorded unfavorable prior year loss development of $49.7 million. As part of the year end closing process, in the fourth quarter of 2003, the Company’s actuaries completed a comprehensive year-end actuarial analysis of loss reserves. Based on the actuarial work performed, the Company’s actuaries noticed higher than expected claims severity in workers' compensation business written for accident years 2001 and 2002, primarily from loss-sensitive and participating workers' compensation business. As a result of this analysis, The PMA Insurance Group increased loss reserves for prior years. Under The PMA Insurance Group's loss-sensitive rating plans, the amount of the insured's premiums is adjusted after the policy period expires based, to a large extent, upon the insured's actual losses incurred during the policy period. Under policies that are subject to dividend plans, the ultimate amount of the dividend that the insured may receive is also based, to a large extent, upon loss experience during the policy period. Accordingly, offsetting the effects of this unfavorable prior year loss development were premium adjustments of $35 million under loss-sensitive plans and reduced policyholder dividends of $8 million, resulting in a net fourth quarter pre-tax charge of $7 million. An independent actuarial firm also conducted a comprehensive review of The PMA Insurance Group’s loss reserves as of December 31, 2003 and concluded that such carried loss reserves were reasonable as of December 31, 2003.
Our analysis was enhanced by an extensive review of specific accounts, comprising about 40% of the carried reserves of the reinsurance business for accident years 1997 to 2000. Our actuaries visited a number of former ceding company clients, which collectively comprised about 25% of the reinsurance business total gross loss and LAE reserves from accident year 1997 to 2000, to discuss reserving and reporting experience with these ceding companies. Our actuaries separately evaluated an additional number of other ceding companies, representing approximately 15% of the reinsurance business total gross loss and LAE reserves from accident year 1997 to 2000, to understand and examine data trends.
As part of determining the market value for each specific investment that we hold, we evaluate each issuer’s ability to fully meet their obligation to pay all amounts, both interest and principal, due in the future. Because we have invested in fixed income obligations with an overall average credit quality of AA+, and all of our investments are currently meeting their obligations with respect to scheduled interest income and principal payments, we believe that we will fully realize the value of our investments. However, future general economic conditions and/or specific company performance issues may cause a particular issuer, or group of issuers in the same industry segment, to become unable to meet their obligation to pay principal and interest as it comes due. If such events were to occur, then we would evaluate our ability to fully recover the recorded value of our investment. Ultimately, we may have to write down an investment to its then determined net realizable value and reflect that write-down in earnings in the period such determination is made.
Based on our evaluation of securities with an unrealized loss at December 31, 2005, we do not believe that any additional other-than-temporary impairment losses, other than those already reflected in the financial statements, are necessary at the balance sheet date. However, if we were to have determined that all securities that were in an unrealized loss position at December 31, 2005 should have been written down to their fair value, we would have recorded an additional other-than-temporary impairment loss of $19.5 million pre-tax.
For additional information about our investments, see Notes 2-B, 3 and 11 of the Consolidated Financial Statements as well as “Investments” beginning on page 50.
reinsurance receivable to its then determined net realizable value and reflect that write-down in earnings in the period such determination is made. We attempt to limit any such exposure to uncollectible reinsurance receivables by performing credit reviews of our reinsurers. In addition, we require collateral, such as assets held in trust or letters of credit, for certain reinsurance receivables. However, if our future estimate of uncollectible receivables exceeds our current expectations, we may need to increase our allowance for uncollectible reinsurance receivables. The increase in this allowance would result in a charge to earnings in the period recorded. Accordingly, any related charge could have a material adverse effect on our financial condition, results of operations and liquidity.
We record deferred tax assets and liabilities to the extent of the tax effect of differences between the financial statement carrying values and tax bases of assets and liabilities. The recoverability of deferred tax assets is evaluated based upon management’s estimates of the future profitability of our taxable entities based on current forecasts. We establish a valuation allowance for deferred tax assets where it appears more likely than not that we will not be able to recover the deferred tax asset. At December 31, 2005, PMA Capital has a net deferred tax asset of $103.7 million, resulting from $186.4 million of gross deferred tax assets reduced by a deferred tax asset valuation allowance of $60.5 million and by $22.2 million of deferred tax liabilities. In establishing the appropriate value of this asset, management must make judgments about our ability to utilize the net tax benefit from the reversal of temporary differences and the utilization of operating loss carryforwards that expire mainly from 2018 through 2025.
In 2003, we established a valuation allowance in the amount of $49 million. This was based upon our assessment that it was more likely than not that a portion of the gross deferred tax assets related to the NOL carryforward and all of the deferred tax asset related to the AMT credit carryforward would not be realized. During 2004 and 2005, we reassessed the valuation allowance previously established against the net deferred tax assets. Factors considered in our reassessment included historical earnings, scheduled reversal of deferred tax liabilities and revised projections of future earnings. Based upon our consideration of these factors in conjunction with the current level of valuation allowance recorded, we increased the valuation allowance with respect to our net deferred tax asset by $8 million and $3.5 million in 2004 and 2005, respectively. The increase is primarily due to the future earnings projections for our Run-off Operations which were revised downward from previous projections.
The valuation allowance of $60.5 million reserves against $52 million of gross deferred tax assets related to the NOL carryforward and the $8.5 projected deferred tax asset related to the AMT credit carryforward because we believe it is more likely than not that this portion of the benefit will not be realized. We will continue to periodically assess the realizability of our net deferred tax asset. If our estimates of future income were to be revised downward and we determined that it was then more likely than not that we would not be able to realize the value of our net deferred tax asset, then this could have a material adverse effect on our results of operations and financial position. For additional information see Note 12 to our Consolidated Financial Statements.
The factors that could cause actual results to vary materially, some of which are described with the forward-looking statements, include, but are not limited to:
regulatory changes in risk-based capital or other regulatory standards that affect the cost of, or demand for, our products or otherwise affect our ability to conduct business, including any future action with respect to our business taken by the Pennsylvania Insurance Department or any other state insurance department;
the impact of future results on the recoverability of our deferred tax asset;
the effect of changes in workers’ compensation statutes and their administration, which may affect the rates that we can charge and the manner in which we administer claims;
our ability to predict and effectively manage claims related to insurance and reinsurance policies;
You should not place undue reliance on any such forward-looking statements. Unless otherwise stated, we disclaim any current intention to update forward-looking information and to release publicly the results of any future revisions we may make to forward-looking statements to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events.
Consolidated Statements of Shareholders’ Equity for the years ended December 31, 2005,
Consolidated Statements of Comprehensive Income (Loss) for the years ended December 31, 2005, 2004 and 2003
Treasury stock, at cost (2005 - 2,234,662 shares; 2004 - 2,541,094 shares)
A. Basis of Presentation - The consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). All significant intercompany accounts and transactions have been eliminated in consolidation. The preparation of consolidated financial statements in conformity with GAAP requires management to make certain estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the period. Actual results could differ from those estimates. In addition, certain prior year amounts have been reclassified to conform to the current year classification. The balance sheet information presented in these financial statements and notes thereto is as of December 31 for each respective year. The statements of operations, cash flows, changes in shareholders’ equity and changes in comprehensive income (loss) information are for the year ended December 31 for each respective year.
The Company participates in a securities lending program through which securities are lent from the Company’s portfolio for short periods of time to qualifying third parties via a lending agent. Borrowers of these securities must provide collateral equal to a minimum of 102% of the market value including accrued interest of the lent securities. Acceptable collateral may be in the form of either cash or securities. Cash received as collateral is invested in short-term investments, and is recorded as such on the Balance Sheet, along with a corresponding liability included in accounts payable, accrued expenses and other liabilities. All securities received as collateral are of similar quality to those securities lent by the Company. The Company is not permitted by contract to sell or repledge the securities
received as collateral. Additionally, the Company limits securities lending to 40% of statutory admitted assets of its insurance subsidiaries, with a 2% limit on statutory admitted assets to any individual borrower. The Company either receives a fee from the borrower or retains a portion of the income earned on the collateral. Under the terms of the securities lending program, the Company is indemnified against borrower default, with the lending agent responsible to the Company for any deficiency between the cost of replacing a security that was not returned and the amount of collateral held by the Company.
C. Premiums - Premiums, including estimates of additional premiums resulting from audits of insureds’ records, and premiums from ceding companies which are typically reported on a delayed basis, are earned principally on a pro rata basis over the terms of the policies. For reinsurance premiums assumed, management must estimate the subject premiums associated with the treaties in order to determine the level of written and earned premiums for a reporting period. Such estimates are based on information from brokers and ceding companies, which can be subject to change as new information becomes available. Any changes occurring or reported to the Company after the policy term are recorded as earned premiums in the period in which the adjustment is made. See Note 4 for additional information. With respect to policies that provide for premium adjustments, such as experience-rated or exposure-based adjustments, such premium adjustments may be made subsequent to the end of the policy’s coverage period and will be recorded as earned premiums in the period in which the adjustment is made. Premiums applicable to the unexpired terms of policies in force are reported as unearned premiums. The estimated premiums receivable on experience-rated or exposure-based policies are reported as a component of premiums receivable.
Certain of the Company’s reinsurance contracts are retroactive in nature. Any benefit derived from retroactive reinsurance contracts is deferred and amortized into income over the estimated settlement period of the underlying claim liabilities unless the contracts call for immediate recovery by the Company from reinsurers as ceded losses are incurred.
J. Stock-Based Compensation - The Company accounts for stock-based compensation using the intrinsic value method prescribed in Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. Accordingly, compensation cost for stock options is measured as the excess, if any, of the quoted market price of the Company’s Class A Common stock at grant date or other measurement date over the amount an employee must pay to acquire the Class A Common stock. The following table illustrates the effect on net income (loss) if the fair value based method had been applied:
K. Other Revenues - Other revenues include service revenues related to unbundled claims, risk management and related services primarily to self-insured clients provided by The PMA Insurance Group, which are earned over the term of the related contracts in proportion to the actual services rendered, and other miscellaneous revenues. During 2004, other revenues included a $6.6 million gain on the sale of a partnership interest.
L. Recent Accounting Pronouncements - In March 2004, the Emerging Issues Task Force (“EITF”) reached a consensus regarding EITF 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.” The consensus provides guidance for evaluating whether an investment is other-than-
The Company’s investment portfolio is diversified and does not contain any significant concentrations in single issuers other than U.S. Treasury and agency obligations. In addition, the Company does not have a significant concentration of investments in any single industry segment other than finance companies, which comprise 11% of invested assets at December 31, 2005. Included in this industry segment are diverse financial institutions, including the financing subsidiaries of automotive manufacturers. We do not believe there are credit related risks associated with our U.S. Treasury and agency securities.
For securities that were in an unrealized loss position, the length of time that such securities have been in an unrealized loss position, as measured by their month-end fair values, is as follows:
The amortized cost and fair value of fixed maturities at December 31, 2005, by contractual maturity, are as follows:
On December 31, 2005, the Company had securities with a total amortized cost of $53.5 million and fair value of $54.2 million on deposit with various governmental authorities, as required by law. In addition, the Company had securities with a total amortized cost and fair value of $20.8 million held in trust for the benefit of certain ceding companies on reinsurance balances assumed by the Run-off Operations. The Company pledged collateral with an amortized cost and fair value of $4.9 million for surety bonds issued to appeal claims judgments at the Run-off Operations. The securities held in trust, on deposit or pledged as collateral are included in total investments and cash on the Balance Sheet.
The following table summarizes the effect on the Company’s underwriting assets and liabilities of the commutation and novation of certain reinsurance and retrocessional contracts by the Run-off Operations segment occurring in 2005 and 2004. The commutations and novations did not have a material effect on the Company’s results of operations for 2005 or 2004.
The components of the Company’s net (favorable) unfavorable development of reserves for losses and LAE for prior accident years, excluding accretion of discount, are as follows:
compensation business. Dividends to policyholders offset this favorable development. Rent-a-captives are used by customers as an alternative method to manage their loss exposure without establishing and capitalizing their own captive insurance company.
During 2003, the Run-off Operations increased its net loss reserves for prior accident years for reinsurance business by $169.1 million, including $150 million during the third quarter. The third quarter 2003 reserve charge related to higher than expected underwriting losses, primarily from casualty business written in accident years 1997 through 2000. Approximately 75% of the charge was related to general liability business written from 1997 to 2000 with substantially all of the remainder of the charge from the commercial automobile line written during those same years. During the third quarter, the Company’s actuaries conducted their periodic comprehensive reserve review. Based on the actuarial work performed, which included analyzing recent trends in the levels of the reported and paid claims, an updated selection of actuarially determined loss reserve estimates was developed by accident year for each major line of reinsurance business written. The information derived during this review indicated that a large portion of the change in expected loss development was due to increasing loss trends emerging in calendar year 2003 for prior accident years. This increase in 2003 loss trends caused management to determine that the reserve levels, primarily for accident years 1997 to 2000, needed to be increased by $150 million. An independent actuarial firm also conducted a comprehensive review of the Company’s Traditional-Treaty, Specialty-Treaty and Facultative reinsurance loss reserves, and concluded that those carried loss reserves were reasonable at September 30, 2003.
On December 6, 2004, the New York jury in the trial regarding the insurance coverage for the World Trade Center rendered a verdict that the September 11, 2001 attack on the World Trade Center constituted two occurrences under the policies issued by certain insurers. During 2005, the Company incurred and paid $1.3 million of losses as a result of this verdict. The Company considers the jury's verdict to be contrary to the terms of the insurance coverage in force and to the intent of the parties involved. Because the litigation is continuing and the appraisal and valuation process is ongoing, the ultimate resolution of this issue cannot be determined at this time. The Company estimates that it could be required to incur an additional charge of up to $4 million pre-tax at the Run-off Operations if it is ultimately determined that the September 11, 2001 attack on the World Trade Center constituted two occurrences under the policies issued by certain of its ceding companies and if as a result of this determination, additional losses are incurred by its ceding companies.
At December 31, 2005, 2004 and 2003, gross reserves for asbestos-related losses were $26.9 million, $27.9 million and $37.8 million, respectively ($13.2 million, $14.0 million and $17.8 million, net of reinsurance, respectively). Of the net asbestos reserves, approximately $10.2 million, $10.3 million and $14.9 million related to IBNR losses at December 31, 2005, 2004 and 2003, respectively.
At December 31, 2005, 2004 and 2003, gross reserves for environmental-related losses were $15.3 million, $16.1 million and $14.2 million, respectively ($5.0 million, $6.4 million and $8.8 million, net of reinsurance, respectively). Of the net environmental reserves, approximately $2.0 million, $3.0 million and $3.7 million related to IBNR losses at December 31, 2005, 2004 and 2003, respectively. All incurred asbestos and environmental losses were for accident years 1986 and prior.
Estimating reserves for asbestos and environmental exposures continues to be difficult because of several factors, including: (i) evolving methodologies for the estimation of the liabilities; (ii) lack of reliable historical claim data; (iii) uncertainties with respect to insurance and reinsurance coverage related to these obligations; (iv) changing judicial interpretations; and (v) changing government standards. Management believes that its reserves for asbestos and environmental claims are appropriately established based upon known facts, existing case law and generally accepted actuarial methodologies. However, the potential exists for changes in federal and state standards for clean-up and liability and changing interpretations by courts resulting from the resolution of coverage issues. These coverage issues in cases in which the company is a party include disputes concerning proof of insurance coverage, questions of allocation of liability and damages among the insured and participating insurers, assertions that asbestos claims are not products or completed operations claims subject to an aggregate limit and contentions that more than a single occurrence exists for purposes of determining the available coverage. Therefore the Company’s ultimate exposure for these claims may vary significantly from the amounts currently recorded, resulting in a potential future adjustment that could be material to the Company’s financial condition, results of operations and liquidity.
Management believes that its unpaid losses and LAE are fairly stated at December 31, 2005. However, estimating the ultimate claims liability is necessarily a complex and judgmental process inasmuch as the amounts are based on management’s informed estimates, assumptions and judgments using data currently available. As additional experience and data become available regarding claims payment and reporting patterns, legal and legislative developments, judicial theories of liability, the impact of regulatory trends on benefit levels for both medical and indemnity payments, changes in social attitudes and economic conditions, the estimates are revised accordingly. If the Company’s ultimate losses, net of reinsurance, prove to differ substantially from the amounts recorded at December 31, 2005, the related adjustments could have a material adverse effect on the Company’s financial condition, results of operations and liquidity.
At December 31, 2005, the Company had reinsurance receivables due from the following unaffiliated reinsurers in excess of 5% of shareholders’ equity:
Includes GE Reinsurance Corporation ($19.0 million) and Employers Reinsurance Company ($2.1 million).
The Company performs credit reviews of its reinsurers focusing on, among other things, financial capacity, stability, trends and commitment to the reinsurance business. Reinsurers failing to meet the Company’s standards are excluded from the Company’s reinsurance programs. In addition, the Company requires collateral, typically assets in trust, letters of credit or funds withheld, to support balances due from certain reinsurers, generally those not authorized to transact business in the applicable jurisdictions. At December 31, 2005 and 2004, the Company’s reinsurance receivables of $1,094.7 million and $1,142.6 million were supported by $444.2 million and $507.2 million of collateral. Of the uncollateralized reinsurance receivables as of December 31, 2005, approximately 93% were recoverable from reinsurers rated “A-” or better by A.M. Best.
The Company’s largest reinsurer is Trabaja Reinsurance Company (“Trabaja”). Reinsurance receivables from Trabaja were $220.1 million at December 31, 2005, of which 95% were collateralized.
In 2002, the Company supplemented its in-force reinsurance programs for The PMA Insurance Group and its former reinsurance business with retroactive reinsurance contracts with Trabaja that provide coverage for adverse loss development on certain lines of business for accident years prior to 2002. These contracts provide coverage of up to $125 million in losses in return for $55 million of funding, which included $50 million of assets and $5 million in ceded premiums. Under the terms of the contracts, losses and LAE of the Run-off Operations ceded to Trabaja for accident years 1996 through 2001 are recoverable as they are incurred by the Company. Any future
In December 2005, the Company entered into interest rate swaps that it has designated as cash flow hedges to manage interest costs and cash flows associated with the variable interest rates associated with a portion of its junior subordinated debt and Surplus Notes. There was no consideration paid or received for these swaps. The swaps will effectively convert $20.0 million of the junior subordinated debt and $10.0 million of Surplus Notes to fixed rate debt with interest rates of 9.17% and 9.56%, respectively.
In November 2004, the Company exchanged $84.1 million aggregate principal amount of 6.50% Convertible Debt for $84.1 million aggregate principal amount of its outstanding 4.25% Senior Convertible Debt due 2022 (“4.25% Convertible Debt” and together with the 6.50% Convertible Debt, the “Convertible Debt”). The Company did not receive any proceeds as a result of the exchange offer. The Company recorded a loss on the debt exchange of $6.0 million, which resulted from the initial recording of the 6.50% Convertible Debt at fair value and the write-off of unamortized issuance costs associated with the 4.25% Convertible Debt. In November 2004, the Company received net proceeds of $15.2 million from the issuance of $15 million aggregate principal amount of 6.50% Convertible Debt in a private placement to a limited number of qualified institutional buyers.
In 2003, the Company issued $57.5 million of 8.50% Senior Notes due June 15, 2018, from which it realized net proceeds of $55.1 million. The Company used the proceeds from the offering to repay the remaining balance outstanding under its prior bank credit facility, to increase the statutory capital and surplus of its insurance subsidiaries, and for general corporate purposes. The Company has the right to call these securities beginning in June 2008.
Total expenses incurred under operating leases were $7.9 million, $8.4 million and $7.8 million for 2005, 2004 and 2003, respectively.
In the event a property and casualty insurer operating in a jurisdiction where the Company’s insurance subsidiaries also operate becomes or is declared insolvent, state insurance regulations provide for the assessment of other insurers to fund any capital deficiency of the insolvent insurer. Generally, this assessment is based upon the ratio of an insurer’s voluntary premiums written to the total premiums written for all insurers in that particular jurisdiction. As of December 31, 2005 and 2004, the Company had recorded liabilities of $4.3 million and $6.6 million for these assessments, which are included in accounts payable, accrued expenses and other liabilities on the Balance Sheet.
The Company is continuously involved in numerous lawsuits arising, for the most part, in the ordinary course of business, either as a liability insurer defending third-party claims brought against its insureds, or as an insurer defending coverage claims brought against it by its policyholders or other insurers. While the outcome of all litigation involving the Company, including insurance-related litigation, cannot be determined, litigation is not expected to result in losses that differ from recorded reserves by amounts that would be material to the Company’s financial condition, results of operations or liquidity. In addition, reinsurance recoveries related to claims in litigation, net of the allowance for uncollectible reinsurance, are not expected to result in recoveries that differ from recorded receivables by amounts that would be material to the Company’s financial condition, results of operations or liquidity.
In 2005, the Company issued 25,254 shares of restricted Class A Common stock to its Directors under the 2004 Directors Plan. The Company also issued 27,500 shares of restricted Class A Common stock to Directors in 2005 in
During the vesting period, restricted shares issued are nontransferable and subject to forfeiture, but the shares are entitled to all of the other rights of the outstanding shares. Restricted shares are forfeited if employees terminate employment, or Directors resign from the Board, prior to the lapse of restrictions except upon death or permanent disability. During 2005 and 2004, 2,900 and 15,900 restricted shares were forfeited.
The Pooled Companies, which are not subject to the Pennsylvania Insurance Department’s Order, paid dividends of $7.0 million and $12.1 million to PMA Capital Corporation in 2005 and 2004, respectively. As of December 31, 2005, the Pooled Companies can pay a maximum of $25.1 million in dividends to PMA Capital Corporation during 2006 without the prior approval of the Pennsylvania Insurance Department. Dividends received from subsidiaries were $24.0 million in 2003.
The Company currently has stock option plans in place for stock options granted to officers and other key employees for the purchase of the Company’s Class A Common stock, under which 4,843,440 Class A Common shares were reserved for issuance at December 31, 2005. The stock options were granted under terms and conditions determined by the Compensation Committee of the Board of Directors. Stock options granted have a maximum term of ten years, generally vest over periods ranging between one and four years, and are typically granted with an exercise price at least equal to the fair market value of the Class A Common stock on the date the options are granted. Information regarding these option plans is as follows:
All options granted in 2005, 2004 and 2003 were granted with an exercise price that equaled or exceeded the market value of the Class A Common stock on the grant date (“out-of-the-money”). The weighted average fair value of options granted in 2005, 2004 and 2003 was $3.62 per share, $3.43 per share and $4.91 per share, respectively.
The Company accounts for stock option compensation using the intrinsic value method. Included in the Company’s net income (loss) were pre-tax stock option compensation costs of $24,000, $(172,000) and $239,000 for 2005, 2004 and 2003, respectively. Stock option compensation increased pre-tax income in 2004 due to the impact of the cancellation of unvested stock options.
A reconciliation between the total income tax expense (benefit) and the amounts computed at the statutory federal income tax rate of 35% is as follows:
At December 31, 2005, the Company had a net operating loss ("NOL") carryforward of $273.4 million, which will expire in years 2018 through 2025, and a $9.2 million tax credit carryforward primarily related to alternative minimum tax ("AMT") credits, which does not expire. The NOL carryforward, which produces a gross deferred tax asset of $95.7 million, will be applied to reduce taxable income of the Company.
The valuation allowance of $60.5 million reserves against $52 million of gross deferred tax assets related to the NOL carryforward and all of the projected deferred tax asset related to the AMT credit carryforward because it is more likely than not that this portion of the benefit will not be realized. The Company will continue to periodically assess the realizability of its net deferred tax asset.
The Company also maintains non-qualified unfunded supplemental defined benefit pension plans (the “Non-qualified Pension Plans”) for the benefit of certain key employees. The projected benefit obligation and accumulated benefit obligation for the Non-qualified Pension Plans were $8.0 million and $8.0 million, respectively, as of December 31, 2005.
On October 27, 2005, the Company announced that it had decided to "freeze" its Qualified Pension Plan and Non-qualified Pension Plans as of December 31, 2005. Under the terms of the freeze, eligible employees retained all of the rights under these plans that they had vested as of December 31, 2005. Effective January 1, 2006, the Company’s 401(k) and 401(k) Excess Plans were renamed The PMA Capital Corporation Retirement Savings Plan and The PMA Capital Retirement Savings Excess Plan and were enhanced to include quarterly age-based employer contributions. The Company incurred a one-time non-cash charge of $229,000 in 2005 due to these changes.
The Company uses a January 1 measurement date for its Plans. For the measurement of Other Postretirement Benefits, a 10% annual rate of increase in the per capita cost of covered health care benefits was assumed for 2005. The rate was assumed to decrease gradually to 5% by 2014 and remain at that level thereafter. A one percentage
point change in assumed health care cost trend rates would have an immaterial impact on the total service and interest cost components of the net periodic benefit cost and the postretirement benefit obligation.
The projected benefit obligation, accumulated benefit obligation and fair value of plan assets for the Qualified Pension Plan were $84.2 million, $84.2 million and $67.7 million respectively, at December 31, 2005 and $78.2 million, $73.2 million and $65.0 million, respectively, at December 31, 2004.
The asset allocation for the Company’s Qualified Pension Plan at the end of 2005 and 2004, and the target allocation for 2006, by asset category, are as follows:
B. Defined Contribution Savings Plan - The Company also maintains a voluntary defined contribution savings plan covering substantially all employees. The Company matches employee contributions up to 5% of compensation. Contributions under such plans expensed in 2005, 2004 and were $2.4 million, $2.6 million and $3.3 million, respectively. Effective January 1, 2006, the Company’s 401(k) and 401(k) Excess Plans were renamed The PMA Capital Corporation Retirement Savings Plan and The PMA Capital Retirement Savings Excess Plan and were enhanced to include quarterly age-based employer contributions.
C. Postemployment Benefits - The Company may provide certain benefits to employees subsequent to their employment, but prior to retirement including severance, long-term and short-term disability payments, and other related benefits. Postemployment benefits attributable to prior service and/or that relate to benefits that vest or accumulate are accrued presently if the payments are probable and reasonably estimable. Postemployment benefits that do not meet such criteria are accrued when payments are probable and reasonably estimable. See Note 14 for additional information regarding severance.
As a result of the decision to exit from and run off this business, 2003 results included a $2.5 million write-down of assets, including approximately $2 million for reinsurance receivables and $500,000 for premiums receivable, reflecting an updated assessment of their estimated net realizable value. The write-down is included in operating expenses in the Statement of Operations for 2003.
In November 2003, the Company announced its decision to withdraw from the reinsurance business previously served by the PMA Re operating segment. As a result of this decision, the results of PMA Re are now reported as Run-off Operations. Run-off Operations also includes the results of the Company’s former excess and surplus lines business.
The PMA Insurance Group’s operations are concentrated in ten contiguous states in the eastern part of the U.S. The economic trends in these individual states may not be independent of one another. Also, The PMA Insurance Group’s products are highly regulated by each of these states. For most of The PMA Insurance Group’s products, the insurance departments of the states in which it conducts business must approve rates and policy forms. In addition, workers’ compensation benefits are determined by statutes and regulations in each of these states. While The PMA Insurance Group considers factors such as rate adequacy, regulatory climate and economic factors in its underwriting process, unfavorable developments in these factors could have an adverse impact on the Company’s financial condition and results of operations. Since November 2003, The PMA Insurance Group has been the Company’s sole remaining ongoing insurance segment. In 2005 and 2004, workers’ compensation net premiums written represented 86% and 85% of The PMA Insurance Group’s net premiums written. In 2003, workers’ compensation net premiums written by The PMA Insurance Group represented 41% of the Company’s net premiums written.
Although the Company believes that it has adequate reinsurance to protect against the estimated probable maximum gross loss from a catastrophe, an especially severe catastrophe or series of catastrophes, or terrorist event, could exceed the Company’s reinsurance and/or retrocessional protection and may have a material adverse impact on the Company’s financial condition, results of operations and liquidity. In 2005, 2004 and 2003, the Company’s loss and LAE ratios were not significantly impacted by catastrophes.
The Company incurred legal and consulting expenses aggregating approximately $3.3 million, $4.4 million and $3.7 million in 2005, 2004 and 2003, respectively, from firms in which directors of the Company are partners or principals.
At December 31, 2003, the Company had notes receivable from officers totaling $65,000 that were accounted for as a reduction of shareholders’ equity. These loans were repaid in 2004.
For 2003, the capital and surplus of The PMA Insurance Group’s domestic insurance subsidiaries was eliminated as they were included in the statutory capital and surplus of PMA Capital Insurance Company, then the parent company of these insurance companies. In June 2004, The PMA Insurance Group was transferred from PMA Capital Insurance Company to PMA Capital Corporation.
We have audited the accompanying consolidated balance sheet of PMA Capital Corporation and subsidiaries (the Company) as of December 31, 2005, and the related consolidated statements of operations, cash flows, shareholders’ equity and comprehensive income (loss) for the year then ended. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audit. The 2004 and 2003 consolidated financial statements were audited by other auditors whose report, dated March 16, 2005, expressed an unqualified opinion on those statements.
In our opinion, the 2005 consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2005 and the results of their operations and their cash flows for the year then ended in conformity with accounting principles generally accepted in the United States of America.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 9, 2006 expressed an unqualified opinion on management’s assessment of internal control over financial reporting and an unqualified opinion on the effectiveness of internal control over financial reporting.
In our opinion, management’s assessment that the Company maintained effective internal control over financial reporting as of December 31, 2005, is fairly stated, in all material respects, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements and financial statement schedules of the Company as of and for the year ended December 31, 2005, and our reports dated March 9, 2006 expressed an unqualified opinion on those financial statements and financial statement schedules.
We have audited the accompanying balance sheet of PMA Capital Corporation and subsidiaries (the “Company”) as of December 31, 2004 and the related consolidated statements of operations, cash flows, shareholders’ equity, and comprehensive income (loss) for each of the two years in the period ended December 31, 2004. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.