Property and casualty insurance operations are conducted through three subsidiaries and represent the most significant segment of the Company’s business, totaling 78 percent of consolidated premiums earned in 2017. The Company’s three property and casualty insurance subsidiaries and two subsidiaries and an affiliate of Employers Mutual (Union Insurance Company of Providence, EMC Property & Casualty Company and Hamilton Mutual Insurance Company) are parties to a pooling agreement with Employers Mutual. Under the terms of the pooling agreement, each company cedes to Employers Mutual all of its insurance business, and assumes from Employers Mutual an amount equal to its participation in the pool. All premiums, losses, settlement expenses, and other underwriting and administrative expenses, excluding the voluntary reinsurance business assumed by Employers Mutual from nonaffiliated insurance companies, are prorated among the parties on the basis of participation in the pool. Employers Mutual negotiates reinsurance agreements that provide protection to the pool and each of its participants, including protection against losses arising from catastrophic events. The aggregate participation of the Company’s property and casualty insurance subsidiaries in the pool is 30 percent.
The purpose of the pooling agreement is to spread the risk of an exposure insured by any of the pool participants among all the companies participating in the pool. The pooling agreement produces a more uniform and stable underwriting result from year to year for the companies participating in the pool than might be experienced individually. In addition, each company benefits from the capacity of the entire pool, rather than being limited to policy exposures of a size commensurate with its own surplus, and from the wide range of policy forms, lines of insurance written, rate filings and commission plans offered by each of the companies.
Reinsurance operations are conducted through EMC Reinsurance Company and accounted for 22 percent of consolidated premiums earned in 2017. The Company’s reinsurance subsidiary is party to a quota share agreement and an inter-company reinsurance program with Employers Mutual. Under the terms of the quota share agreement, the reinsurance subsidiary assumes 100 percent of Employers Mutual’s assumed reinsurance business, subject to certain exceptions. The inter-company reinsurance program in place with Employers Mutual covers both business assumed from Employers Mutual through the quota share agreement, as well as business obtained outside the quota share agreement. Since 2016, the reinsurance program has consisted of two treaties. The first is a per occurrence catastrophe excess of loss treaty with a retention of $10.0 million, a limit of $10.0 million, 20 percent co-participation, and no reinstatement. The total cost of this treaty was approximately $1.7 million in 2017 and $2.0 million in 2016. The second is an annual aggregate catastrophe excess of loss treaty with a retention of $20.0 million, a limit of $100.0 million, and 20 percent co-participation. The total cost of this treaty was approximately $3.2 million in both 2017 and 2016. Any losses recovered under the per occurrence treaty inure to the benefit of the aggregate treaty, and only catastrophic events with total losses greater than $500,000 are subject to the terms of the aggregate treaty. Prior to 2016, the reinsurance program with Employers Mutual consisted of a single excess of loss reinsurance agreement. Under the terms of that agreement, the reinsurance subsidiary retained the first $4.0 million of losses per event, and also retained 20 percent of any losses between $4.0 million and $10.0 million and 10 percent of any losses between $10.0 million and $50.0 million. The cost of the excess of loss reinsurance protection, which included reimbursement for the cost of reinsurance protection purchased by Employers Mutual to protect itself from the assumption of excessive losses in the event of a major catastrophe, was calculated as 8.0 percent of the reinsurance subsidiary’s total assumed reinsurance premiums written, and amounted to $10.8 million in 2015. Losses and settlement expenses ceded to Employers Mutual under these reinsurance programs totaled $16.8 million in 2017, ($467,000) in 2016 and $622,000 in 2015.
In connection with the change in the inter-company reinsurance program in 2016, the reinsurance subsidiary began purchasing additional reinsurance protection (through Employers Mutual) in peak exposure territories from external parties in which coverage is triggered when losses experienced by the insurance industry from a catastrophic event exceed a specified threshold. Any reinsurance recoveries received from external parties reduces the amount of losses ceded to Employers Mutual under the inter-company reinsurance program. The net cost of this external reinsurance protection was approximately $5.6 million and $3.5 million in 2017 and 2016, respectively. No recoveries were received from the external parties in 2017 or 2016.
The Company closely monitors the activities of state legislatures, the United States Congress and federal and state agencies through its membership in various organizations. In particular, our trade organizations are working to achieve a nationwide data security and breach standard, to promote accident avoidance and accident prevention technology, to oppose legislative or regulatory changes that weaken the private workers' compensation insurance marketplace, and to prevent the weakening of the consumer-focused state insurance regulatory system.
On December 22, 2017, the Tax Cuts and Jobs Act of 2017 (TCJA) was signed into law. Among other provisions, the TCJA lowered the federal corporate tax rate from 35 percent to 21 percent effective January 1, 2018. The Company recorded a one-time deferred income tax benefit in connection with the adoption of the TCJA in the fourth quarter. Beginning in 2018, the Company's effective tax rate is expected to be in the mid-teens, compared to the upper twenties in prior years. While this reduction in the effective tax rate is viewed favorably by management, it is currently unknown what impact, if any, this reduction in the corporate tax rate will have on premium rate levels and competition in general. Because of the local market knowledge provided by the Company's sixteen branch offices, management can closely monitor market conditions for any indications of increased competition resulting from the lower tax rate, and can evaluate and respond to such actions in a timely manner.
Effective January 1, 2016, Personal Lines Operations assumed responsibility for the growth and profitability of personal lines business throughout the country. In connection with this change in oversight, management implemented new personal auto and homeowners products that have been rolled-out in all locations and have been well received by agents and policyholders. Management believes that the overall quality of the personal lines book of business improved during 2017; however, that improvement was overshadowed by an increased level of catastrophe and storm losses. Management continues to closely monitor the performance of the personal lines business, and expects to expand personal lines into additional states in the future to further diversify the exposures of this business.
There is an inherent amount of uncertainty involved in the establishment of insurance liabilities. This uncertainty is greatest in the current and more recent accident years because a smaller percentage of the expected ultimate claims have been reported, adjusted and settled compared to more mature accident years. For this reason, the property and casualty insurance segment's carried reserves for these accident years continue to reflect prudently conservative assumptions. As the carried reserves for these accident years run off, the overall expectation is that, more often than not, favorable development will occur. However, with the familiarity gained and the adjustments made under the new reserving methodology, the magnitude of favorable development reported in future periods is expected to be somewhat less than what has been observed in recent periods.
Loss and Settlement Expense Ratio. The loss and settlement expense ratio is the ratio (expressed as a percentage) of losses and settlement expenses incurred to premiums earned, and measures the underwriting profitability of a company’s insurance business. The loss and settlement expense ratio is generally measured on both a gross (direct and assumed) and net (gross less ceded) basis. Management uses the gross loss and settlement expense ratio as a measure of the Company’s overall underwriting profitability of the insurance business it writes and to assess the adequacy of the Company’s pricing. The net loss and settlement expense ratio is meaningful in evaluating the Company’s financial results, which are net of ceded reinsurance, as reflected in the consolidated financial statements. The loss and settlement expense ratios are generally calculated in the same way for GAAP and statutory accounting purposes.
Catastrophe and storm losses. For the property and casualty insurance segment, catastrophe and storm losses include losses attributed to events that have occurred in the United States which have been assigned an occurrence number by the Property & Liability Resource Bureau (PLRB) Catastrophe Services. According to PLRB, an occurrence number is assigned when an event has produced conditions severe enough to have caused, or to be likely to have caused, property damage. For the reinsurance segment, catastrophe and storm losses include losses that have occurred in the United States, Puerto Rico and the U.S. Virgin Islands which have been designated as catastrophes by Property Claims Services (PCS), as well as non-U.S. catastrophe and storm losses reported by the ceding companies. According to PCS, catastrophe serial numbers are assigned to events that cause $25.0 million or more in direct insured losses to property, and affect a significant number of policyholders and insurers.
In the property and casualty insurance segment, the methodology used to establish direct loss and allocated settlement expense reserves changed in 2016. Beginning in September 2016, estimated ultimate loss and allocated settlement expense amounts for most claims are established by accident year and line of business using standard actuarial techniques. At each reporting date, the amounts to be carried for incurred but not reported (IBNR) loss reserves and allocated settlement expense reserves are determined by subtracting the amounts incurred to date (paid amounts plus case loss reserves carried for reported claims) from the estimated ultimate amounts. Under this methodology, changes in the incurred amounts result in corresponding adjustments to the reserve amounts. Prior to September 2016, case loss reserves (including bulk case loss reserves), IBNR loss reserves and settlement expense reserves were all established independently of each other, and the amounts were added together to determine the total liability for losses and settlement expenses. Under that methodology, adjustments to any of the reserve components did not result in corresponding adjustments to the other reserve components. The implementation of the new reserving methodology did not have a material impact on total carried reserves for the property and casualty insurance segment; however, there was some movement of allocated settlement expense reserves to IBNR loss reserves, and a reallocation of loss and allocated settlement expense reserves by accident year. In connection with this reallocation of reserves by accident year, approximately $5.6 million of IBNR loss and allocated settlement expense reserves were moved from prior accident years to the current accident year in multiple lines of business. This reduction in prior accident years' reserves produced favorable development; however, this development is "mechanical in nature", and did not have any impact on earnings because the total amount of carried reserves did not change.
In the reinsurance segment, Employers Mutual records the case and IBNR loss reserves reported by the ceding companies for the Home Office Reinsurance Assumed Department (“HORAD”) book of business. Since many ceding companies in the HORAD book of business do not report IBNR loss reserves, Employers Mutual establishes a bulk IBNR loss reserve, which is based on an actuarial reserve analysis, to cover a lag in reporting. For MRB, Employers Mutual records the case and IBNR loss reserves reported to it by the management of the association, along with a relatively small IBNR loss reserve to cover a one-month reporting lag. The booking of the lag IBNR loss reserve may be suspended, and negative bulk IBNR loss reserves may be established, during periods when the actuarial reviews indicate MRB's carried reserves are more than adequate to cover its liabilities. To verify the adequacy of the reported reserves, an actuarial evaluation of MRB’s reserves is performed at each year-end.
Following is a summary of the carried loss and settlement expense reserves for the property and casualty insurance segment at December 31, 2017 and 2016.
Branch claims personnel establish case loss reserves for individual claims, with mandatory home office claims department review of reserves that exceed a specified threshold. The philosophy utilized to establish case loss reserves is exposure based, and implicitly assumes a consistent inflationary and legal environment. When claims department personnel establish case loss reserves, they take into account various factors that influence the potential exposure.
The claims department has implemented specific line-of-business guidelines that are used to establish the individual case loss reserve estimates. These guidelines, which are used for both short-tail and long-tail claims, require the claims department personnel to reserve for the probable (most likely) exposure for each claim. Probable exposure is defined as what is likely to be awarded if the case were to be decided by a civil court in the applicable venue or, in the case of a workers’ compensation case, by that state’s Workers’ Compensation Commission. This evaluation process is repeated throughout the life of the claim at regular intervals, and as additional information becomes available. While performing these regular reviews, the branch claims personnel are able to make adjustments to the case loss reserves for location and time specific factors, such as legal venue, inflation, and changes in applicable laws.
The property and casualty insurance subsidiaries have exposure to asbestos and environmental claims arising primarily from the other liability line of business. These exposures are closely monitored by management, and IBNR loss reserves have been established to cover estimated ultimate losses. The loss and settlement expense reserves associated with asbestos claims have been increased each year for the last several years due to continued reporting of new claims at a rate not previously anticipated, as well as updated internal ultimate loss and settlement expense evaluations. During 2017, a settlement was reached with a former insured, resulting in the Company recognizing $4.5 million (its share) of losses and settlement expenses to remove all past and future asbestos liability exposure related to that policyholder, and loss and settlement expense reserves for asbestos claims were also strengthened approximately $900,000.
At December 31, 2017, there was no backlog in the processing of assumed reinsurance information. Approximately $151.9 million, or 66 percent, of the reinsurance segment’s carried reserves were reported by the ceding companies. Employers Mutual receives loss reserve and paid loss data from its ceding companies on individual excess of loss contracts. If a claim involves a single or small group of claimants, a summary of the loss and claim outlook is normally provided. Summarized data is provided for catastrophe claims and pro rata business, which is subject to closer review if inconsistencies are suspected.
Carried reserves established in addition to those reported by the ceding companies totaled approximately $77.8 million at December 31, 2017. Since many ceding companies in the HORAD book of business do not report IBNR loss reserves, Employers Mutual establishes a bulk IBNR loss reserve to cover the lag in reporting. For the few ceding companies that do report IBNR loss reserves, Employers Mutual carries them as reported. These reported IBNR loss reserves are subtracted from the total IBNR loss reserve calculated by Employers Mutual’s actuaries, with the difference carried as bulk IBNR loss reserves. Except for a negative bulk IBNR loss reserve established by Employers Mutual's actuaries in 2016 and 2015, and a small IBNR loss reserve generally established to cover a one-month lag in reporting, the MRB IBNR loss reserve is established by the management of MRB. Employers Mutual rarely records additional case loss reserves.
The after-tax impact on the Company’s earnings, calculated using the federal corporate tax rate of 35 percent, under each scenario is as follows:
Disputes with ceding companies do not occur often. Employers Mutual performs claims audits and encourages prompt reporting of reinsurance claims. Employers Mutual also reviews claim reports for accuracy, completeness and adequate reserving. Most reinsurance contracts contain arbitration clauses to resolve disputes, but such disputes are generally resolved without arbitration due to the long-term and ongoing relationships that exist with those companies. There were no matters in dispute at December 31, 2017.
The pool participants are defending approximately 25 claim files because of lawsuits alleging “silica” exposure in Mississippi, some of which involve multiple plaintiffs. The plaintiffs allege employment exposure to “airborne respirable silica dust,” causing “serious and permanent lung injuries” (i.e., silicosis). Silicosis injuries are identified in the upper lobes of the lungs, while asbestos injuries are localized in the lower lobes.
The plaintiffs in the silicosis lawsuits are sandblasters, gravel and concrete workers, ceramic workers and road construction workers. All these lawsuits are subject to express reservation of rights based upon the lack of an injury within the applicable policy periods because many silica lawsuits, like asbestos lawsuits, do not specifically allege dates of exposure or dates of injury. The pool participants’ policyholder (a sand and gravel hauler) that has been named as defendant in these silica lawsuits has had little or no exposure, and is routinely dismissed from silica litigation with nominal or no payment.
The pool participants’ non-asbestos direct product liability claims are considered to be highly uncertain exposures due to the many uncertainties inherent in determining the loss, and the significant periods of time that can elapse between the occurrence of the loss and the ultimate settlement of the claim. The majority of the pool participants’ product liability claims arise from small to medium-sized manufacturers, contractors, petroleum distributors, and mobile home and auto dealerships. No specific claim trends are evident from the pool participants’ manufacturing clients, as the claims activity on these policies is generally isolated and can be severe. Specific product liability coverage is provided to the pool participants’ mobile home and auto dealership policyholders, and the claims from these policies tend to be relatively small. Certain construction defect claims are also reported under product liability coverage. During 2017, 42 of these claims were reported to the pool participants.
The net periodic pension and postretirement benefit costs, as well as the prepaid assets and liabilities of these plans, are determined by actuarial valuations. Inherent in these valuations are key assumptions regarding the discount rate, the expected long-term rate of return on plan assets, and the rate of future compensation increases (pension plans only). The assumptions used in the actuarial valuations are updated annually. Material changes in the net periodic pension and postretirement benefit costs may occur in the future due to changes in these assumptions or changes in other factors, such as the number of plan participants, the level of benefits provided, asset values and applicable legislation or regulations.
The discount rate utilized in the valuations is based on an analysis of the total rate of return that could be generated by a hypothetical portfolio of high-quality bonds created to generate cash flows that match the plans’ expected benefit payments. No callable bonds are used in this analysis and the discount rate produced by this analysis is compared to interest rates of applicable published indices for reasonableness. The discount rates used in the pension benefit obligation valuations at December 31, 2017, 2016 and 2015 were 3.60 percent, 4.07 percent and 3.90 percent, respectively. The discount rates used in the postretirement benefit obligation valuations at December 31, 2017, 2016 and 2015 were 3.63 percent, 4.21 percent and 4.42 percent, respectively. The discount rates used in the pension and postretirement benefit obligation valuations are also used in the calculation of the net periodic benefit costs for the subsequent year. A 0.25 percentage point decrease in the discount rates used in the 2017 valuations would increase the Company’s net periodic pension and postretirement benefit costs for 2018 by approximately $132,000. Conversely, a 0.25 percentage point increase in the 2017 discount rates would decrease the Company’s net periodic pension and postretirement benefit costs for 2018 by approximately $13,000.
In accordance with GAAP, actuarial gains/losses contained in the valuations that result from (1) actual experience that differs from that assumed, or (2) a change in actuarial assumptions, is accumulated and, if in excess of a specified corridor, amortized to expense over future periods. As of December 31, 2017, all of the benefit plans, other than the qualified pension plan, had accumulated actuarial losses in excess of the corridor that will be partially amortized into expense in 2018. The Company’s share of the accumulated actuarial losses that will be amortized into expense during 2018 amounts to $410,000. Prior service credits for plan amendments are also contained in the valuations, and are amortized into income over the future service periods of the participants. As of December 31, 2017, the postretirement benefit plans have prior service credits that are being amortized into income in future periods. The prior service credit being amortized into income during 2018 is $3.2 million.
The Company reported net income of $39.2 million ($1.84 per share) in 2017 compared to $46.2 million ($2.20 per share) in 2016. Net income declined in 2017 despite a one-time $9.1 million deferred income tax benefit resulting from the enactment of the TCJA. This decline is primarily attributed to a large amount of catastrophe and storm losses incurred by the reinsurance segment during the third quarter, as well as a reduction in the amount of favorable development experienced on prior years' reserves. Considering the extraordinary amount of catastrophe and storm losses incurred by the insurance industry during 2017, management is satisfied with the Company's results. The property and casualty insurance segment continued to perform well, as the underlying loss and settlement expense ratio improved during the second half of the year. Also encouraging is the recent improvement in the pricing environment in the property and casualty insurance segment and the reinsurance segment during the January 1, 2018 renewals.
Premiums earned increased 2.5 percent to $607.2 million in 2017 from $592.4 million in 2016. Rate levels for both segments continue to be constrained by a high level of competition, especially for quality accounts with good loss experience; however, there were some indications of moderate rate level improvement during the fourth quarter. Average rate level increases were slightly positive for the year in the property and casualty insurance segment, with variances by line of business. In the reinsurance segment, rate levels stabilized somewhat during the January 1, 2017 renewal season, when approximately 70 percent of the business renews, after several years of continuous declines. The lines of business experiencing the greatest profitability challenges in the property and casualty insurance segment, namely commercial auto and personal lines, are currently receiving larger (mid-single digit) rate increases. During the January 1, 2018 renewal season, moderate price increases were achieved on most of the reinsurance segment's property per risk and catastrophe programs.
Premiums earned for the property and casualty insurance segment increased 3.5 percent to $472.4 million in 2017 from $456.5 million in 2016. This increase is primarily attributed to new business in both commercial and personal lines of business, growth in insured exposures and an increase in retained policies in the commercial lines of business. New business premium (representing 15 percent of the pool participants’ direct premiums written) was approximately 15 percent higher than in 2016. Commercial lines new business continues to be in the desired range of growth, and accounted for most of the increase in total new business premium. Personal lines new business premium was up significantly, but is measured against a relatively small amount of new business premium in 2016. While management continues to seek growth in most territories, it is particularly focused on achieving growth outside of the core Midwest market, which will help diversify the pool participants' book of business geographically, while staying consistent with the industry and line of business mix of the existing book of business. Renewal business premium increased approximately five percent during 2017. After factoring in the continued implementation of some mandatory rate reductions on workers' compensation business in a few states, the overall rate change on renewal business was positive, but less than one percent. Rates are expected to continue to be mixed in 2018, with the largest rate increases expected in the commercial auto line of business. Rate decreases are expected in the workers' compensation and general liability lines of business, and rates on most other lines of business are expected to be flat or increase slightly. The overall policy retention rate remained strong during 2017 at 85.8 percent (commercial lines at 86.9 percent and personal lines at 83.7 percent). These retention rates approximate those reported at the end of 2016.
Premiums earned for the reinsurance segment decreased 0.8 percent to $134.8 million in 2017 from $135.9 million in 2016. This decrease is primarily attributed to MRB's withdrawal from non-standard automobile business, but also reflects a decline in some casualty business that converted from a pro rata structure in 2016 to an excess of loss structure in 2017. However, the addition of some new business and growth on some existing accounts largely offset those declines. Underwriting capacity remained strong during the January 1, 2018 renewal season, despite the unusually large amount of catastrophe and storm losses incurred by the reinsurance industry in 2017. As a result, reinsurance rate levels only increased moderately for those lines and territories most affected by the 2017 events (property per risk and catastrophe programs), and remained stable in most segments of the market not affected by the 2017 events. Rate levels for international business were also stable, with renewal rates largely flat or up slightly.
Favorable development on the property and casualty insurance segment's prior years' reserves totaled $15.7 million and $24.4 million in 2017 and 2016, respectively. Included in the development amount reported for 2017 is $4.5 million of adverse development experienced in the other liability line of business stemming from the settlement of claims for past and future legal fees and losses on a multi-year asbestos exposure associated with a former insured. Under the new reserving methodology implemented in the third quarter of 2016, development on prior accident years' reserves is determined primarily by changes in the prior accident years' ultimate loss and settlement expense ratio projections established by management. As a result, the explicit drivers of development on prior years' reserves are identifiable beginning in 2017. Due to additional insights gained and the adjustments made under the new reserving methodology during 2017, the magnitude of favorable development reported in future periods is expected to be somewhat less than what has been observed in recent periods. For a detailed discussion of the development experienced on prior accident years’ reserves during 2017 and 2016, see the discussion entitled “Loss and Settlement Expense Reserves” under the “Narrative Description of Business” heading in the Business Section under Part I, Item 1 of this Form 10-K.
Aside from catastrophe and storm losses, the remaining increase in the reinsurance segment's loss and settlement expense ratio is due to a decline in favorable development on prior years' reserves. It is expected that future development will still be favorable, but less so than what has been observed in the recent past, and closer to neutral. For a detailed discussion of the development experienced on prior accident years’ reserves during 2017 and 2016, see the discussion entitled “Loss and Settlement Expense Reserves” under the “Narrative Description of Business” heading in the Business Section under Part I, Item 1 of this Form 10-K.
The acquisition expense ratio for the property and casualty insurance segment decreased to 34.2 percent in 2017 from 34.8 percent in 2016. This decrease is primarily attributed to a decline in policyholder dividend expense, largely from a couple of the pool participants' safety dividend groups. Partially offsetting the decrease were higher expenses for agents' contingent commissions, data analytics initiatives, and salaries.
Income tax expense decreased 96.6 percent to $578,000 in 2017 from $17.0 million in 2016. As noted above, the TCJA was signed into law on December 22, 2017, lowering the federal corporate tax rate from 35 percent to 21 percent effective January 1, 2018. Companies are required to calculate deferred taxes using tax rates expected to be in effect when tax timing differences reverse, which, as of December 22, 2017, is now 21 percent rather than the previous 35 percent. The Company was in a net deferred tax liability position on the date of enactment, which means that the reduction in the tax rate resulted in a lower deferred tax liability. This reduction in the deferred tax liability ($9.1 million) is reflected as a deferred income tax benefit in the fourth quarter. Including this deferred income tax benefit, the effective tax rate for 2017 was 1.5 percent, and is expected to be in the mid-teens in future years compared to the upper twenties historically. Excluding this deferred income tax benefit, the effective tax rate for 2017 was 24.2 percent, compared to 26.9 percent in 2016. The primary contributors to the differences between these effective tax rates and the United States federal corporate tax rate of 35 percent are tax-exempt interest income earned, the dividends received deduction, and, especially in 2016, investment tax credits recognized from renewable energy tax credit investments ($672,000 in 2017 and $1.4 million in 2016).
Premiums earned increased 3.9 percent to $592.4 million in 2016 from $570.3 million in 2015. Despite increasingly competitive market conditions, both segments reported an increase in premium income. Rate levels for both segments continued to be constrained by a high level of competition, especially for quality accounts with good loss experience. Average rate level increases were just slightly positive in the property and casualty insurance segment in 2016, while the reinsurance segment continued to experience pricing pressure during the January 1, 2016 renewal season, when approximately 70 percent of its business renewed; however, the deterioration in pricing did slow considerably from that experienced in 2015. On an overall basis, the new and revised inter-company reinsurance programs between the Company's insurance segments and Employers Mutual reduced premiums earned by $5.6 million in 2016. For 2017, the cost the inter-company reinsurance programs would decline by $730,000.
Premiums earned for the reinsurance segment increased 10.5 percent to $135.9 million in 2016 from $123.1 million in 2015. This increase reflected a $2.3 million reduction in the total cost of the revised inter-company reinsurance program with Employers Mutual. For purposes of this comparison, the total cost of the 2016 reinsurance program included the premium paid to Employers Mutual ($5.1 million), as well as the cost of additional reinsurance protection purchased from external parties to provide increased protection in peak exposure territories. During 2015, the premium paid to Employers Mutual ($10.8 million, or 8 percent of total assumed reinsurance premiums written) included the cost of reinsurance protection purchased from external parties by Employers Mutual for its benefit. The reinsurance subsidiary purchased $5.1 million of additional reinsurance protection from external parties during 2016, with $3.5 million of ceded earned premium recognized in 2016. Excluding the reduction in the cost of the revised inter-company reinsurance program with Employers Mutual, premiums earned increased 8.6 percent, or $10.5 million; however, a $7.2 million negative premium adjustment recorded in the fourth quarter of 2015 was distorting this percentage increase. This premium adjustment was reported by the ceding company for the offshore energy and liability proportional account, and reduced the ultimate amount of premiums expected to be earned for underwriting years 2012 through 2014. Without this adjustment, and excluding the reduction in the cost of the revised inter-company reinsurance program with Employers Mutual, premiums earned increased approximately 2.6 percent in 2016. This increase was largely from growth in the property pro rata line of business, as well as the addition of some new domestic excess of loss contracts. During 2015, the ceded premium associated with the inter-company reinsurance program was allocated to all lines of business (both pro rata and excess of loss) because the premium was based on total assumed reinsurance premiums written. Beginning in 2016, the ceded premium for the inter-company reinsurance program was a fixed amount that was allocated to only the excess of loss line of business. The assumed reinsurance market continued to experience pricing pressure due to the influx of nontraditional capital and the lack of major catastrophic events. Pricing declines moderated somewhat during the January 1, 2017 renewal season, as rate level declines were much lower than those experienced on January 1, 2016 renewals. Rate decreases were estimated to be in the low-to-mid single digits across the excess of loss book of business.
Other factors impacting the property and casualty insurance segment's 2016 loss and settlement expense ratio include an increase in claim severity in the commercial auto line of business, and an increase in catastrophe and storm losses. Both the commercial auto and personal lines of business continued to generate unfavorable results in 2016, posting loss and settlement expense ratios of 84.2 percent and 72.8 percent, respectively. The industry was forecasting continued deterioration in the commercial auto line of business in 2017, and management was forecasting similar deterioration in the property and casualty insurance segment's results for this line of business if no additional steps were taken to improve profitability. Recognizing the importance of this issue, management implemented an intensive, multi-year Accelerate Commercial Auto Profitability project during 2016, with a goal of returning this line of business to profitability by mid-2019. Management continued to focus on the implementation of its new personal lines strategy, and had completed the roll-out of the new personal auto and homeowners policies in all states where personal lines business was written. Early indications were that the new policies had been well received by agents and policyholders; however, it would take some time before profitability improves.
Catastrophe and storm losses accounted for 7.7 percentage points of the property and casualty insurance segment's loss and settlement expense ratio in 2016, compared to 6.6 percentage points in 2015. The most recent 10-year average for this period was 9.8 percentage points. The property and casualty insurance segment recovered $7.5 million of catastrophe and storm losses under the new inter-company reinsurance program with Employers Mutual in 2016 ($5.0 million under the treaty covering the period from January 1 through June 30, and $2.5 million under the treaty covering the period from July 1 through December 31). Taking the loss recoveries received and the premiums paid to Employers Mutual into consideration, the new inter-company reinsurance program with Employers Mutual reduced the catastrophe and storm loss ratio for 2016 by 0.5 percentage points.
The loss and settlement expense ratio for the reinsurance segment increased to 68.1 percent in 2016 from 64.1 percent in 2015. The loss and settlement expense ratio for 2015 reflected an unusually low amount of reported large losses (losses greater than $100,000) and two large reductions in reported reserves for prior accident year events. A decline in catastrophe and storm losses helped limit the increase in the reinsurance segment's loss and settlement expense ratio. The largest catastrophe and storm loss incurred in 2016 was a $3.5 million loss stemming from the Alberta, Canada wildfire, while the largest loss incurred in 2015 was $4.5 million ($4.1 million net of reinsurance recovery under the inter-company reinsurance program with Employers Mutual) from the Tianjin, China explosion. No recoveries were made under the revised inter-company reinsurance program with Employers Mutual during 2016. The decline in the total cost of the revised inter-company reinsurance program with Employers Mutual produced a 1.4 percentage point decline in the loss and settlement expense ratio for 2016. This reduction was reflected in the catastrophe and storm loss ratio, which declined to 9.3 percentage points in 2016 from 12.0 percentage points in 2015. The most recent 10-year average for catastrophe and storm losses was 13.0 percentage points.
The acquisition expense ratio for the property and casualty insurance segment increased to 34.8 percent in 2016 from 32.9 percent in 2015. The increase was primarily attributed to higher policyholder dividend expense resulting from favorable loss experience on some safety dividend groups. The 2016 ratio also reflected the premiums ceded to Employers Mutual under the new inter-company reinsurance program, which added 0.6 percentage points to the ratio.
Net investment income increased 4.2 percent to $47.5 million in 2016 from $45.6 million in 2015. The increase was primarily attributed to a higher amount of dividend income in 2016, but also reflected an increase in investment income from other long-term investments. The Company’s equity portfolio produced dividend income of $6.9 million and $5.6 million in 2016 and 2015, respectively. Current interest rate levels remained below the average book yield of the fixed maturity portfolio, and would therefore likely continue to limit future growth in net investment income. The average coupon rate on the fixed maturity portfolio, excluding interest-only securities, had declined slightly over the past year, coming in at 3.8 percent at December 31, 2016 compared to 3.9 percent at both December 31, 2015 and 2014. The effective duration of the fixed maturity portfolio, excluding interest-only securities, increased to 5.2 at December 31, 2016 from 4.6 at December 31, 2015.
The Company invests for the long term and generally purchases fixed maturity securities with the intent to hold them to maturity. Despite this intent, the Company currently classifies fixed maturity securities as available-for-sale to provide flexibility in the management of its investment portfolio. At December 31, 2017 and 2016, the Company had net unrealized holding gains, net of deferred taxes, on its fixed maturity securities available-for-sale of $17.3 million and $6.6 million, respectively. The fluctuation in the fair value of these investments is primarily due to changes in the interest rate environment during this time period, but also reflects fluctuations in risk premium spreads over U.S. Treasuries. Since the Company intends to hold fixed maturity securities to maturity, such fluctuations in the fair value of these investments are not expected to have a material impact on the operations of the Company, as forced liquidations of investments are not anticipated. The Company closely monitors the bond market and makes appropriate adjustments in its portfolio as conditions warrant.
The Company held $13.6 million and $12.5 million in minority ownership interests in limited partnerships and limited liability companies at December 31, 2017 and 2016, respectively. These balances generally include investments in private equity arrangements, with the following two notable exceptions. The Company funds a limited partnership that is designed to help protect it from a sudden and significant decline in the value of its equity portfolio. During the 2017 and 2016, the Company invested additional funds of $5.8 million and $4.9 million, respectively, into this program. The Company's reinsurance subsidiary began investing in limited liability companies that convey renewable energy tax credits in 2016. During 2016, the reinsurance subsidiary invested $6.6 million in a limited liability company that produced $4.4 million of tax credits in 2016 and $775,000 of tax credits in 2017. During 2017, the reinsurance subsidiary invested $2.1 million in another limited liability company that produced $1.7 million of tax credits in 2017. After reductions for the utilization of the tax credits and a $209,000 impairment loss recognized during the fourth quarter of 2016, the carrying values of these investments totaled approximately $1.5 million and $2.0 million at December 31, 2017 and 2016, respectively. These investments are included in "other long-term investments" in the Company's financial statements, with the limited partnership carried under the equity method of accounting.
The Company’s total cash and invested assets at December 31, 2017 and 2016 are summarized as follows:
The amortized cost and estimated fair value of fixed maturity and equity securities at December 31, 2017 were as follows:
As of December 31, 2017, the Company had no material commitments for capital expenditures.
The Company does not purchase non-investment grade fixed maturity securities. Any non-investment grade fixed maturity securities held are the result of rating downgrades that occurred subsequent to their purchase. At December 31, 2017, the Company held $2.9 million of non-investment grade fixed maturity securities in a net unrealized gain position of $38,000.
Following is a schedule of gross realized losses recognized in 2017. The schedule is aged according to the length of time the underlying securities were in an unrealized loss position.
The following table reflects the Company's contractual obligations as of December 31, 2017. Included in the table are the estimated payments that the Company expects to make in the settlement of its loss and settlement expense reserves and with respect to its long-term debt. One of the Company’s property and casualty insurance subsidiaries leases office facilities in Bismarck, North Dakota with lease terms expiring in 2024. Employers Mutual has entered into various leases for branch and service office facilities with lease terms expiring through 2027. All of these lease costs are included as expenses under the pooling agreement. Included in the following table is the Company's current 30.0 percent aggregate participation percentage of all operating lease obligations of the parties to the pooling agreement.
1 The amounts presented are estimates of the dollar amounts and time periods in which the Company expects to pay out its gross loss and settlement expense reserves. These amounts are based on historical payment patterns and do not represent actual contractual obligations. The actual payment amounts and the related timing of those payments could differ significantly from these estimates.
2 Long-term debt reflects the surplus notes issued by the Company’s property and casualty insurance subsidiaries to Employer Mutual, which have no maturity date. Excluded from long-term debt are pension and other postretirement benefit obligations.
The participants in the pooling agreement are subject to guaranty fund assessments by states in which they write business. Guaranty fund assessments are used by states to pay policyholder liabilities of insolvent insurers domiciled in those states. Many states allow assessments to be recovered through premium tax offsets. The Company has accrued estimated guaranty fund assessments of $706,000 and $851,000 as of December 31, 2017 and 2016, respectively. Premium tax offsets of $897,000 and $1.0 million, which are related to prior guarantee fund payments and current assessments, have been accrued as of December 31, 2017 and 2016, respectively. The guaranty fund assessments are expected to be paid over the next two years and the premium tax offsets are expected to be realized within ten years of the payments. The participants in the pooling agreement are also subject to second-injury fund assessments, which are designed to encourage employers to employ workers with pre-existing disabilities. The Company had accrued estimated second-injury fund assessments of $2.0 million and $1.9 million as of December 31, 2017 and 2016, respectively. The second-injury fund assessment accruals are based on projected loss payments. The periods over which the assessments will be paid is not known.
The participants in the pooling agreement have purchased annuities from life insurance companies, under which the claimant is payee, to fund future payments that are fixed pursuant to specific claim settlement provisions. The Company’s share of case loss reserves eliminated by the purchase of those annuities was $110,000 at December 31, 2017. The Company had a contingent liability for the aggregate guaranteed amount of the annuities of $183,000 at December 31, 2017 should the issuers of those annuities fail to perform. The probability of a material loss due to failure of performance by the issuers of these annuities is considered remote.
Municipal fixed maturity securities, including taxable, tax-exempt and pre-refunded securities, totaled $307.5 million as of December 31, 2017. Municipal securities are well diversified between general obligation and revenue bonds, as well as geographically. The Company’s credit analysis of municipal securities is predominantly based on the underlying credit quality of the obligor. Therefore, although a portion of the Company’s municipal securities are guaranteed by financial guaranty insurers, reliance is placed on the underlying obligor to pay all contractual cash flows. The ratings of insured municipal securities generally reflect the rating of the underlying primary obligor. The average quality of the municipal fixed maturity securities portfolio is Aa1/AA+ with over 98 percent of securities rated A3/A- or higher. Approximately $35.6 million of the Company’s municipal securities have been pre-refunded, which means that funds have been set aside in escrow to satisfy the future interest and principal obligations of the securities.
Management assessed the effectiveness of the Company’s internal control over financial reporting based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 Framework) (the COSO criteria). Based on this assessment, management believes that, as of December 31, 2017, the Company maintained effective internal control over financial reporting.
We have audited EMC Insurance Group Inc. and Subsidiaries’ internal control over financial reporting as of December 31, 2017, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) (the COSO criteria). In our opinion, EMC Insurance Group Inc. and Subsidiaries (the Company) maintained, in all material respects, effective internal control over financial reporting as of December 31, 2017, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the Company’s internal control over financial reporting as of December 31, 2017, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations and the Treadway Commission (2013 framework), and our report dated March 5, 2018 expressed an unqualified opinion thereon.
Costs related to the acquisition of insurance contracts are deferred and amortized to expense as the associated premium revenue is recognized. Only incremental costs or costs directly related to the successful acquisition of new or renewal insurance contracts are capitalized. Accordingly, acquisition costs consist of commissions, premium taxes, and salary and benefit expenses of employees directly involved in the underwriting of insurance policies that are successfully issued.
Certain commercial lines of business written by the property and casualty insurance subsidiaries, including workers’ compensation, are eligible for policyholder dividends in accordance with provisions of the underlying insurance policies. Net premiums written subject to policyholder dividends represented approximately 26 percent and 22 percent of the property and casualty insurance subsidiaries’ total net commercial line premiums written in 2017 and 2016, respectively. Policyholder dividends are accrued over the terms of the underlying policy periods.
Liabilities for losses reflect losses incurred through the balance sheet date and are based upon the estimated ultimate loss ratios established by line of business and accident year, and estimates of losses expected under assumed reinsurance contracts. Liabilities for settlement expenses are provided by estimating expenses expected to be incurred in settling the claims provided for in the loss reserves. Changes in reserves estimates are reflected in net income in the year such changes are recorded (see note 4).
In February 2018, the Financial Accounting Standards Board (FASB) issued updated guidance in Income Statement-Comprehensive Income Topic 220 of the Accounting Standards CodificationTM (Codification or ASC). The objective of this update is to allow a reclassification from accumulated other comprehensive income to retained earnings for stranded tax effects resulting from the Tax Cuts and Jobs Act of 2017 (TCJA), and requires certain disclosures about the stranded tax effects. The Company adopted this guidance in 2017, and elected to transfer the stranded tax effects in accumulated other comprehensive income to retained earnings as reflected in the consolidated statements of stockholders' equity. The Company releases the tax effects in accumulated other comprehensive income on an individual unit of account basis.
Employers Mutual has various employee benefit plans, including two defined benefit pension plans, and two postretirement benefit plans that provide retiree healthcare and life insurance benefits. Although the Company has no employees of its own, it is responsible for its share of the plans' expenses and related prepaid assets and liabilities (the "funded status") as determined under the terms of the pooling agreement. Accordingly, the Company recognizes its share of the funded status of Employers Mutual’s pension and postretirement benefit plans on its balance sheet, with changes in the funded status of the plans recognized through “other comprehensive income.” In addition, the Company is responsible for its share of costs of these plans allocated by Employers Mutual to subsidiaries that do not participate in the pooling agreement (see note 2). During 2016, Employers Mutual's management determined that an allocation of the plans' funded status to the Company's reinsurance subsidiary would no longer be made because the amounts were immaterial and significant time and cost was needed to determine the allocation. As a result, the assets and liabilities allocated to the reinsurance subsidiary as of December 31, 2015 were settled with Employers Mutual during 2016.
The accounts receivable balance consists of assumed reinsurance premiums receivable (net of any commissions) on business written directly by the reinsurance subsidiary, and commission income receivable on excess and surplus lines business marketed by EMC Underwriters, LLC. These receivables are carried at their initial recognition amounts. It is the Company’s policy to reflect the impairment of receivables through a valuation allowance until ultimately collected or charged-off. No valuation allowance is currently carried, as no amounts are deemed impaired. No interest income, other fees, or deferred costs related to these receivables are assessed or recognized.
Goodwill represents the excess of cost over the fair value of net assets of acquired subsidiaries. Goodwill is not amortized, but is instead subject to impairment if the carrying value of the goodwill exceeds the estimated fair value of net assets. If the carrying amount of the reporting unit (including goodwill) exceeds the computed fair value, an impairment loss is recognized through the income statement equal to the excess amount, but not greater than the balance of the goodwill. Goodwill was not deemed to be impaired in 2017, 2016 or 2015.
In March 2017, the FASB issued updated guidance in Compensation-Retirement Benefits Topic 715 of the ASC. The objective of this update is to improve the presentation of net periodic pension and postretirement benefit costs by disaggregating the components of these expenses (disclosing the service cost component separately from the other components) for income statement reporting. Also included in this update is a prohibition against including components of the net periodic pension and postretirement benefit costs, other than the service cost component, in any capitalized assets. This guidance is effective for interim and annual periods beginning after December 15, 2017. The portion of the guidance related to the income statement display of net periodic pension and postretirement benefit costs is to be applied retrospectively, while the prohibition against including these costs, other than the service cost component, in capitalized assets is to be applied prospectively. Early adoption is permitted. The Company has adopted this guidance as of January 1, 2018. Adoption will not impact consolidated stockholders' equity initially; however, the prohibition against including components of the net periodic pension and postretirement benefit costs, other than the service cost component, in capitalized assets is expected to result in a relatively small change in the deferred policy acquisition cost asset starting March 31, 2018, which is expected to have an immaterial impact, net of tax, on consolidated stockholders' equity and net income from that which would otherwise have been reported.
The Company’s three property and casualty insurance subsidiaries and two subsidiaries and an affiliate of Employers Mutual (Union Insurance Company of Providence, EMC Property & Casualty Company and Hamilton Mutual Insurance Company) are parties to a pooling agreement with Employers Mutual. Under the terms of the pooling agreement, each company cedes to Employers Mutual all of its insurance business, and assumes from Employers Mutual an amount equal to its participation in the pool. All premiums, losses, settlement expenses, and other underwriting and administrative expenses, excluding the voluntary reinsurance business assumed by Employers Mutual from nonaffiliated insurance companies, are prorated among the parties on the basis of participation in the pool. Employers Mutual negotiates reinsurance agreements that provide protection to the pool and each of its participants, including protection against losses arising from catastrophic events. The aggregate participation of the Company’s property and casualty insurance subsidiaries in the pool is 30 percent.
The Company’s reinsurance subsidiary is party to a quota share agreement and an inter-company reinsurance program with Employers Mutual. Under the terms of the quota share agreement, the reinsurance subsidiary assumes 100 percent of Employers Mutual’s assumed reinsurance business, subject to certain exceptions. The inter-company reinsurance program in place with Employers Mutual covers both business assumed from Employers Mutual through the quota share agreement, as well as business obtained outside the quota share agreement. The Inter-Company Committees of the boards of directors of the Company and Employers Mutual approved a change in the inter-company reinsurance program between the Company's reinsurance subsidiary and Employers Mutual starting in 2016. This revised reinsurance program now consists of two treaties. The first is a per occurrence catastrophe excess of loss treaty with a retention of $10.0 million, a limit of $10.0 million, 20 percent co-participation, and no reinstatement. The total cost of this treaty was approximately $1.7 million in 2017. The second is an annual aggregate catastrophe excess of loss treaty with a retention of $20.0 million, a limit of $100.0 million, and 20 percent co-participation. The total cost of this treaty was approximately $3.2 million in 2017. Any losses recovered under the per occurrence treaty inure to the benefit of the aggregate treaty, and only catastrophic events with total losses greater than $500,000 are subject to the terms of the aggregate treaty. The terms of the program were the same in 2016 with the exception of the costs, which were $2.0 million for the per occurrence treaty and $3.2 million for the annual aggregate treaty. Prior to 2016, the reinsurance program with Employers Mutual consisted of a single excess of loss reinsurance agreement. Under the terms of that agreement, the reinsurance subsidiary retained the first $4.0 million of losses per event, and also retained 20 percent of any losses between $4.0 million and $10.0 million and 10 percent of any losses between $10.0 million and $50.0 million. The cost of the excess of loss reinsurance protection, which included reimbursement for the cost of reinsurance protection purchased by Employers Mutual to protect itself from the assumption of excessive losses in the event of a major catastrophe, was calculated as 8.0 percent of the reinsurance subsidiary’s total assumed reinsurance premiums written in 2015, and amounted to $10.8 million. Losses and settlement expenses ceded to Employers Mutual under the inter-company reinsurance program totaled $16.8 million in 2017, compared to a negative $467,000 during 2016, and $622,000 during 2015. In accordance with the terms of the treaties, the 2016 treaties were commuted at the end of 2017, with no payment and no gain or loss recognized on the commutation.
The Company does not have any employees of its own. Employers Mutual performs all operations for all of its subsidiaries and affiliate. Such services include data processing, claims, financial, actuarial, legal, auditing, marketing and underwriting. Employers Mutual allocates a portion of the cost of these services to its subsidiaries that do not participate in the pooling agreement based upon a number of criteria, including usage of the services and the number of transactions. The remaining costs are charged to the pooling agreement and each pool participant shares in the total cost in accordance with its pool participation percentage. Costs allocated to the Company by Employers Mutual for services provided to the holding company and its subsidiaries that do not participate in the pooling agreement amounted to $4.4 million, $4.7 million and $3.4 million in 2017, 2016 and 2015, respectively. Costs allocated to the Company through the operation of the pooling agreement amounted to $97.7 million, $92.3 million and $87.4 million in 2017, 2016 and 2015, respectively.
Investment expenses are based on actual expenses incurred by the Company and its subsidiaries, plus an allocation of other investment expenses incurred by Employers Mutual, which is based on a weighted-average of total invested assets and number of investment transactions. Investment expenses allocated to the Company by Employers Mutual amounted to $1.6 million, $1.4 million and $1.4 million in 2017, 2016 and 2015, respectively.
For the property and casualty insurance segment, the December 31, 2017 estimate of loss and settlement expense reserves for accident years 2016 and prior decreased $15.7 million from the estimate at December 31, 2016. This decrease represents 3.2 percent of the December 31, 2016 gross carried reserves and is primarily attributed to reductions in prior year ultimate loss ratios for every line of business except commercial auto liability and surety bonds (included in "other" lines of business). Commercial auto liability experienced adverse development as ultimate loss and settlement expense ratios were increased for accident years 2013-2016 due to increases in projected severity and/or frequency. The adverse development from surety bonds was due to two large accident year 2015 losses. The two lines of business contributing the majority of favorable development were other liability and workers' compensation. Other liability’s ultimate loss ratios were decreased for most accident years from 2001 through 2016 mainly in response to decreases in expected ultimate severity. Workers' compensation’s favorable development reflects a reduction in the accident year 2016 ultimate ratio as reported losses to date are materially more favorable than anticipated in frequency and severity assumptions underlying the December 31, 2016 selection. Included in the development amount is adverse development experienced in the other liability line of business stemming from the settlement of claims for past and future legal fees and losses on a multi-year asbestos exposure associated with a former insured, and a slight strengthening of remaining reserves.
For the reinsurance segment, the December 31, 2016 estimate of loss and settlement expense reserves for accident years 2015 and prior decreased $10.9 million from the estimate at December 31, 2015. This decrease represented 5.5 percent of the December 31, 2015 gross carried reserves and was attributed to favorable development in the 2015 accident year in the HORAD pro rata line of business, and an increase in the amount of negative bulk IBNR loss reserve carried on prior years' reserves in the MRB book of business.
Following is information about reported incurred and paid claims development as of December 31, 2017, net of reinsurance, as well as cumulative claim frequency and the amount of IBNR loss reserves carried (representing both IBNR liabilities and expected loss reserve development on reported claims). The information displayed for assumed reinsurance is restated to reflect all foreign currency denominated transactions on the basis of current (December 31, 2017) exchange rates. The number of reported claims (cumulative claim frequency) for the Company’s direct insurance business represents the total number of claims reported by the participants in the pooling agreement, and is determined on the basis of each unique combination of claimant, specific policy coverage, and type of loss. This is in contrast to all other reported amounts that are stated at the aggregate 30 percent pool participation percentage of the Company's property and casualty insurance subsidiaries. The cumulative claim frequency for the Company’s assumed reinsurance business is not readily available. Consistent with industry practices, bordereauxs on pro rata accounts often exclude claim frequency information, and if it is included, the level of detail provided by the ceding companies can vary significantly. Excess of loss contracts customarily report total losses subject to the treaty without detailed loss listings.
The following table sets forth a reconciliation of the incurred and paid claims development tables to the liability for losses and settlement expenses:
The Company has exposure to asbestos and environmental related claims associated with the insurance business written by the parties to the pooling agreement and the reinsurance business assumed from Employers Mutual by the reinsurance subsidiary. Asbestos and environmental losses paid by the Company have averaged $2.9 million per year over the past five years. Reserves for asbestos and environmental related claims for direct insurance and assumed reinsurance business totaled $11.7 million and $13.3 million ($11.4 million and $13.0 million net of reinsurance) at December 31, 2017 and 2016, respectively.
Prior to 2008, actual losses paid for asbestos-related claims had been minimal due to the plaintiffs’ failure to identify an exposure to any asbestos-containing products associated with the pool participants’ current and former policyholders. However, paid losses and settlement expenses have increased significantly since 2008 as a result of claims attributed to one former policyholder. During the period 2009 through 2017, the Company's share of paid losses and settlement expenses attributed to this former policyholder, a furnace manufacturer, was $12.5 million (mostly settlement expenses). A coverage-in-place agreement was executed with this former policyholder in 2009 and a national coordinating counsel was retained to address the multi-state litigation issues. The asbestos exposure associated with this former policyholder has increased in recent years, and this trend may possibly continue into the future with increased per plaintiff settlements. Approximately 692 asbestos exposure claims associated with this former policyholder remain open. During 2017 a settlement was reached with another former insured, resulting in the Company recognizing $4.5 million (its share) of settlement expenses to remove all past and future asbestos liability exposure related to that policyholder.
The NAIC utilizes a risk-based capital model to help state regulators assess the capital adequacy of insurance companies and identify insurers that are in, or are perceived as approaching, financial difficulty. This model establishes minimum capital needs based on the risks applicable to the operations of the individual insurer. The risk-based capital requirements for property and casualty insurance companies measure three major areas of risk: asset risk, credit risk and underwriting risk. Companies having less statutory surplus than required by the risk-based capital requirements are subject to varying degrees of regulatory scrutiny and intervention, depending on the severity of the inadequacy. At December 31, 2017, the Company’s insurance subsidiaries had total adjusted statutory capital of $560.1 million, which exceeds the minimum risk-based capital requirement of $94.4 million.
The amount of dividends available for distribution to the Company by its insurance subsidiaries is limited by law to a percentage of the statutory unassigned surplus of each of the subsidiaries as of the previous December 31, as determined in accordance with accounting practices prescribed by insurance regulatory authorities of the state of domicile of each subsidiary. Under Iowa law, the maximum dividend that may be paid within a 12 month period without prior regulatory approval is restricted to the greater of 10 percent of statutory surplus as regards policyholders as of the preceding December 31, or net income of the preceding calendar year on a statutory basis, not greater than earned statutory surplus (North Dakota, the state of domicile of Dakota Fire Insurance Company, imposes similar restrictions, except that it is limited to the lesser of 10 percent of statutory surplus as regards policyholders as of the preceding December 31, or net income excluding capital gains of the preceding calendar year on a statutory basis, not greater than earned statutory surplus). At December 31, 2017, $54.2 million was available for distribution to the Company in 2018 without prior approval.
The carrying amounts and the estimated fair values of the Company’s financial instruments as of December 31, 2017 and 2016 are summarized in the tables below.
Mortgage-backed and asset-backed securities are first reviewed for the appropriate pricing speed (if prepayable), spread, yield and volatility. The securities are priced with models using spreads and other information solicited from market buy- and sell-side sources, including primary and secondary dealers, portfolio managers, and research analysts. To determine a tranche’s price, first the benchmark yield is determined and adjusted for collateral performance, tranche level attributes and market conditions. Then the cash flow for each tranche is generated (using consensus prepayment speed assumptions including, as appropriate, a prepayment projection based on historical statistics of the underlying collateral). The tranche-level yield is used to discount the cash flows and generate the price. Depending on the characteristics of the tranche, a volatility-driven, multi-dimensional single cash flow stream model or an option-adjusted spread model may be used. When cash flows or other security structure or market information is not available, broker quotes may be used.
A small number of the Company’s securities are not priced by the independent pricing service. Two of these are equity securities that are reported as Level 3 fair value measurements since no observable inputs are used in their valuations. The largest of these equity security holdings is in a privately placed non-redeemable convertible preferred stock investment in a start-up technology company that Employers Mutual is working closely with in its data analytics activities. This security is carried at its cost, which is presumed to approximate fair value. The other equity security, a much smaller holding, continues to be reported at the fair value obtained from the Securities Valuation Office (SVO) of the NAIC. The SVO establishes a per share price for this security based on an annual review of that company’s financial statements, typically performed during the second quarter. The other securities not priced by the Company’s independent pricing service consist of eight fixed maturity securities (nine at December 31, 2016). Two of these fixed maturity securities, classified as Level 3 fair value measurements, are corporate securities that convey premium tax benefits and are not publicly traded. The fair values for these securities are based on discounted cash flow analyses. The other fixed maturity securities are classified as Level 2 fair value measurements. The fair values for these fixed maturity securities were obtained from either the SVO, the Company’s investment custodian, or the Company's investment department using similar pricing techniques as the Company's independent pricing service.
Presented in the tables below are the estimated fair values of the Company’s financial instruments as of December 31, 2017 and 2016.
Presented in the table below is a reconciliation of the assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the years ended December 31, 2017 and 2016. Any unrealized gains or losses on these securities are recognized in other comprehensive income (loss). Any gains or losses from settlements, disposals or impairments of these securities are reported as realized investment gains or losses in net income.
There were no transfers into or out of Levels 1 or 2 during 2017 or 2016. It is the Company’s policy to recognize transfers between levels at the beginning of the reporting period.
A summary of net changes in unrealized holding gains (losses) on securities available-for-sale is included in the table below.
On December 22, 2017 the TCJA was signed into law. Among other provisions, the TCJA lowered the federal corporate tax rate from 35 percent to 21 percent, effective January 1, 2018. Since the change in tax rate is not effective until 2018, current tax expense in 2017 is unaffected; however, the temporary tax differences that comprised the net deferred income tax liability at the enactment date are now projected to reverse at the lower 21 percent tax rate. The re-measurement of deferred income tax assets and liabilities resulted in the recognition of a $9.1 million deferred income tax benefit.
Temporary differences between the consolidated financial statement carrying amount and tax basis of assets and liabilities that give rise to significant portions of the deferred income tax asset (liability) at December 31, 2017 and 2016 are as follows:
The actual income tax expense for the years ended December 31, 2017, 2016 and 2015 differed from the “expected” income tax expense for those years (computed by applying the United States federal corporate tax rate of 35 percent to income before income tax expense) as follows:
Comprehensive income tax expense included in the consolidated financial statements for the years ended December 31, 2017, 2016 and 2015 is as follows. The deferred income tax benefit that resulted from the enactment of the TCJA in 2017 is included in the "operations" line.
The Company had no provision for uncertain income tax positions at December 31, 2017 or 2016. The Company recognized no interest expense or other penalties related to U.S. federal or state income taxes during 2017, 2016 or 2015. It is the Company’s accounting policy to reflect income tax penalties as other expense, and interest as interest expense.
Employers Mutual’s non-qualified defined benefit supplemental retirement plan provides additional retirement benefits for a select group of management and highly-compensated employees. This plan enables select employees to receive retirement benefits without the limit on compensation imposed on qualified defined benefit pension plans by the Internal Revenue Service (IRS) and to recognize compensation that has been deferred in the non-qualified deferred compensation plan. The plan is unfunded and benefits generally vest after three years of service.
Employers Mutual also offers postretirement benefit plans which provide an HRA and life insurance benefits for eligible retired employees. Substantially all of its employees may become eligible for those benefits if they reach age 55 and have attained the required length of service while working for Employers Mutual. Under the HRA, Employers Mutual reimburses eligible participants, up to a pre-determined maximum, for amounts expended to enroll in publicly available individual health care plans and/or pay for qualifying out-of-pocket health care costs. The obligations of the HRA are based on the total amount of reimbursements expected to be made by Employers Mutual over the lives of the participants, rather than the total amount of medical benefits expected to be paid over the participants’ lives. Therefore, the obligations of the HRA are not directly impacted by changes in the cost of health care. However, the maximum amount Employers Mutual will reimburse eligible participants is adjusted periodically based on an analysis of the change in health care costs. Such adjustments are reflected as plan amendments and increased the postretirement benefit plans' benefit obligation $2.7 million in 2017 and $2.2 million in 2016. During December 2017, Employers Mutual notified its employees that the life insurance benefit will be eliminated for employees retiring after 2018. As a result, the postretirement benefit plans' benefit obligation as of December 31, 2017 decreased $3.8 million. This change is also reflected as a plan amendment. The life insurance plan is noncontributory. The benefits provided under both plans are subject to change.
The following table sets forth the funded status of Employers Mutual’s pension and postretirement benefit plans as of December 31, 2017 and 2016, based upon measurement dates of December 31, 2017 and 2016, respectively.
The following table sets forth the projected benefit obligation, accumulated benefit obligation and fair value of plan assets of Employers Mutual’s non-qualified pension plan. The amounts related to the qualified pension plan are not included since the plan assets exceeded the accumulated benefit obligation.
The fair values of the assets held in Employers Mutual’s VEBA trust are as follows:
Presented below is a reconciliation of the assets measured at fair value using significant unobservable inputs (Level 3) for the years ended December 31, 2017 and 2016.
In accordance with ASU 2015-07, a fair value hierarchy table is not included here since all of the Plan's investments are measured at fair value using the net asset value per share (or its equivalent) practical expedient, which are not classified in the fair value hierarchy. Presented below are the fair values of assets held in Employers Mutual's defined benefit retirement plan:
Employers Mutual plans to contribute approximately $8.0 million to the pension plan in 2018. No contributions are expected to be made to the VEBA trust in 2018.
The Company participates in other benefit plans sponsored by Employers Mutual, including its 401(k) Plan, Board and Executive Non-Qualified Excess Plans and Defined Contribution Supplemental Executive Retirement Plan. The Company’s share of expenses for these plans amounted to $2.9 million, $2.7 million and $2.5 million in 2017, 2016 and 2015, respectively.
The Company has a stock-based compensation plan for non-employee directors. Employers Mutual also has several stock plans which utilize the common stock of the Company. Employers Mutual can provide the common stock required under its plans by: 1) using shares of common stock that it currently owns; 2) purchasing common stock in the open market; or 3) directly purchasing common stock from the Company at the current fair value. Employers Mutual's current practice is to purchase common stock from the Company for use in all of its stock plans (including its non-employee director stock purchase plan and its employee stock purchase plan). A portion of the compensation expense recognized by Employers Mutual (as the requisite service period for granted options and restricted stock awards/units is rendered) is allocated to the Company’s property and casualty insurance subsidiaries though their participation in the pooling agreement.
On May 26, 2017, the Company registered 150,000 shares of its common stock for use in the EMC Insurance Group Inc. 2017 Non-Employee Director Stock Plan (the "2017 Director Plan"). The 2017 Director Plan provides for the awarding of non-qualified stock options, restricted stock, restricted stock units and other stock-based awards to the Company's non-employee directors. During 2017, 2,000 shares of restricted stock were granted to non-employee directors of the Company under this plan. These shares of restricted stock vest over a one year period. Dividends on the unvested restricted stock are accrued and will be paid to the directors at the time of vesting.
Options granted under the 2007 Plan generally had a vesting period of five years, with options becoming exercisable in equal annual cumulative increments commencing on the first anniversary of the option grant. Option prices cannot be less than the fair value of the common stock on the date of grant. Restricted stock awards granted under the 2007 Plan generally have a vesting period of four years, with shares vesting in equal annual cumulative increments commencing on the first anniversary of the grant. With the exception of death, permanent disability or a change in control, any unvested shares of restricted stock are forfeited on termination of employment, including retirement. Holders of unvested shares of restricted stock receive compensation income equal to the amount of any dividends declared on the common stock.
The Company recognized compensation expense from these plans of $801,000 ($521,000 net of tax), $788,000 ($512,000 net of tax) and $500,000 ($325,000 net of tax) in 2017, 2016 and 2015, respectively. Due to the historically small number of forfeitures, the Company has elected to recognize the reduction to compensation expense from forfeitures as they occur.
A summary of the stock option activity under Employers Mutual’s stock plans for 2017, 2016 and 2015 is as follows:
As discussed above, during 2017 Employers Mutual began issuing restricted stock unit awards to eligible employees. These awards are accounted for as liability-based awards, whereby the liability is remeasured at each reporting date as the average of the high and low trading prices of the Company's common stock on that date. Upon settlement, the Company will receive the full fair value for all shares issued. The Company's share of this liability at December 31, 2017 was $543,000. A summary of restricted stock unit awards activity for 2017 is as follows:
The Company’s portion of the total intrinsic value of options exercised under Employers Mutual’s stock plans was $901,000, $1.1 million and $770,000 in 2017, 2016 and 2015, respectively. Under the terms of the pooling and quota share agreements, these amounts were paid to Employers Mutual. The Company receives the full fair value, as of the exercise date, for all shares issued in connection with option exercises. Additional information relating to options outstanding and options vested (exercisable) at December 31, 2017 is as follows:
Incentive stock options generally do not generate income tax deductions for the Company. The Company has recorded a deferred income tax benefit for non-qualified stock options and restricted stock awards that have been issued. The Company’s portion of the current income tax deduction realized from exercises of non-qualified stock options was $239,000, $284,000 and $121,000 in 2017, 2016 and 2015, respectively. These actual deductions are generally in excess of the deferred tax benefits recorded in conjunction with the compensation expense (referred to as excess tax benefits), which reduce income tax expense (prior to 2016 were recorded to additional paid in capital). The income tax benefit that results from disqualifying dispositions of stock purchased through the exercise of incentive stock options is deemed immaterial.
On May 30, 2008, the Company registered 750,000 shares of its common stock for use in the Employers Mutual Casualty Company 2008 Employee Stock Purchase Plan. All employees are eligible to participate in the plan. An employee may participate in the plan by delivering, during the first twenty days of the calendar month preceding the first day of an election period, a payroll deduction authorization to the plan administrator; or making a cash contribution (employees designated as “Insiders” are required to give six months advance notice prior to participating in the plan). Participants pay 85 percent of the fair market value of the stock on the date of purchase. The plan is administered by the Board of Directors of Employers Mutual, which has the right to amend or terminate the plan at any time; however, no such amendment or termination shall adversely affect the rights and privileges of participants. Expenses allocated to the Company in connection with this plan totaled $100,000, $78,000 and $59,000 in 2017, 2016 and 2015, respectively.
During 2017, shares were purchased under the plan at prices ranging from $23.64 to $25.15. Activity under the plan was as follows:
During 2017, shares were purchased under the plan at prices ranging from $20.15 to $23.15. Activity under the plan was as follows:
On November 3, 2011, the Company’s Board of Directors authorized a $15.0 million stock repurchase program. This program does not have an expiration date. The timing and terms of the purchases are determined by management based on board approved parameters and market conditions, and are conducted in accordance with the applicable rules of the Securities and Exchange Commission. Common stock repurchased under this program will be retired by the Company. During 2016, the Company repurchased 17,300 shares under this program at an average cost of $22.14.
One of the Company’s property and casualty insurance subsidiaries leases office facilities in Bismarck, North Dakota with lease terms expiring in 2024. Employers Mutual has entered into various leases for branch and service office facilities with lease terms expiring through 2027. All of these lease costs are included as expenses under the pooling agreement. The following table reflects the Company's share of lease commitments as of December 31, 2017.
The participants in the pooling agreement are subject to guaranty fund assessments by states in which they write business. Guaranty fund assessments are used by states to pay policyholder liabilities of insolvent insurers domiciled in those states. Many states allow assessments to be recovered through premium tax offsets. The Company has accrued estimated guaranty fund assessments of $706,000 and $851,000 as of December 31, 2017 and 2016, respectively. Premium tax offsets of $897,000 and $1.0 million, which are related to prior guarantee fund payments and current assessments, have been accrued as of December 31, 2017 and 2016, respectively. The guaranty fund assessments are expected to be paid over the next two years and the premium tax offsets are expected to be realized within ten years of the payments. The participants in the pooling agreement are also subject to second-injury fund assessments, which are designed to encourage employers to employ workers with pre-existing disabilities. The Company has accrued estimated second-injury fund assessments of $2.0 million and $1.9 million as of December 31, 2017 and 2016, respectively. The second-injury fund assessment accruals are based on projected loss payments. The periods over which the assessments will be paid is not known.