PMA Capital Corporation’s and PMA Re’s headquarters are located in approximately 88,000 square feet of leased space in center city Philadelphia, Pennsylvania. The PMA Insurance Group’s headquarters are located in a four story, 110,000 square foot building that we own in Blue Bell, Pennsylvania. We also lease approximately 63,000 square feet of office space in Yardley, Pennsylvania, which previously housed our excess and surplus lines business and now is subleased to an unaffiliated third party. We also own an approximately 16,585 square foot building in Harrisburg, Pennsylvania that we lease to PMA Foundation, which is currently under agreement of sale to PMA Foundation for $1.6 million.
Income (loss) before cumulative effect of accounting change $ (93,569 ) $ (48,024 ) $ 7,103
Results for 2003 were impacted by $49 million resulting from the recording of a valuation allowance on the Company's deferred tax asset. Results for 2002 were impacted by $43 million pre-tax ($28 million after-tax) for costs associated with the exit from and run off of Caliber One, our former excess and surplus lines business. Results for 2001 were impacted by $30 million pre-tax ($20 million after-tax) for World Trade Center losses.
Corporate and Other (22,816 ) (14,339 ) (6,322 ) (19,142 ) (20,765 )
Loss and LAE ratio 77.6 % 75.0 % 74.7 % 74.9 % 75.1 %
Expense Ratio(7) 25.1 % 26.4 % 26.7 % 29.3 % 31.7 %
Combined ratio(8) 102.8 % 103.2 % 105.5 % 111.7 % 115.4 %
The combined ratio computed on a GAAP basis is equal to losses and loss adjustment expenses plus acquisition expenses and policyholders' dividends (where applicable), all divided by net premiums earned.
The operating ratio is equal to the combined ratio less the net investment income ratio, which is computed by dividing net investment income by net premiums earned.
The following is a discussion of the financial condition of PMA Capital Corporation and its consolidated subsidiaries (“PMA Capital” or the “Company” which also may be referred to as “we” or “us”) as of December 31, 2003, compared with December 31, 2002, and the results of operations of PMA Capital for 2003 and 2002, compared with the immediately preceding year. The balance sheet information presented below is as of December 31 for each respective year. The statement of operations information is for the year ended December 31 for each respective year.
This discussion and analysis should be read in conjunction with our audited Consolidated Financial Statements and Notes thereto presented in Item 8 of this Form 10-K ("Consolidated Financial Statements"). You should also read our discussion of Critical Accounting Estimates beginning on page 59 for an explanation of those accounting estimates that we believe are most important to the portrayal of our financial condition and results of operations and that require our most difficult, subjective and complex judgments.
This Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) contains forward-looking statements, which involve inherent risks and uncertainties. Statements that are not historical facts, including statements about our beliefs and expectations, and containing words such as “believes,” “estimates,” “anticipates,” “expects” or similar words, are forward-looking statements. These statements are based upon current estimates, assumptions and projections. Actual results may differ materially from those projected in such forward-looking statements, and therefore, you should not place undue reliance on them. See "Cautionary Statements" beginning on page 62 for a list of factors that could cause our actual results to differ materially from those contained in any forward-looking statement. Also, see "Item 1 - Business - Risk Factors" for a further discussion of risks that could materially affect our business.
Losses and LAE are the most significant expense items affecting our insurance business. Like all insurers, we establish reserves representing estimates of future amounts needed to pay claims with respect to insured events that have occurred, including events that have not been reported to us. We also establish reserves for LAE, which represent the estimated expenses of settling claims, including legal and other fees, and general expenses of administering the claims adjustment process. Reserves are merely estimates and do not and cannot represent an exact measure of liability. If actual losses and LAE are larger than our loss reserve estimates, or if our actual claims reported to us exceed our estimate of the number of claims to be reported to us, we have to increase reserves for prior years. Changes in reserve estimates may be due to a wide range of factors, including inflation, changes in claims and litigation trends and legislative or regulatory changes. We incur a charge to earnings in the period the
reserves are increased. In 2003, we recorded a total of $169 million in charges to increase loss reserves for prior years in our PMA Re segment. See "Item 1 - Business - Risk Factors" for additional information.
These charges to increase loss reserves led to the downgrade of the insurer financial strength ratings of PMA Capital Insurance Company, our reinsurance subsidiary, and The PMA Insurance Group (Pennsylvania Manufacturers’ Association Insurance Company, Pennsylvania Manufacturers Indemnity Company and Manufacturers Alliance Insurance Company), or the Pooled Companies, our primary insurance subsidiaries, by the rating agencies that rate the financial strength of our insurance subsidiaries, particularly A.M. Best. The downgrade by A.M. Best of the financial strength rating of PMA Capital Insurance Company from A- (4th of 16) to B++ (5th of 16) was a substantial factor in our decision to withdraw from the reinsurance business. In addition, A.M. Best’s lowering of the financial strength rating of The PMA Insurance Group companies from A- (4th of 16) to B++ (5th of 16) has constrained The PMA Insurance Group’s ability to attract and retain business. Further, the recent ratings downgrades may make it more difficult to write business at the same rates and favorable terms and conditions as our current businesses. We currently believe that one of the most significant challenges that we have in 2004 is restoring the A- A.M. Best rating of The PMA Insurance Group. We believe the restoration of the A- rating is necessary for the growth of our primary insurance operations. We are currently evaluating various alternatives which we believe would allow the rating to be upgraded.
The net loss for 2003 reflects a third quarter after-tax charge of $97.5 million ($150 million pre-tax), to increase loss reserves at PMA Re. On November 6, 2003, we announced our decision to exit from the reinsurance business and we are no longer writing new reinsurance business. See "Recent Developments" beginning on page 38 for additional information. Additionally, we established a valuation allowance of $49 million on our deferred tax asset in 2003.
Included in net income (loss) are after-tax net realized investment gains of $9.0 million in 2003, compared to after-tax net realized investment losses of $10.5 million for 2002 and gains of $5.2 million for 2001. Net realized investment gains in 2003 were primarily attributable to sales intended to change the duration of our investment portfolio in order to better match our cash flows with our liability payouts. Net realized investment losses for 2002 primarily reflect impairment losses of $15.4 million after-tax ($23.8 million pre-tax) on fixed income securities, primarily corporate bonds issued by telecommunications and energy companies. Net realized investment gains for 2001 reflect the sale of securities because of our decision to shift the mix of our invested asset portfolio from U.S. Treasury and agency securities to corporate bonds and structured securities as a means to enhance our portfolio’s yield. As a result of investment sales pursuant to this strategy and the declining interest rates in 2001, we recorded net realized investment gains in 2001.
Also included in net income for 2001 is a $6.3 million after-tax gain ($9.8 million pre-tax included in other revenues) on the sale of certain real estate properties and a tax benefit of $10.1 million resulting from the completion of an IRS examination of our 1996 tax return.
Consolidated revenues were $1,301.2 million, $1,075.1 million and $850.0 million in 2003, 2002 and 2001. The increases in revenues primarily reflect higher net premiums earned. Since PMA Re is no longer writing new reinsurance business, we do not expect this increasing trend in consolidated revenues to continue.
In May 2002, we announced our decision to withdraw from the excess and surplus lines marketplace. As a result of this decision, the results of this segment, formerly known as Caliber One, are reported as Run-off Operations.
We also provide combined ratios and operating ratios for our insurance segments on pages 39 and 43. The “combined ratio” is a measure of property and casualty underwriting performance. The combined ratio computed using GAAP-basis numbers is equal to losses and LAE, plus acquisition expenses, insurance-related operating expenses and policyholders’ dividends, where applicable, all divided by net premiums earned. A combined ratio of less than 100% reflects an underwriting profit. Because time normally elapses between the receipt of premiums and the payment of claims and certain related expenses, we invest the available premiums. Underwriting results do not include investment income from these funds. Given the long-tail nature of our liabilities, we believe that the operating ratios are also important in evaluating our business. The operating ratio is the combined ratio less the net investment income ratio, which is net investment income divided by premiums earned.
• Moody's Investors Service announced that it has lowered the insurer financial strength ratings of PMA Capital Insurance Company from Baa1 (8th of 21) to B1 (14th of 21), and the Pooled Companies from Baa1 (8th of 21) to Ba1 (11th of 21), each with negative outlook. Moody's also lowered the senior debt ratings on PMA Capital Corporation from Ba1 (11th of 21) to B3 (16th of 21). These debt ratings remain under review with direction uncertain.
On November 24, 2003, we announced that we had voluntarily withdrawn from the Standard & Poor’s rating process.
On November 4, 2003, our Board of Directors resolved to suspend the dividends on our Class A Common stock.
Insurance Company agreed, among other things, not to pay dividends to us without the prior approval of the Pennsylvania Insurance Department; enter into any new reinsurance contracts, treaties or agreements, except as may be required by law; alter it or its Pennsylvania-domiciled insurance company subsidiaries’ ownership structure; and agreed to provide the Department with certain financial and operating information. See "Item 1 - Business - Regulatory" for additional information regarding our agreement with the Pennsylvania Insurance Department.
Several purported class action lawsuits have been filed against us and certain other defendants. We intend to vigorously defend against the claims asserted in these actions. The lawsuits are in their earliest stages. The lawsuits may have a material adverse effect on our financial condition, results of operations and liquidity. For additional information, see "Item 1 - Legal Proceedings."
Less: net investment income ratio 5.8 % 8.7 % 11.4 %
Pre-tax operating income for The PMA Insurance Group was $21.5 million in 2003, compared to $25.3 million in 2002 and $23.1 million in 2001. The lower pre-tax operating income in 2003, compared to 2002, primarily reflects lower underwriting results from accident years 2001 and 2002 in the workers’ compensation lines of business and lower net investment income, partially offset by improved current accident year underwriting results. The increase in operating income for 2002, compared to 2001, was primarily due to improved underwriting results, partially offset by lower net investment income.
For workers’ compensation coverages, the premium charged on fixed-cost policies is primarily based upon the manual rates filed with state insurance departments. Manual rates in The PMA Insurance Group’s principal marketing territories for workers’ compensation increased on average approximately 8% in 2003 and 13% in 2002. These increases in manual rates generally reflect the effects of higher average medical and indemnity costs in recent years. Manual rate changes directly affect the prices that The PMA Insurance Group can charge for its rate sensitive workers’ compensation products, which include fixed cost and dividend policies that comprise approximately 58% of workers’ compensation premiums for 2003.
Although we cannot currently predict the ultimate effect of the recent A.M. Best financial strength rating downgrade on The PMA Insurance Group’s business, such downgrade will likely result in lower premiums written. Further, the recent ratings downgrades may make it more difficult to write business at the same rates and favorable terms and conditions as our current businesses.
Premiums ceded increased $11.8 million in 2003, compared to 2002 and increased $1.9 million in 2002, compared to 2001. Premiums ceded for workers’ compensation and integrated disability increased by $21.1 million in 2003 and $7.9 million in 2002, compared to the immediately preceding year, as a result of the increase in direct premiums written as well as higher rates being charged by reinsurers. Premiums ceded for Commercial Lines were lower by $9.3 million and $5.9 million in 2003 and 2002, respectively, primarily because we have increased our net retentions in Commercial Lines from $250,000 in 2001 to $500,000 in 2002 and $1.5 million in 2003.
The loss and LAE ratio increased slightly in 2002, compared to 2001, primarily due to a higher current accident year loss and LAE ratio, partially offset by lower unfavorable prior year development. The current accident year loss and LAE ratio increased by 1.0 point in 2002, compared to 2001, primarily due to increased reinsurance costs and higher workers’ compensation loss trends, partially offset by price increases. The PMA Insurance Group experienced $1.1 million and $2.9 million of unfavorable prior year development in 2002 and 2001, respectively. The lower unfavorable prior year development reduced the loss and LAE ratio by 0.5 points in 2002, compared to 2001. The unfavorable prior year development in 2002 and 2001 primarily reflects higher than expected claims handling costs. For additional information regarding The PMA Insurance Group’s loss reserves, see "Loss Reserves" beginning on page 47.
The expense ratio improved by 0.3 points in 2002, compared to 2001, as premium growth outpaced the increase in expenses. The policyholders’ dividend ratio improved by 2.3 points in 2002, compared to 2001, primarily because we sold less business under dividend plans and wrote business under lower paying dividend plans. Lower dividend payments are effectively another form of price increase that contributes to the overall profitability of our workers’ compensation business.
PMA Re recorded a pre-tax operating loss of $79.4 million in 2003, compared to pre-tax operating income of $13.4 million in 2002 and a pre-tax operating loss of $3.1 million in 2001. PMA Re’s results for 2003 reflect the third quarter reserve charge of $150 million associated mainly with accident years 1997 to 2000. Additionally, as a result of the decision to exit from and run off this business, PMA Re’s results for 2003 include exit costs of $2.6 million, mainly related to severance benefits for terminated employees. PMA Re’s 2002 results were impacted by approximately $64 million due to unfavorable prior year loss development. PMA Re’s results for 2001 include a pre-tax charge of approximately $30 million relating to the effects of the losses caused by the terrorist attack on the World Trade Center. See "Losses and Expenses" beginning on page 45 for additional information.
Gross premiums written increased $300.2 million for 2002, compared to 2001, reflecting higher premiums in all of our business units. Additionally, gross premiums written increased in 2002, compared to 2001, due to PMA Re’s increased participation in aviation, ocean marine and accident reinsurance business (included in Other in the tables on pages 43 and 44) due to significantly improved market conditions in these lines.
We expect PMA Re to continue to have gross and net premiums written in 2004 as certain contracts written in 2003 and prior years will continue to generate premiums in 2004. Similarly, because premiums are earned principally on a pro rata basis over the coverage periods of the underlying policies, PMA Re will earn premiums in 2004.
The loss and LAE ratio was 88.0% for 2003, compared to 79.6% in 2002 and 87.4% in 2001. During 2003, PMA Re increased its net loss reserves for prior accident years by $169.1 million, including $150 million during the third quarter. PMA Re’s 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 from the commercial automobile line written during those same years. During the third quarter, our 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 business written by PMA Re. 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 us 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 PMA Re’s Traditional-Treaty, Specialty-Treaty and Facultative loss reserves, and concluded that those carried loss reserves were reasonable at September 30, 2003.
For 2001, PMA Re’s loss and LAE ratio reflects the impact on losses and LAE and earned premium of the terrorist attack on the World Trade Center, which increased net losses and LAE by $25 million and decreased net premiums earned by $5 million.
As a result of the decision to exit from and run off this business, PMA Re’s operating expenses for 2003 include exit costs of $2.6 million, mainly employee termination benefits, the majority of which were paid during the first quarter of 2004.
Approximately 75 employees at PMA Re were terminated in accordance with our exit plan. Approximately 90 positions, primarily claims and financial, remain at PMA Re after the terminations. We have established an employee retention arrangement for these remaining employees. Under this arrangement, PMA Re expects to record expenses of approximately $2 million in 2004, which includes retention bonuses and severance. We expect to pay the majority of these costs in 2004 and 2005.
Net investment income was $32.5 million, $48.7 million and $45.4 million in 2003, 2002 and 2001, respectively. The decline in 2003, compared to 2002, reflects lower yields on the invested asset portfolio of approximately 110 basis points on an average invested asset base that increased approximately 10%, and lower interest earned of $9.0 million on funds held arrangements. For 2003, the reduction in interest earned on funds held arrangements was substantially offset by lower losses on the associated assumed Finite Risk and Financial Products contracts. 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 increase in net investment income in 2002, compared to 2001, reflects higher interest earned of $9.7 million on funds held arrangements, partially offset by lower investment earnings of $6.4 million on the invested asset portfolio. The lower investment earnings resulted from a drop in yields of approximately 100 basis points on an average invested asset base that increased approximately 5% during 2002.
Summarized financial results of the Run-off Operations, formerly known as Caliber One, are as follows:
Pre-tax operating loss $ (818 ) $ (87,501 ) $ (26,168 )
million, including reinsurance costs of approximately $19 million, long-term lease costs of approximately $4 million and involuntary employee termination benefits of approximately $3 million. At December 31, 2003, the Company has a remaining obligation of approximately $859,000 for net lease costs and approximately $152,000 for severance.
The Corporate and Other segment includes unallocated investment income and expenses, including debt service. This segment recorded pre-tax operating losses of $22.8 million, $14.3 million and $6.3 million in 2003, 2002 and 2001, respectively. Included in results for 2003 are approximately $3 million of accrued costs associated primarily with the remaining salary obligations under employment contracts with our former executive officers. Interest expense increased by $6.6 million in 2003, compared to 2002, primarily due to a higher average amount of debt outstanding. Interest expense declined $3.3 million during 2002, compared to 2001, reflecting a lower average amount of debt outstanding and lower interest rates throughout the year. During 2001, we sold certain real estate properties for net proceeds totaling $14.4 million, resulting in a pre-tax gain of $9.8 million, which is recorded in other revenues.
Unpaid losses and LAE reflect management’s best estimate of future amounts needed to pay claims and related settlement costs with respect to insured events which have occurred, including events that have not been reported to us. In many cases, significant periods of time, ranging up to several years or more, may elapse between the occurrence of an insured loss, the reporting of the loss to us and our payment of that loss. In addition, because reinsurers rely on their ceding companies to provide them with information regarding incurred losses, reported claims for reinsurers become known more slowly than for primary insurers and are subject to more unforeseen development and uncertainty. As part of the process for determining our unpaid losses and LAE, various actuarial models are used that analyze historical data and consider the impact of current developments and trends, such as trends in claims severity and frequency and claims settlement trends. Also considered are legal developments, regulatory trends, legislative developments, changes in social attitudes and economic conditions.
to differ substantially from the amounts recorded at December 31, 2003, the related adjustments could have a material adverse effect on our financial condition, results of operations and liquidity. See the discussion under Losses and Expenses beginning on pages 41 and 45, and Run-off Operations beginning on page 46 for additional information regarding increases in loss reserves for prior years.
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, due to changing interpretations by courts involving coverage issues, the potential for changes in federal and state standards for clean-up and liability, as well as issues involving policy provisions, allocation of liability and damages among participating insurers, and proof of coverage, 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 59 for additional information. In addition, see "Cautionary Statements" beginning on page 62 and "Item 1 - Business - Risk Factors" for a discussion of factors that may adversely impact our losses and LAE in the future.
At December 31, 2003, we had reinsurance receivables due from the following unaffiliated reinsurers in excess of 5% of our shareholders’ equity:
In 2003 and 2002, our loss and LAE ratios were not significantly impacted by catastrophes. In 2001, our loss and LAE ratios were impacted by the attack on the World Trade Center as discussed under "Losses and Expenses" beginning on page 45. Although we believe that we have adequate reinsurance to protect against the estimated probable maximum gross loss from a catastrophe, an especially severe catastrophe or series of catastrophes could exceed our reinsurance and/or retrocessional protection and may have a material adverse impact on our financial condition, results of operations and liquidity.
See Note 6 to our Consolidated Financial Statements for additional discussion.
In November 2002, the Terrorism Risk Insurance Act of 2002 (“TRIA”) became effective. TRIA provides federal reinsurance protection for property and casualty losses in the United States or to United States aircraft or vessels arising from certified terrorist acts through the end of 2005. For terrorist acts to be covered under TRIA, 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. TRIA 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. TRIA requires insurers to retain losses based on a percentage of their commercial lines direct earned premiums for the prior year equal to a 7% deductible for 2003, 10% for 2004 and 15% for 2005. The federal government covers 90% of the losses above the deductible, while a company retains 10% of the losses. TRIA contains an annual limit of $100 billion of covered industry-wide losses. TRIA applies to 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 $43 million in 2004 if a covered terrorist act were to occur.
As discussed above, we have refined our underwriting processes to account for terrorism risks and TRIA may mitigate the potential impact of terrorism losses on our results. However, because of TRIA’s uncertain application, the amount of terrorism losses that The PMA Insurance Group must retain under TRIA and the fact that TRIA does not apply to, and we do not have terrorism exclusions in all of, our reinsurance business, future terrorist attacks may result in losses that could have a material adverse effect on our financial condition, results of operations and liquidity. For additional information regarding the underwriting criteria of our operating segments, see "Item 1 - Business - The PMA Insurance Group, Underwriting."
Liquidity is a measure of an entity’s ability to secure sufficient cash to meet its contractual obligations and operating needs. Our insurance operations generate cash by writing insurance policies and collecting premiums. The cash generated is used to pay losses and LAE and operating expenses. Any excess cash is invested and earns investment income. Operating cash flows increased significantly in 2003 and 2002, compared to the immediately preceding year, reflecting higher revenues due to price increases across all of our lines of business.
Our domestic insurance subsidiaries’ ability to pay dividends to us is limited by the insurance laws and regulations of Pennsylvania. All of our domestic insurance entities are owned by PMA Capital Insurance Company. As a result, dividends from The PMA Insurance Group’s Pooled Companies may not be paid directly to PMA Capital. Instead, only PMA Capital Insurance Company, a Pennsylvania domiciled company, may pay dividends directly to PMA Capital. Under Pennsylvania law, approximately $17 million of dividends would be available to be paid by PMA Capital Insurance Company to us in 2004 without the prior approval of the Pennsylvania Insurance Department as of December 31, 2003. However, PMA Capital Insurance Company has agreed with the Pennsylvania Insurance Department that PMA Capital Insurance Company will not pay dividends to us without the prior approval of the Pennsylvania Insurance Department. As of December 31, 2003, The PMA Insurance Group’s Pooled Companies can pay up to $23.2 million in dividends to PMA Capital Insurance Company during 2004. PMA Capital received dividends from subsidiaries of $24.0 million, $28.0 million and $29.6 million in 2003, 2002 and 2001, respectively.
Net tax payments received from subsidiaries were $5.6 million, $12.0 million and $2.4 million in 2003, 2002 and 2001, respectively.
The operating lease obligations referred to in the table above are primarily obligations of our insurance subsidiaries and are net of sublease payments of $1.4 million in 2004, $3.0 million in 2005-2006, $4.8 million in 2007-2009 and $7.7 million thereafter.
We have the right to defer interest payments on Trust Preferred 1, 2 and 3 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 trust subsidiaries are guaranteed by PMA Capital with respect to distributions and payments of Trust Preferred 1, 2 and 3.
We did not repurchase any shares during 2003. We repurchased 90,000 shares and 299,000 shares of our Class A Common stock at a cost of $1.7 million and $5.3 million in 2002 and 2001, respectively. Our remaining share repurchase authorization at December 31, 2003 is $15.4 million. Decisions regarding share repurchases are subject to prevailing market conditions and an evaluation of the costs and benefits associated with alternative uses of capital.
Our investment portfolio includes only fixed maturities, short-term investments and cash. The portfolio is diversified and does not contain any significant concentrations in single issuers other than U.S. Treasury and agency obligations. Our largest exposure to a single corporate issuer is $26.2 million, or 1.3% of total invested assets. In addition, we do not have a significant concentration of our investments in any single industry segment other than finance companies, which comprise 14% of invested assets at December 31, 2003. Included in this industry segment are diverse financial institutions, including the financing subsidiaries of automotive manufacturers. Substantially all of our investments are dollar denominated as of December 31, 2003.
As of December 31, 2003, the duration of our investments that support the insurance reserves was 3.4 years and the duration of our insurance reserves was 2.8 years. The difference in the duration of our investments and our insurance reserves reflects our decision to maintain a longer asset duration in order to enhance overall yield.
In addition to company-specific financial information and general economic data, we also consider our ability and intent to hold a particular security to maturity or until the market value of the bond recovers to a level in excess of the carrying value. Our ability and intent to hold securities to such time is evidenced by our strategy and process to match the cash flow characteristics of the invested asset portfolio, both interest income and principal repayment, to the actuarially determined estimated liability pay-out patterns of each insurance company’s claims liabilities. As a result of this periodic review process, we have determined that there currently is no need to sell any of the fixed maturity investments prior to their scheduled/expected maturity to fund anticipated claim payments.
As of December 31, 2003, our investment asset portfolio had gross unrealized losses of $12.0 million. For securities that were in an unrealized loss position at December 31, 2003, 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:
During 2002, we impaired securities issued by 11 companies, resulting in impairment charges of $23.8 million pre-tax during 2002, including $14.2 million for WorldCom. In 2001, we recognized an impairment loss of $1.6 million pre-tax resulting from the issuer filing for bankruptcy. See Critical Accounting Estimates - Investments on page 60 for additional information.
The net realized investment losses for 2002 primarily reflect impairment charges of $23.8 million on fixed income securities, primarily corporate bonds issued by telecommunications and energy companies. Net realized investment gains for 2001 reflect the sale of securities pursuant to a shift in the mix of our invested asset portfolio from U.S. Treasury and agency securities to corporate bonds and structured securities as a means to enhance our portfolio’s yield. As a result of investment sales pursuant to this strategy and given the declining interest rates in 2001, we recorded net realized investment gains in 2001.
See "Item 1 - Business - Investments" and Notes 2B and 4 to our Consolidated Financial Statements for additional discussion about our investment portfolio.
A significant portion of our assets and liabilities are financial instruments that are subject to the market risk of potential losses from adverse changes in market rates and prices. Our primary market risk exposures relate to interest rate risk on fixed rate domestic medium-term instruments and, to a lesser extent, domestic short- and long-term instruments. To manage our exposure to market risk, we have established strategies, asset quality standards, asset allocations and other relevant criteria for our investment portfolio. In addition, invested asset cash flows are structured after considering projected liability cash flows with actuarial models. All of our financial instruments are held for purposes other than trading. As stated above, our portfolio does not contain a significant concentration in single issuers other than U.S. Treasury and agency obligations. In addition, we do not have a significant concentration of our investments in any single industry segment other than finance companies, which comprise approximately 14% of invested assets at December 31, 2003. Included in this industry segment are diverse financial institutions, including the financing subsidiaries of automotive manufacturers. See Notes 2B, 4, 7 and 12 to our Consolidated Financial Statements for additional information about financial instruments.
Caution should be used in evaluating our overall market risk from the information below, since actual results could differ materially because the information was developed using estimates and assumptions as described below, and because insurance liabilities and reinsurance receivables are excluded in the hypothetical effects (insurance liabilities represent 68% of our total liabilities and reinsurance receivables represent 29% of our total assets).
The hypothetical effects of changes in market rates or prices on the fair values of financial instruments as of December 31, 2003, excluding insurance liabilities and reinsurance receivables on unpaid losses because such insurance related assets and liabilities are not carried at fair value, would have been as follows:
• If interest rates had increased by 100 basis points, there would have been no significant change in the fair value of our debt. The change in fair values was determined by estimating the present value of future cash flows using models that measure the change in net present values arising from selected hypothetical changes in market interest rates.
• If interest rates had increased by 100 basis points, there would have been a net decrease of approximately $77 million in the fair value of our investment portfolio. The change in fair values was determined by estimating the present value of future cash flows using various models, primarily duration modeling.
In general, our businesses are subject to a changing social, economic, legal, legislative and regulatory environment that could affect them. Some of the changes include initiatives to restrict insurance pricing and the application of underwriting standards and reinterpretations of insurance contracts long after the policies were written in an effort to provide coverage unanticipated by us. The eventual effect on us of the changing environment in which we operate remains uncertain. The Pennsylvania Insurance Department is currently conducting its triennial examination of our insurance subsidiaries, including a review of the future business plans of those subsidiaries. Although we have not received the final report of the Department, we do not expect any material adverse effect on our statutory financial statements as a result of the examination.
In December 2003, the FASB revised Statement of Financial Accounting Standards (“SFAS”) No. 132, “Employers’ Disclosures About Pensions and Other Postretirement Benefits,” to require additional disclosures regarding defined benefit pension plans and other defined benefit postretirement plans. We have applied the disclosure provisions of SFAS No. 132 to our Consolidated Financial Statements for 2003.
Effective July 1, 2003, we adopted SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities.” This statement amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts (collectively referred to as derivatives) and for hedging activities under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities.” Adoption of this statement did not have an impact on our financial condition, results of operations or liquidity.
In July 2002, the FASB issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.” SFAS No. 146 requires companies to recognize costs associated with exit or disposal activities when they are incurred rather than at the date of a commitment to an exit or disposal plan. SFAS No. 146 is to be applied prospectively to exit or disposal activities initiated after December 31, 2002. Accordingly, this standard does not apply to our exit from the excess and surplus lines business, which we announced in May 2002. We applied the provisions of SFAS No. 146 to our exit from the reinsurance business, which we announced in November 2003.
It is important to realize and understand that the process of estimating our ultimate claims liability is necessarily a complex and judgmental process inasmuch as the amounts are based on management’s informed estimates and judgments using data currently available. As additional experience and data become available regarding claim payment and reporting patterns, legal and legislative developments, the impact of regulatory trends on benefit levels for both medical and indemnity payments, and changes in social attitudes and economic conditions, we revise our estimates accordingly. In addition, because reinsurers rely on their ceding companies to provide them with information regarding incurred losses, reported claims for reinsurers become known more slowly than for primary insurers and are subject to more unforeseen development and uncertainty. We believe that our liability for unpaid losses and loss adjustment expenses is fairly stated at December 31, 2003. However, if our future estimate of ultimate unpaid losses is larger than the
For additional information about our liability for unpaid losses and loss adjustment expenses, see Notes 2-D and 5 to the Consolidated Financial Statements as well as "Item 1 - Business - Loss Reserves."
All investments in our portfolio are carried at market value. For 99% of our investments, we determine the market value using prices obtained in the public markets, both primary and secondary markets. These market prices reflect publicly reported values of recent purchase and sale transactions for each specific, individual security. Therefore, we believe that the reported fair values for our investments at December 31, 2003 reflect the value that we could realize if we sold these investments in the open market at that time.
Based on our evaluation of reinsurance receivables at December 31, 2003, we have established an allowance for amounts that we have concluded are uncollectible at the balance sheet date. In evaluating collectibility, we considered historical payment performance of our reinsurers, the fact that our reinsurers are current on their obligations to our insurance subsidiaries, and any known disputes or collection issues as of the balance sheet date. To these factors, we applied our informed judgment in ascertaining the appropriate level of allowance for uncollectible amounts. At December 31, 2003, approximately $36 million of uncollateralized reinsurance receivables, including $14 million due for ceded IBNR, are due from reinsurers who have ratings that declined to below “Adequate, ” defined as B++ or below by A.M. Best, in 2003 or who were under regulatory supervision or in liquidation in 2003.
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. As discussed in "PMA Re - Premiums" beginning on page 43, in the second quarter of 2002, PMA Re recognized $44 million of net written premiums for prior underwriting years due to a difference between the originally estimated and actual premiums. Due to the customary lag in reporting premium data by some of PMA Re’s clients, PMA Re must estimate the ultimate written premiums to be received from a ceding company based upon data received when we initially receive the submission including broker and ceding company data and projections. Actual premiums written for PMA Re reported in the Statement of Operations are based upon reports received from ceding companies, supplemented by our own estimates of premiums written for which ceding company reports have not been received. Differences between such estimates and actual amounts are recorded in the period in which the actual amounts are determined.
The premiums on reinsurance business ceded are recorded as incurred on a pro rata basis over the contract period. Certain ceded reinsurance contracts contain provisions requiring us to pay additional premiums ranging from 20% to
• the effect on The PMA Insurance Group's premium writings and profitability due to the downgrade of its financial strength rating by A.M. Best to B++;
• the effect on The PMA Insurance Group's premium writings, profitability and ratings due to its status as a subsidiary of PMA Capital Insurance Company;
• 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;
• severity of natural disasters and other catastrophes, including the impact of future acts of terrorism, in connection with insurance and reinsurance policies;
Consolidated Statements of Shareholders' Equity for the years ended December 31, 2003, 2002 and 2001
Treasury stock, at cost (2003 - 2,883,542 shares; 2002 - 2,889,023 shares) (52,426 ) (52,535 )
2003 - $(8,039); 2002 - $15,710; 2001 - $10,634 (14,930 ) 29,177
Balance at beginning of year (62 ) (158 ) (56 )
Balance at beginning of year (52,535 ) (55,797 ) (52,772 )
Class A Common stock dividends declared (9,870 ) (13,142 ) (9,018 )
The PMA Insurance Group - The PMA Insurance Group writes workers’ compensation, integrated disability and, to a lesser extent, other standard lines of commercial insurance, primarily in the eastern part of the United States. Approximately 90% of The PMA Insurance Group’s business is produced through independent agents and brokers.
Run-off Operations - Prior to May 1, 2002, the Company operated a third specialty risk management business, Caliber One, which wrote excess and surplus lines of business throughout the United States, generally through surplus lines brokers. Effective May 1, 2002, the Company announced its decision to withdraw from the excess and surplus lines marketplace. As a result of this decision, the results of this segment are reported as Run-off Operations. See Note 15 for additional information.
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 restated 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 statement of operations information is for the year ended December 31 for each respective year.
B. Investments - All fixed maturities are classified as available-for-sale and, accordingly, are carried at fair value. Changes in fair value of fixed maturities, net of income tax effects, are reflected in accumulated other comprehensive income (loss). All short-term, highly liquid investments, which have original maturities of one year or less from acquisition date, are treated as short-term investments and are carried at amortized cost, which approximates fair value.
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 payout pattern of the underlying claim liabilities unless the contracts call for immediate recovery by the Company from reinsurers as ceded losses are incurred.
F. Deferred Acquisition Costs - Costs that directly relate to and vary with the acquisition of new and renewal business are deferred and amortized over the period during which the related premiums are earned. Such direct costs include
commissions, brokerage and premium taxes, as well as other policy issuance costs and underwriting expenses. The Company determines whether acquisition costs are recoverable considering future losses and LAE, maintenance costs and anticipated investment income. To the extent that acquisition costs are not recoverable, the deficiency is charged to income in the period identified.
G. Dividends to Policyholders - The PMA Insurance Group sells certain workers’ compensation insurance policies with dividend payment features. These policyholders share in the underwriting results of their respective policies in the form of dividends declared at the discretion of the Board of Directors of The PMA Insurance Group’s operating companies. Dividends to policyholders are accrued during the period in which the related premiums are earned and are determined based on the terms of the individual policies.
Diluted - pro forma $ (3.02 ) $ (1.58 ) $ 0.27
In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” This statement establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances). This statement is effective for instruments entered into or modified after May 31, 2003 and the disclosure requirements were effective beginning with the third quarter of 2003. Adoption of this statement did not have an impact on the Company’s financial statements.
In July 2002, the FASB issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.” SFAS No. 146 requires companies to recognize costs associated with exit or disposal activities when they are incurred rather than at the date of a commitment to an exit or disposal plan. SFAS No. 146 is to be applied prospectively to exit or disposal activities initiated after December 31, 2002. Accordingly, this standard does not apply to the Company’s exit from the excess and surplus lines business, which the Company announced in May 2002. The Company applied the provisions of SFAS No. 146 to its exit from the reinsurance business, which the Company announced in November 2003.
On November 6, 2003, the Company announced its decision to withdraw from the reinsurance business previously served by PMA Re, which is no longer writing new reinsurance business. As a result of the decision to exit from and run off this business, the Company’s results for 2003 include a charge of $5.7 million pre-tax ($2.6 million in PMA Re, mainly for employee termination benefits, and $3.1 million in Corporate and Other associated primarily with salary obligations under employment contracts with our former executive officers). Approximately 75 employees at PMA Re were terminated in accordance with the Company’s exit plan. The majority of these employee termination costs were paid during the first quarter of 2004. Approximately 90 positions, primarily claims and financial, remain at PMA Re after the terminations. The Company has established an employee retention arrangement for the remaining employees. Under this arrangement, PMA
U.S. Treasury securities and obligations of U.S. Government agencies $ 315,911
As of December 31, 2003, the Company’s investment asset portfolio had gross unrealized losses of $12.0 million. For securities that were in an unrealized loss position at December 31, 2003, 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:
On December 31, 2003, the Company had securities with a total amortized cost of $44.1 million and fair value of $45.9 million held in trust for the benefit of certain ceding companies on reinsurance balances assumed by PMA Re and securities with a total amortized cost of $18.0 million and fair value of $18.2 million pledged as collateral for letters of credit issued on behalf of the Company. In addition, the Company had securities with a total amortized cost of $34.7 million and fair value of $37.5 million on deposit with various governmental authorities, as required by law. Securities with a total amortized cost of $5.5 million and fair value of $6.2 million were held in trust to support the Company’s participation in the underwriting capacity of a Lloyd’s of London syndicate. The securities held in trust, on deposit or pledged as collateral are included in fixed maturities on the Balance Sheet.
During 2003, The PMA Insurance Group recorded unfavorable prior year loss development of $49.7 million. 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, The PMA Insurance Group increased loss reserves for prior years by $50 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. 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.
During 2003, PMA Re increased its net loss reserves for prior accident years by $169.1 million, including $150 million during the third quarter. PMA Re’s 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 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 business written by PMA Re. 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 PMA Re’s Traditional-Treaty, Specialty-Treaty and Facultative loss reserves, and concluded that those carried loss reserves were reasonable at September 30, 2003.
During 2002, the Run-off Operations recorded unfavorable prior year development of $51.8 million. During 2002, company actuaries conducted reserve reviews to determine the impact of any emerging data on anticipated loss development trends and recorded unpaid losses and LAE reserves. 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 business written by this segment. Management’s selection of the ultimate losses resulting from their reviews indicated that net loss reserves for prior accident years, mainly 1999 and 2000, needed to be increased by $51.8 million. This unfavorable prior year development reflects the impact of higher than expected claim severity and, to a lesser extent, frequency, that emerged in 2002 on casualty lines of business, primarily professional liability policies for the nursing homes class of business; general liability, including policies covering contractors’ liability for construction defects; and commercial automobile, mainly for accident years 1999 and 2000.
As a result of its reserve reviews conducted in 2001, the Run-off Operations revised its estimate of ultimate expected claims activity and, accordingly, increased its estimate of ultimate losses, substantially all for accident years 1999 and 2000. During 2001, the Run-off Operations recorded unfavorable prior year loss development of $22.2 million. These losses primarily
reflect higher than expected claim frequency and severity that emerged in 2001 on certain casualty lines of business, primarily professional liability policies for the nursing homes class of business, and, to a lesser extent, property lines of business.
Unpaid losses for the Company’s workers’ compensation claims, net of reinsurance, at December 31, 2003 and 2002 were $433.8 million and $326.7 million, net of discount of $54.6 million and $76.7 million, respectively. The discount rate used was approximately 5% at December 31, 2003 and 2002.
Management believes that its unpaid losses and LAE are fairly stated at December 31, 2003. However, estimating the ultimate claims liability is necessarily a complex and judgmental process inasmuch as the amounts are based on management’s informed estimates 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, 2003, the related adjustments could have a material adverse effect on the Company’s financial condition, results of operations and liquidity.
At December 31, 2003, 2002 and 2001, gross reserves for environmental-related losses were $14.2 million, $18.2 million and $29.6 million, respectively ($8.8 million, $14.3 million and $16.0 million, net of reinsurance, respectively). Of the net environmental reserves, approximately $3.7 million, $7.9 million and $9.2 million related to IBNR losses at December 31, 2003, 2002 and 2001, respectively. All incurred asbestos and environmental losses were for accident years 1986 and prior.
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, 2003 and 2002, the Company’s reinsurance receivables of $1,220.3 million and $1,295.1 million were supported by $644.1 million and $666.9 million of collateral. Of the uncollateralized reinsurance receivables as of December 31, 2003, approximately 91% were recoverable from reinsurers rated “A-” or better by A.M. Best. The Company believes that the amounts receivable from reinsurers are fully collectible and that the valuation allowance is adequate to cover any disputes about amounts owed by reinsurers to the Company.
Our largest reinsurer is Trabaja Reinsurance Company (“Trabaja”). Reinsurance receivables from Trabaja were $288.7 million at December 31, 2003, of which 94% were collateralized.
Trabaja, formerly PMA Insurance Cayman, Ltd. (“PMA Cayman”), is a wholly owned subsidiary of London Life and Casualty Reinsurance Corporation (“London Reinsurance Group”). The Company sold PMA Cayman to London Reinsurance Group for $1.8 million, and transferred approximately $230 million of cash and invested assets as well as loss reserves to the buyer in 1998. Under the terms of the sale of PMA Cayman to London Reinsurance Group in 1998, the Company has agreed to indemnify London Reinsurance Group, up to a maximum of $15 million if the actual claim payments in the aggregate exceed the estimated payments upon which the loss reserves of PMA Cayman were established. If the actual claim payments in the aggregate are less than the estimated payments upon which the loss reserves have been established, then the Company will participate in such favorable loss reserve development.
The Company has the right to defer interest payments on Trust Preferred 1, 2 and 3 for up to twenty consecutive quarters but, if so deferred, it may not declare or pay cash dividends or distributions on its Class A common stock. The Company has guaranteed the obligations of these statutory trust subsidiaries with respect to distributions and payments on the trust preferred securities issued by these subsidiaries.
In October 2002, the Company issued $86.25 million aggregate principal amount of 4.25% convertible senior debentures (“Convertible Debt”) due September 30, 2022 from which the Company received net proceeds of $83.7 million. The Convertible Debt bears interest at a rate of 4.25% per annum, payable semi-annually on March 30 and September 30. In addition, contingent interest may be payable by the Company to the holders of the Convertible Debt commencing September 30, 2006, under certain circumstances. Because of the debt ratings assigned to the Convertible Debt, holders of the Convertible Debt may currently convert their debentures at a conversion price of $16.368 per share, subject to adjustment upon certain events. Further, holders of the Convertible Debt, at their option, may require the Company to repurchase all or a portion of their debentures on September 30, 2006, 2008, 2010, 2012 and 2017, or subject to specified exceptions, upon a change in control. The Company may choose to pay the repurchase price in cash or shares of Class A common stock. The Convertible Debt is redeemable in cash, in whole or in part, at the Company’s option at any time on or after September 30, 2006.
At December 31, 2003 and 2002, the aggregate outstanding face amount of letters of credit issued on behalf of the Company was $12.0 million and $15.7 million, respectively. The Company utilizes letters of credit primarily for collateralizing reinsurance obligations of its insurance subsidiaries. At December 31, 2003, fees for the letters of credit were 2.0% per annum.
The debt covenants supporting the letters of credit contain provisions that, among other matters, limit the Company’s ability to incur additional indebtedness, merge, consolidate and acquire or sell assets.
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, 2003 and 2002, the Company had recorded liabilities of $7.5 million and $5.4 million for these assessments, which are included in accounts payable, accrued expenses and other liabilities on the Balance Sheet.
The Company has an interest in a partnership for which it has provided a guaranty of $7.0 million related to loans on properties of the partnership. This guaranty shall continue to be in force until the related loan has been satisfied. The loan is scheduled to be repaid on November 1, 2004.
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
Several other purported class action lawsuits, captioned Augenbaum v. PMA Capital Corporation, et. al. (initiated November 6, 2003), Klinghoffer v. PMA Capital Corporation, et. al. (initiated November 10, 2003), and Pollin v. PMA Capital Corporation, John W. Smithson and Frederick W. Anton III (initiated November 11, 2003) were filed in the Eastern District of Pennsylvania by alleged purchasers of the Company’s 4.25% Convertible Debentures and 8.50% Monthly Income Senior Notes. The Klinghoffer and Pollin complaints name PMA Capital Corporation, PMA Capital Trust I, PMA Capital Trust II, certain of the Company’s officers and directors and investment banking firms as defendants. The complaints allege, among other things, that the defendants violated Sections 11, 12(a)(2) and 15 of the Securities Act of 1933, as amended, by making materially false and misleading statements about its reserves in the registration statement, prospectuses and prospectus supplements in connection with the debt.
The lawsuits seek unspecified compensatory damages and reasonable costs and expenses. The Company intends to vigorously defend against the claims asserted in these actions. The lawsuits are in their earliest stages. The lawsuits may have a material adverse effect on the Company’s financial condition, results of operations and liquidity.
In 2003, shareholders approved an increase in the authorized shares of the Company's Class A Common stock, which has a $5 par value, from 40 million shares to 60 million shares.
In December 2001, the Company issued 9,775,000 shares of its Class A Common stock, realizing net proceeds of $157.9 million. The Company used the net proceeds from this issuance to contribute additional capital to its reinsurance subsidiary and to repay $62.5 million of its then outstanding bank credit facility.
The Company declared dividends on its Class A Common stock of $0.315, $0.42 and $0.42 per share in 2003, 2002 and 2001, respectively. On November 4, 2003, the Company’s Board of Directors resolved to suspend dividends on the Company’s Class A Common stock.
Option price range at end of year $9.14 to $21.50 $11.50 to $21.50 $10.00 to $21.50
Option price range for exercised shares $11.50 $10.00 to $17.00 $8.00 to $17.00
Stock options outstanding and options exercisable at December 31, 2003 were as follows:
For all years presented, there were no differences in the numerator (net income (loss)) for the basic and diluted earnings per share calculation.
The effect of 2.9 million, 3.1 million and 873,000 stock options were excluded from the computation of diluted earnings per share for 2003, 2002 and 2001, respectively, because they would have been anti-dilutive.
As of December 31, 2003 and 2002, the carrying amounts for the Company’s financial instruments approximated their estimated fair value, other than the Convertible Debt, which had a fair value of approximately $65 million, compared to a carrying value of $86.25 million, and the Senior Notes, which had a fair value of approximately $50 million, compared to a carrying value of $57.5 million. The Company measures the fair value of fixed maturities, the Convertible Debt and the Senior Notes based upon quoted market prices or by obtaining quotes from dealers. The fair value of bank debt was estimated using discounted cash flow calculations based upon the Company’s incremental borrowing rate for similar types of borrowing facilities or the rate utilized to prepay obligations, where applicable. For other financial instruments, the carrying values approximate their fair values. Certain financial instruments, specifically amounts relating to insurance and reinsurance contracts, are excluded from this disclosure.
Federal income tax at the statutory rate $ (23,711 ) $ (27,705 ) $ (1,546 )
At December 31, 2003, the Company had a net operating loss (“NOL”) carryforward of $193.2 million, which will expire in 2018 through 2023, and an $8.5 million alternative minimum tax (“AMT”) credit carryforward, which does not expire. The NOL carryforward, which produces a gross deferred tax asset of $67.6 million, will be applied to reduce future taxable income of the Company. During 2003, the Company updated its evaluation of the realizability of its net deferred tax asset, considering a number of factors including recent earnings history, expectations for future earnings, timing of reversal of temporary differences and the expiration dates associated with the NOL carryforwards. Based upon management’s consideration of these factors, the Company established a valuation allowance in the amount of $49 million. The valuation allowance reserves against $40.5 million of gross deferred tax assets related to the NOL carryforward and all of the 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’s Federal income tax returns are subject to audit by the Internal Revenue Service (“IRS”), and provisions are made in the financial statements in anticipation of the results of these audits. In 2001, the IRS completed its examination of the Company’s 1996 U.S. Federal tax return with no material changes to the Company’s filed tax return. No other tax years are currently under audit by the IRS. In management’s opinion, adequate liabilities have been established for all years.
Benefit obligation greater than the fair value of plan assets $ (15,069 ) $ (9,806 ) $ (9,777 ) $ (8,808 )
Accrued benefit cost (5,337 ) (4,438 ) (13,542 ) (13,435 )
Amortization of transition obligation (5 ) (4 ) (4 ) -
Discount rate 6.25 % 6.75 % 7.25 % 6.25 % 6.75 % 7.25 %
Rate of compensation increase 4.00 % 4.50 % 4.75 % -
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 2004. The rate was assumed to decrease gradually to 5% by 2009 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 decline in Qualified Pension Plan asset performance in recent years, coupled with historically low interest rates (which are the key assumption in estimating plan liabilities) caused the Company to record a $24.0 million increase in our accrued Qualified Pension Plan liability and to take a $15.6 million non-cash charge to equity in the fourth quarter of 2003. This charge did not impact earnings or cash flow, and could reverse in future periods if either interest rates increase or market performance and plan asset returns improve.
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 Notes 3 and 15 for additional information regarding severance.
As a result of the decision to exit from and run off this business, 2002 results for the Run-off Operations include a charge of $43 million pre-tax ($28 million after-tax). Components of the pre-tax charge include approximately $16 million to write-down assets to their estimated net realizable value, including non-cash charges of approximately $6 million for leasehold improvements and other fixed assets and $1.3 million for goodwill.
In addition, the $43 million pre-tax charge includes expenses associated with the recognition of liabilities of approximately $27 million, including reinsurance costs of approximately $19 million, long-term lease costs of approximately $4 million and involuntary employee termination benefits of approximately $3 million. See Note 16 for additional information regarding the reinsurance component of the charge. The charge was included in operating expenses (approximately $24 million) and net premiums earned (approximately $19 million) in the Statement of Operations in 2002. At December 31, 2003, the Company has a remaining balance of approximately $859,000 for net lease costs and approximately $152,000 for severance.
During 2002, approximately 80 Caliber One employees, primarily in the underwriting area, were terminated in accordance with the Company’s exit plan. Approximately 14 positions, primarily claims and accounting staff, remain as of December
31, 2003. Involuntary employee termination benefits of $730,000 and $1.9 million were paid during 2003 and 2002, respectively.
PMA Re has agreed to assume the claims obligations of the Run-off Operations if the actual claim payments in the aggregate exceed the estimated payments upon which the loss reserves of the Run-off Operations were established. As a result of this transaction, PMA Re recorded assumed premiums of $10 million in 2002. No losses were recorded by PMA Re in connection with this transaction. Also during 2002, PMA Re recorded assumed premiums of $8.5 million in connection with the assumption of losses from the Run-off Operations, which PMA Re retroceded under its existing retrocessional contracts. As a result of these two transactions, the Run-off Operations recorded a ceded premium charge of $18.5 million in 2002 as part of the charge to exit from and run off the excess and surplus lines business. These amounts are reflected in the individual business segments’ pre-tax operating income (loss) and revenues.
The Company actively manages its exposure to catastrophes through its underwriting process, where the Company generally monitors the accumulation of insurable values in catastrophe-prone regions. The PMA Insurance Group maintains catastrophe reinsurance protection of 95% of $18.0 million excess of $2.0 million. In writing property reinsurance coverages, PMA Re typically required per occurrence loss limitations for contracts that could have had catastrophe exposure. Through per risk reinsurance, the Company manages its net retention in each exposure. PMA Re’s property per occurrence reinsurance provides catastrophe protection of $40.0 million in excess of $10.0 million on its traditional property book. PMA Re can also recover an additional $20.0 million of Traditional and/or Finite Risk and Financial Products occurrence losses under certain industry loss scenarios. Certain of these contracts require that the Company cede additional premiums of up to 20% of ceded losses depending on the level of such losses.
As of December 31, 2003, the Company’s largest shareholder was PMA Foundation (the “Foundation”), a not-for-profit corporation qualified under Section 501(c)(6) of the Internal Revenue Code, whose purposes include the promotion of the common business interests of its members and the economic prosperity of the Commonwealth of Pennsylvania. As of December 31, 2003, the Foundation owned 5,242,150 shares, or 16.7%, of the Company’s Class A Common stock. The Company and certain of its subsidiaries provide certain administrative services to the Foundation for which the Company and its subsidiaries receive reimbursement. Total reimbursements amounted to $13,000 for each of 2003, 2002 and 2001. The Foundation also leased its Harrisburg, Pennsylvania headquarters facility from a subsidiary of the Company under an operating lease which required rent payments of $25,000 per month, and reimbursed a subsidiary of the Company for its use of office space. Rent and related reimbursements paid to the Company’s affiliates by the Foundation was $304,000 for 2003, 2002 and 2001. In February 2004, the Company agreed to sell this building to the Foundation for gross proceeds of $1.6 million. As of March 8, 2004, the Foundation owned 2,165,471 shares, or 6.9 %, of the Company’s Class A Common stock.
Until December 31, 2003, the Company had an executive loan program, through which a financial institution provided personal demand loans to the Company’s officers. The Company had provided collateral and agreed to purchase any loan in default. In November 2003, the financial institution sold the Company's collateral partially securing the loans of two former officers of the Company in satisfaction of their loans in the aggregate amount of $2.0 million. The Company is seeking repayment of the loans from the former officers and is accruing interest on these loans at a rate of 3.3% as of December 31, 2003. These loans are included in other assets on the Balance Sheet at December 31, 2003.
PMA Capital Insurance Company $ (84,413 ) $ (8,039 ) $ (18,708 )
The Company’s statutory financial statements are presented on the basis of accounting practices prescribed or permitted by the Pennsylvania Insurance Department (for PMA Capital Insurance Company and The PMA Insurance Group) and the Delaware Insurance Department (for Caliber One Indemnity Company). Pennsylvania and Delaware have adopted Codification as the basis of their statutory accounting practices. However, Pennsylvania has retained the prescribed practice of non-tabular discounting of unpaid losses and LAE for workers’ compensation, which was not permitted under Codification. This prescribed accounting practice increased statutory capital and surplus by $435,000, $13.0 million and $22.2 million at December 31, 2003, 2002 and 2001, respectively, over what it would have been had the prescribed practice not been allowed.
We have audited the accompanying consolidated balance sheet of PMA Capital Corporation and subsidiaries (the “Company”) as of December 31, 2003, and the related consolidated statements of operations, cash flows, shareholders’ equity, and comprehensive income (loss) for the year then ended. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the financial statements based on our audit. The consolidated financial statements of the Company for the years ended December 31, 2002 and 2001 were audited by other auditors whose report, dated February 5, 2003, expressed an unqualified opinion on those statements.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of PMA Capital Corporation and subsidiaries at December 31, 2003, 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.
In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations, cash flows, shareholder's equity and comprehensive income (loss) present fairly, in all material respects, the financial position of PMA Capital Corporation and its subsidiaries at December 31, 2002 and 2001, and the results of their operations and their cash flows for each of the two years in the period ended December 31, 2002 in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States of America, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assesing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
Includes $24 million, or $0.76 per basic and diluted share, for the third quarter, and $25 million, or $0.80 per basic and diluted share, for the fourth quarter, to record a valuation allowance on our deferred tax asset.