The following table sets forth selected consolidated financial data for MIG at and for each of the years in the five year period ended December 31, 2010. You should read this data in conjunction with the Group’s consolidated financial statements and accompanying notes, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and other financial information included elsewhere in this report.
(1) Includes Net Income and the change in Unrealized Gains and Losses of the investment portfolio as well as a defined benefit pension adjustment.
(2) The sum of losses, loss adjustment expenses, underwriting expenses and dividends to policyholders divided by net premiums earned. A combined ratio of less than 100% means a company is making an
(3) The sum of the ratio of underwriting expenses divided by net premiums written, and the ratio of losses, loss adjustment expenses, and dividends to policyholders divided by net premiums earned.
(5) The ratio of investment income, net of expenses divided by average cash and investments
Variations in premium earned are subject to a number of factors, including:
· limitations on rates arising from competitive market place conditions or regulation;
· general economic conditions and economic conditions in sectors in which the group offers insurance products, such as the construction industry;
· the Group’s ability to maintain it’s A (“Excellent”) rating by A.M. Best;
· the ability of the Group to maintain a reputation for efficiency and fairness in claims administration;
Variations on investment income are subject to a number of factors, including:
· changes in prices of debt and equity securities generally and those held by the Group specifically.
· the availability, cost and terms of reinsurance and the financial condition of our reinsurers;
The amount of loss and loss adjustment expense reserves for reported claims is based primarily upon a case-by-case evaluation of the type of risk involved, specific knowledge of the circumstances surrounding each claim, and the insurance policy provisions relating to the type of loss. The amounts of loss reserves for unreported losses and loss adjustment expenses are determined using historical information by line of business, adjusted to current conditions. Inflation is ordinarily provided for implicitly in the reserving function through analysis of costs, trends, and reviews of historical reserving results over multiple years. Our loss reserves are not discounted to present value.
We maintain bulk and IBNR reserves (usually referred to as “IBNR reserves”) to provide for claims already incurred that have not yet been reported (and which often may not yet be known to the insured) and for future developments on reported claims. The IBNR reserve is determined by estimating our insurance companies’ ultimate net liability for both reported and incurred but not reported claims and then subtracting both the case reserves and payments made to date for reported claims; as such, the “IBNR reserves” represent the difference between the estimated ultimate cost of all claims that have occurred or will occur and the reported losses and loss adjustment expenses. Reported losses include cumulative paid losses and loss adjustment expenses plus aggregate case reserves. A relatively large proportion of our gross and net loss reserves, particularly for long tail liability classes, are reserves for IBNR losses. Approximately 79% of our aggregate gross loss reserves at December 31, 2010 and 2009, were bulk and IBNR reserves.
Ratios of cumulative and incremental incurred and paid losses to earned premiums and to estimated ultimate incurred losses;
The paid loss development method is mechanically identical to the reported loss development method described above with the exception that paid losses replace incurred losses. The paid method does not rely on case reserves or their adequacy in making projections.
In July of 1995, the California Supreme Court rendered its Opinion in Admiral Insurance Company vs. Montrose Chemical Corporation (the Montrose Decision). In that decision, the California Supreme Court ruled that in the case of a continuous and progressively deteriorating loss, such as pollution liability (or construction defect liability), an insurance company has a definitive duty to defend the policyholder until all uncertainty related to the severity and cause of the loss is extinguished.
For further information relating to the determination of loss and loss adjustment expense reserves, please see the discussion under “Loss and Loss Adjustment Expense Reserves” contained in ITEM 1. “Business” of this Form 10-K.
In 2010, the Group recorded a pre-tax charge to earnings of $115,000 for write-downs of other-than-temporarily impaired securities, of which $89,000 related to two fixed income securities and $26,000 related to one equity security. The write-downs of fixed income securities were attributable to credit issues, and accordingly recognized as realized investment losses in the consolidated statement of earnings. The equity security impairment related to a common stock security, which demonstrated weakening fundamentals in its business.
Revenue and income by segment is as follows for the years ended December 31, 2010, 2009 and 2008.
The availability of reinsurance at reasonable pricing is an important part of our business. Effective January 1, 2009, we increased our retention to $1,000,000 (from a maximum retention of $850,000 in 2008) on the casualty, property and workers’ compensation lines of business. As we increase the net retention of the business we write, net premiums written and earned will increase and ceded losses will decrease. The impact of increased retentions under our reinsurance program was offset in part by a decline in direct written premiums due to the contraction of the economy in our markets and the competitive marketplace, particularly as it relates to new construction contractors we insure. As older reinsurance treaties run off, the impact described above of the new reinsurance program will become more evident in net premiums written, net premiums earned and net losses incurred.
The key elements of our business model are the sale of properly priced and underwritten personal and commercial property and casualty insurance through independent agents and the investment of the premiums in a manner designed to assure that claims and expenses can be paid while providing a return on the capital employed. Loss trends and investment performance are critical factors in influencing the success of the business model. These factors are affected by the factors impacting the insurance industry in general and factors unique to us as described in the following discussion.
Net investment income decreased $0.3 million or 2.3% to $13.9 million in 2010 as compared to $14.2 million in 2009. This decrease was driven by a low interest rate environment in the first three quarters of the year, as maturing and sold fixed income securities were reinvested at lower rates combined with an increase in the allocation of expense to the investment function of the Company.
Total revenues declined to $153.6 million in 2010 from $157.3 million in 2009 due to lower net premiums written, offset by a slightly larger net realized investment gain in 2010 as compared to 2009. Net premiums written decreased $5.1 million, or 3.7%, to $132.7 million in 2010, as compared to $137.8 million in 2009. Net premiums earned totaled $136.0 million in 2010, as compared to $140.4 million in 2009, representing a 3.2%, or $4.4 million, decrease.
Direct premiums written decreased 3.0%, or $4.5 million, to $148.5 million as a result of the weak economy, particularly in California, and competition in our all of our market places. The decline in net premiums written and net premiums earned is attributable to the decline in direct written premium, combined with a decrease in assumed premiums from participation in mandatory residual markets. The decrease in direct premiums written includes a $1.8 million reduction in surety written premium due to the weak economy and tightened underwriting criteria.
Despite the competitive market conditions and weakened economy, the Group’s policy retention on renewal has been favorable across most product lines and the Group has been able to grow its policy count, aided through the introduction of new products. In the fourth quarter of 2008, a new Business Owners Policy for California risks was introduced. This product targets small to medium sized businesses, which have been shown to be somewhat less price sensitive and demonstrate higher renewal retention than larger accounts. In 2009 and 2010, a new contracting product which specializes in covering artisan contractors was introduced in Arizona, California, Nevada and Oregon. Artisan contractors primarily provide repair and maintenance services, and this segment tends to experience less severe market fluctuations compared to the construction industry. These products continued to grow during 2010. We also began writing refuse haulers in our east coast markets and introduced a garage liability product.
Net realized investment gains amounted to $1.8 million in 2010, as compared to $0.6 million in 2009. The Group had gains on the sales of securities of $2.0 million and $0.9 million, and write-downs of other than temporary impairments of $0.1 million and $0.8 million, in 2010 and 2009, respectively. The Group also recorded a loss on the mark-to-market of interest rate swaps in 2010 of $0.1 million, and a gain in 2009 of $0.5 million. We have three ongoing interest rate swap agreements to hedge against interest rate risk on our floating rate trust preferred securities obligations. The estimated fair value of the interest rates swaps is obtained from the third-party financial institution counterparty. We mark the investments to market using these valuations and record the change in the economic value of the interest rate swaps as a realized gain or loss in the consolidated statement of earnings. See also the discussion of other than temporary impairments on investment securities in the “Critical Accounting Policies” section.
Among our portfolio holdings, the only direct subprime exposure consists of asset-backed securities (ABS) within the home equity subsector. The ABS home equity subsector totaled $0.5 million on December 31, 2010, representing 2.8% of the ABS holdings and 0.1% of total fixed income portfolio holdings. The subprime related exposure consists of three individual securities, of which two are insured by monolines against default of principal and interest. However, since FGIC is no longer rated and AMBAC has been downgraded to Caa2/R, the two insured securities are now rated according to the higher of the underlying collateral or the monoline rating. One bond is rated Caa1/D while the other is rated Ca/D. With regard to the remaining security without monoline insurance, it is rated C/B by Moody’s and S&P, respectively.
The estimated fair value and unrealized loss for securities in a temporary unrealized loss position as of December 31, 2010 are as follows:
The following table summarizes the period of time that equity securities sold at a loss during 2010 had been in a continuous unrealized loss position:
In 2010 our commercial lines net premiums earned decreased by $4.0 million, or 3.3%, to $116.9 million, as compared to net premiums earned in 2009 of $120.9 million. The decrease in net premiums earned was caused by the 3.2% decline in direct premiums written.
In the commercial lines segment for 2010 we had underwriting income of $8.3 million, an increase from the underwriting income of $4.3 million in 2009, a GAAP combined ratio of 92.9%, a GAAP loss and loss adjustment expense ratio of 58.2% and a GAAP underwriting expense ratio of 34.7%, compared to a GAAP combined ratio of 96.4%, a GAAP loss and loss adjustment expense ratio of 60.0% and a GAAP underwriting expense ratio of 36.4% in 2009. Our commercial lines loss ratio for 2010 reflects a redundancy in loss development for our commercial automobile business and a lower level of adverse prior year loss reserve development for commercial multi-peril business.
In the personal lines segment for 2010 we had an underwriting loss of $3.4 million, a GAAP combined ratio of 117.6%, a GAAP loss and loss adjustment expense ratio of 82.5% and a GAAP underwriting expense ratio of 35.1%, compared to an underwriting loss of $1.0 million, a GAAP combined ratio of 104.9%, a GAAP loss and loss adjustment expense ratio of 69.4% and a GAAP underwriting expense ratio of 35.5% in 2009.
Underwriting expenses decreased by $3.6 million, or 7.1%, to $47.3 million in 2010, as compared to $50.9 million in 2009. The decrease in underwriting expenses primarily reflects a decrease in other underwriting expenses in 2010, primarily due to decrease profit sharing payments to agents for 2010. Additionally, beginning at the end of 2008 the Group undertook a significant expense reduction program, resulting in significant cost reductions, which are reflected in lower other underwriting expenses in 2010 and 2009 and, subject to the deferred acquisition cost methodology, to some extent in 2010 and 2009 amortization of deferred acquisition costs. Other underwriting expenses include contingent ceding commission of $1.4 million in 2010 compared to $0.6 million in 2009 reflecting favorable ceded loss development on certain reinsurance treaties, primarily FPIC pre-2007 treaties and also reflect lower share-based compensation expense.
Audit premium is derived principally from the contractor book of business written by FPIC. The premium on these policies is estimated at policy inception based on a prediction of the volume of the insured’s business operations during the policy period. In addition to endorsing the policy throughout the policy period based on known information, at policy expiration FPIC may conduct an audit of the insured’s business operations in order to adjust the policy premium from an estimate to actual. Contractor liability policy premium tends to vary with local construction activity as well as changes in the nature of the contractor’s operations. The decline in construction related activity and failing businesses in the construction industry caused by the weak California economy has impacted both the volume of premium for the contractor in-force book of business (as well as reducing related exposures) and the related audit premium on expiring policies. Audits, primarily of construction related policies, generated return premium of $3.7 million in 2009, representing a decline of $1.1 million as compared to $2.6 million of return audit premium generated in 2008.
Despite the competitive market conditions and weakened economy, the Group’s policy retention on renewal has been favorable across most product lines and the Group has been able to grow its policy count, aided through the introduction of new products. In the fourth quarter of 2008, a new Business Owners Policy for California risks was introduced. This product targets small to medium sized businesses, which have been shown to be somewhat less price sensitive and demonstrate higher renewal retention than larger accounts. In 2009, a new contracting product which specializes in covering artisan contractors was introduced in Arizona and California. Artisan contractors primarily provide repair and maintenance services, and this segment tends to experience less severe market fluctuations compared to the construction industry.
Dividend income declined 19.4% to $283,000 in 2009, as compared to $351,000 in 2008, due to a reduction in the size of our equities portfolio since 2008. Interest income on cash and cash equivalents declined $314,000, or 66.4%, to $159,000 in 2009, as compared to $473,000 in 2008, primarily as a result of extremely low short term yields in 2009. Investment expenses increased $434,000 to $2.2 million in 2009, from $1.8 million in 2008.
Fixed income investments represent 97.5% of invested assets. As of December 31, 2009, the fixed income portfolio consisted of 99% investment grade securities, with 1% non-investment grade rated securities, which includes three corporate securities held with a combined market value of $1.3 million, three asset-backed securities held with a combined market value of $0.6 million, one mortgage-backed security with a market value of $0.1 million, and one small tax-exempt municipal bond. The fixed income portfolio had an average rating of Aa3/AA and an average tax equivalent book yield of 5.14%.
Among our portfolio holdings, the only direct subprime exposure consisted of asset-backed securities (ABS) within the home equity subsector. The ABS home equity subsector totaled $0.5 million on December 31, 2009, representing 3.21% of the ABS holdings and 0.14% of total fixed income portfolio holdings. The subprime related exposure consisted of three individual securities, of which two are insured by monolines against default of principal and interest. However, since FGIC is no longer rated and AMBAC has been downgraded to Caa2/CC, the two insured securities are now rated according to the higher of the underlying collateral or the monoline rating. One bond is rated Ba3/BB while the other is rated Caa2/CCC. With regard to the remaining security without monoline insurance, it is rated A3/B by Moody’s and S&P, respectively.
Fixed maturity investments with unrealized losses for less than twelve months are primarily due to changes in the interest rate environment. At December 31, 2009 the Group had 3 fixed maturity securities with unrealized losses for more than twelve months. Of the 3 securities with unrealized losses for more than twelve months, all of them have fair values of no less than 92% of book value. The Group does not believe these declines are other than temporary due to the credit quality of the holdings. We currently have no intention or expectation that we will have to sell these securities before recovery.
One of our strategies in this market is to introduce new products leveraging our core skills. In the fourth quarter of 2008, a new Business Owners Policy for California risks was introduced. This product targets small to medium sized businesses, which have been shown to be somewhat less price sensitive and demonstrating higher renewal retention than larger accounts. This product also helps to balance FPIC’s business between property and casualty exposures. In 2009, a new contracting product which specializes in covering artisan contractors was introduced in Arizona and California, and is being developed for Nevada and Oregon with a targeted introduction in early 2010. Artisan contractors primarily provide repair and maintenance services, and this segment tends to experience less severe market fluctuations compared to the construction industry. During 2009, a new Garage Program was introduced in New Jersey and Pennsylvania, which targets repair shops, auto body shops, and gas stations.
In the personal lines segment for 2009 we had an underwriting loss of $1.0 million, a GAAP combined ratio of 104.9%, a GAAP loss and loss adjustment expense ratio of 69.4% and a GAAP underwriting expense ratio of 35.5%, compared to an underwriting loss of $1.4 million, a GAAP combined ratio of 107.1%, a GAAP loss and loss adjustment expense ratio of 69.5% and a GAAP underwriting expense ratio of 37.6% in 2008.
Federal income tax expense was $5.0 million and $2.2 million for 2009 and 2008, respectively. The effective tax rate was 26.7% and 20.8% for 2009 and 2008, respectively. The 2009 effective tax rate was higher than that of 2008 because the 2009 pre-tax income was not impacted by the significant level of other than temporary investment impairments reflected in the 2008 pre-tax income, and by the fact that tax-advantaged income was slightly lower in 2009.
Our insurance companies maintain investment and reinsurance programs that are intended to provide sufficient funds to meet their obligations without forced sales of investments. This requires them to ladder the maturity of their portfolios and thereby maintain a portion of their investment portfolio in relatively short-term and highly liquid assets to ensure the availability of funds.
MIG began paying quarterly dividends of $0.05 per common share in the second quarter of 2006. On April 16, 2008, MIG’s Board of Directors increased the quarterly dividend from $0.05 per share of common stock to $0.075 per share of common stock, effective with the payment of the June 27, 2008 dividend. . On April 14, 2010, MIG’s Board of Directors increased the quarterly dividend from $0.075 per share of common stock to $0.10 per share of common stock, effective with the payment of the June 28, 2010 dividend. The amount of dividends paid during 2010 and 2009 totaled $2.4 million and $1.9 million, respectively. The shareholder dividend was funded from the Group’s insurance companies, for which approval was sought and received (where necessary) from each of the insurance companies’ primary regulators. The Merger Agreement prohibits the Company from paying any dividends on its stock.
The Group maintains an Employee Stock Ownership Plan (ESOP), which purchased 626,111 shares from the Group at the time of the Conversion in return for a note bearing interest at 4% on the principal amount of $6,261,110. MIC makes annual contributions to the ESOP sufficient for it to make its required annual payment under the terms of the loan to the Holding Company. It is anticipated that approximately 10% of the original ESOP shares will be allocated annually to employee participants of the ESOP. An expense charge is booked ratably during each year for the shares committed to be allocated to participants that year, determined with reference to the fair market value of the Group’s stock at the time the commitment to allocate the shares is accrued and recognized. The issuance of the shares to the ESOP was fully recognized in the additional paid-in capital account at Conversion, with a contra account entitled Unearned ESOP Shares established in the stockholders’ equity section of the balance sheet for the unallocated shares at an amount equal to their original per-share purchase price. Shareholder dividends received on unallocated ESOP shares are used to pay-down principal and interest owed on the loan to the Holding Company.
The Group adopted a stock-based incentive plan at its 2004 annual meeting of shareholders. Pursuant to that plan, the Group may issue a total of 876,555 shares, which amount will increase automatically each year by 1% of the number of shares outstanding at the end of the preceding year. At December 31, 2010, the shares authorized under the plan have been increased under this provision to 1,270,514 shares. During 2010, the Group made no grants of restricted stock, incentive stock options and non-qualified stock options.
Total assets increased 1%, or $8.2 million, to $603.6 million, at December 31, 2010, as compared to $595.4 million at December 31, 2009. The Group’s cash and invested assets increased $19.1 million or 5%, primarily due to net cash provided by operating activities. Premiums receivable decreased $1.2 million or 3%,which is consistent with the 3% decline in total direct premiums written. Reinsurance receivables decreased $6.7 million or 8%, reflecting the decrease in ceded loss and loss adjustment expense reserves. Prepaid reinsurance premiums increased $0.5 million or 8%, principally due to changes in certain of the Group’s reinsurance contracts. Property and equipment decreased $1.2 million, or 6%, due primarily to depreciation. Additionally, the deferred income tax asset decreased $1.8 million or 36%, due to the change in deferred taxes on the unrealized gains on securities as well as changes in a variety of temporary differences items.
Total stockholders’ equity increased $17.4 million or 11%, to $177.6 million, at December 31, 2010, from $160.2 million at December 31, 2009, primarily due to net income of $14.7 million, changes in unrealized holding gains and losses on securities of $3.1 million, stock compensation plan amortization of $0.1 million, ESOP shares committed to be allocated to participants of $1.2 million and issuance of common stock of $0.6 million, offset by stockholder dividends of $2.4 million and changes in valuation for the defined benefit pension plan of $41,000.
In February 2008, the FASB provided guidance which delayed the application fair value measurement until January 1, 2009 for non-financial assets and non-financial liabilities, except those that are recognized or disclosed at fair value in the consolidated financial statements on a recurring basis. The delayed application did not have a material impact on the Group’s results of operations, financial condition, or liquidity.
In March 2008, the FASB issued guidance changing the disclosure requirements for derivative instruments and hedging activities and specifically requires qualitative disclosures about objectives and strategies for using derivatives, quantitative disclosures about fair value amounts of, and gains and losses on, derivative instruments, and disclosures about credit-risk-related contingent features in derivative agreements. The guidance is effective for financial statements issued for fiscal years beginning after November 15, 2008. The guidance did not have a material effect on the Group’s disclosures.
The Group was not a party to any unconsolidated arrangement or financial instrument with special purpose entities or other vehicles at December 31, 2010 that would give rise to previously undisclosed market, credit or financing risk.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Mercer Insurance Group, Inc. and subsidiaries as of December 31, 2010 and 2009, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2010, in conformity with U.S. generally accepted accounting principles.
Mercer Insurance Group, Inc. (MIG) and subsidiaries (collectively, the Group) includes Mercer Insurance Company (MIC), its subsidiaries Mercer Insurance Company of New Jersey, Inc. (MICNJ), Franklin Insurance Company (FIC), and BICUS Services Corporation (BICUS), and Financial Pacific Insurance Group, Inc. (FPIG) and its subsidiaries Financial Pacific Insurance Company (FPIC) and Financial Pacific Insurance Agency (FPIA), which is currently inactive. FPIG also holds an interest in three statutory business trusts that were formed for the purpose of issuing Floating Rate Capital Securities (see note 17).
The Group’s business activities are separated into three operating segments, which are commercial lines of insurance, personal lines of insurance and the investment function. The commercial lines of business consist primarily of multi-peril and commercial auto coverage. These two commercial lines represented 60%, 60% and 62%, and 20%, 19% and 17%, respectively, of the Group’s net premiums written in 2010, 2009 and 2008. The personal lines business consists primarily of homeowners insurance in Pennsylvania and New Jersey and private passenger automobile insurance in Pennsylvania. These two personal lines represented 9%, 9% and 8%, and 3 %, 4% and 4%, respectively, of the Group’s net premiums written in 2010, 2009 and 2008.
The consolidated financial statements are prepared in accordance with U.S. generally accepted accounting principles (GAAP), which differ in some respects from those followed in reports to insurance regulatory authorities. The insurance subsidiaries within the Group participate in a reinsurance pooling arrangement (the Pool) whereby each insurance affiliate’s underwriting results are combined and then distributed proportionately to each participant. Each insurer’s share in the Pool is based on their respective statutory surplus as of the beginning of each year. The effects of the Pool as well as all other significant intercompany accounts and transactions have been eliminated in consolidation.
The preparation of the accompanying financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Significant items subject to such estimates include liabilities for losses and loss adjustment expenses, deferred policy acquisition costs, reinsurance, goodwill impairment, deferred income tax assets and investment valuation and assessment of other than temporary impairment of investments. Actual results could differ from those estimates.
For the years ending December 31, 2010, 2009 and 2008, there were no agents in the Group that individually produced greater than 5% of the Group’s direct written premiums.
Realized investment gains and losses are determined on the specific identification basis. An invested asset is considered impaired when its fair value declines below cost. The Group recognizes as a realized investment loss any impairment of a fixed maturity investment which is determined to be other-than-temporarily impaired because the present value of future cash flows expected to be collected from the security is less than the amortized cost of the security (i.e. a credit loss exists) or where the Group intends to sell or more-likely-than-not will be required to sell the security prior to recovering the security’s amortized cost basis. Impaired equity securities are other-than-temporarily impaired when it becomes apparent that the Group will not recover its cost over a reasonable period of time, in which case the impairment is recorded as a realized investment loss. Factors considered in determining whether a credit loss exists and over what period of time the security is expected to recover include the length of time and the extent to which fair value has been below cost, adverse conditions specifically related to the security, the industry or the geographic area, the financial condition and near-term prospects of the issuer, analysis and guidance provided by rating agencies and analysts, and changes in fair value subsequent to the balance sheet date. Where a realized investment loss is recognized for an impairment, the cost basis of the security is written down to fair value for equity securities and for fixed maturity investments where impairment is solely related to credit. Where a fixed income security is other-than-temporarily impaired and the impairment is not attributable to credit issues, this impairment loss, or portion of a larger impairment loss, is included within other comprehensive income. Subsequent recoveries in the fair value of other-than-temporarily impaired securities are recognized through the Statement of Earnings at disposition.
Premium and reinsurance receivables of paid losses - The carrying amounts reported in the consolidated balance sheet for these instruments approximate their fair values.
As of December 31, 2010, the Group has $44 of unrecognized total compensation cost related to non-vested stock options and restricted stock. That cost will be recognized over the remaining weighted-average vesting period of .75 years, based on the estimated grant date fair value.
The Group uses the asset and liability method of accounting for income taxes. Deferred income taxes arise from the recognition of temporary differences between financial statement carrying amounts and the tax bases of the Group’s assets and liabilities. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. A valuation allowance is provided when it is more likely than not that some portion of the deferred tax asset will not be realized. The effect of a change in tax rates is recognized in the period of the enactment date.
Goodwill is tested annually for impairment, and is tested for impairment more frequently if events and circumstances indicate that the asset might be impaired. An impairment loss is recognized to the extent that the carrying amount exceeds the asset’s fair value. This determination is made at the reporting unit level and consists of two steps. First, the Group determines the fair value of a reporting unit and compares it to its carrying amount. Second, if the carrying amount of a reporting unit exceeds its fair value, an impairment loss is recognized for any excess of the carrying amount of the reporting unit’s goodwill over the implied fair value of that goodwill. The implied fair value of goodwill is determined by allocating the fair value of the reporting unit in a manner similar to a purchase price allocation. The residual fair value after this allocation is the implied fair value of the reporting unit goodwill. The Group has two reporting units with goodwill as of December 31, 2010 and 2009. The Group performed the annual impairment tests as of December 31, 2010 and 2009, and the results indicated that the fair value of the reporting units exceeded their carrying amounts.
Intangible assets held by the Group have definite lives and the value is amortized on a straight-line basis over their useful lives, ranging from eight to fourteen years. The carrying amount of these intangible assets are regularly reviewed for indicators of impairments in value. Impairment is recognized only if the carrying amount of the intangible asset is not recoverable from its undiscounted cash flows and is measured as the difference between the carrying amount and the fair value of the asset.
Basic EPS is computed by dividing income available to common shareholders by the weighted average number of common shares outstanding during the period. The computation of diluted EPS reflects the effect of potentially dilutive securities. The denominator for basic and diluted EPS includes ESOP shares committed to be released.
In April 2009, the FASB issued guidance modifying the requirements for recognizing other-than-temporarily impaired debt securities and significantly changes the existing impairment model for such securities. This guidance also modifies the presentation of other-than-temporary impairment losses. Such modifications include changing the amount of the other-than-temporary impairment that is recognized in earnings when there are credit losses on a debt security that the entity does not intend to sell and it is not more-likely-than-not that the entity will be required to sell prior to recovery. In these situations, the portion of the total impairment that is related to the credit loss would be recognized as a charge against operations, and the remaining portion would be included in other comprehensive income. The guidance also increases the frequency of and expands already required disclosures about the other-than-temporary impairment of debt and equity securities. This guidance is effective for fiscal years ending after June 15, 2009.
In May 2009, the FASB issued guidance which establishes the standards of accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued. The Group adopted this standard, which did not have a material impact on the Group’s consolidated financial statements.
In June 2009, the FASB issued guidance that establishes the FASB Accounting Standards Codification as the source of authoritative GAAP for nongovernmental entities. The Codification will supersede all existing non-SEC accounting and reporting standards. The Codification is effective for financial statements issued for interim and annual periods ending after September 15, 2009. As the Codification did not change existing GAAP, the guidance did not have an impact on the Group’s financial condition or results of operations but did change the way the Group refers to GAAP accounting standards.
In January 2010, the FASB issued ASU 2010-06, Fair Value Measurements and Disclosures (Topic 820 - Improving Disclosures about Fair Value Measurements. This guidance requires: (i) separate disclosure of significant transfers between Level 1 and Level 2 of the fair value hierarchy and reasons for the transfers; (ii) disclosure, on a gross basis, of purchases, sales, issuances, and net settlements within Level 3 of the fair value hierarchy; (iii) disclosures by class of assets and liabilities; and (iv) a description of the valuation techniques and inputs used to measure fair value for both recurring and nonrecurring fair value measurements. This guidance is effective for reporting periods beginning after December 15, 2009, except for the Level 3 disclosure requirements, which will be effective for fiscal years beginning after December 15, 2010 and interim periods within those fiscal years. The Group has included the disclosures required by this guidance in their notes to the consolidated financial statements, where appropriate.
The changes in net unrealized gains (losses) of securities are as follows:
The following table shows the Group’s corporate fixed income securities and equity holdings by industry sector:
The estimated market value and unrealized loss for securities in a temporary unrealized loss position as of December 31, 2010 are as follows:
Fixed maturity investments with unrealized losses for less than twelve months are primarily due to changes in the interest rate environment. At December 31, 2010, the Group had no fixed maturity securities with unrealized losses for more than twelve months.
There are 4 common stock securities that are in an unrealized loss position at December 31, 2009. All of these securities have been in an unrealized loss position for less than 6 months. There is one preferred stock security that has been in an unrealized loss position for more than twelve months.
The amortized cost and estimated fair value of fixed-income securities at December 31, 2010, by contractual maturity, are shown below. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
In 2010, the Group recorded a pre-tax charge to earnings of $115 for write-downs of other-than-temporarily impaired securities, of which $89 related to two fixed income securities and $26 related to one equity security. The write-downs of fixed income securities were attributable to credit issues, and accordingly recognized as realized investment losses in the consolidated statement of earnings. The equity security impairment related to a common stock security, which demonstrated weakening fundamentals in its business.
The Group has no material amount of non-credit other-than-temporary impairment loss carried in Other Comprehensive Income at December 31, 2010.
intended to be or were required of necessity to be sold
Change in credit loss due to accretion of increase in cash flows for securities
Proceeds from sales of securities were $23,552, $16,755, and $7,740 in 2010, 2009, and 2008, respectively.
In 2009, the Group constructed a new 41,000 square foot building for its office in Rocklin, California at a cost of $5,110. This office space replaced 25,000 square feet the Group previously leased in Rocklin for its west coast operations.
The following table presents, by line of business, the change in the liability for unpaid losses and loss adjustment expenses incurred in the years ended December 31, 2010, 2009 and 2008, for insured events of prior years.
The commercial multi-peril line of business experienced adverse prior year development of $2.0 million in 2010, $5.3 million in 2009, and $9.2 million in 2008. The majority of this development relates to the west coast contractor liability book of business. Contractor liability claims, particularly construction defect claims, are long-tailed in nature and are reported and develop over a period of ten to twelve years. The reduction in adverse development in 2010 and 2009 reflects a combination of reduced levels of adverse development on the west coast commercial multi-peril liability, particularly on the 2002 and prior accident years, favorable development on the west coast of the 2003 and subsequent accident years and improved development on the east coast commercial multi-peril liability.
With $20.9 million, $23.3 million, and $23.5 million of recorded reserves, net of reinsurance, at December 31, 2010, 2009, and 2008, respectively, commercial automobile is the Group’s second largest reserved line of business, representing 9 %, 10%, and 11%, respectively, of the Group’s total carried net loss and loss adjustment expense reserves at December 31, 2010, 2009, and 2008.
The commercial automobile line of business experienced favorable prior year development of $8.2 million in 2010, $4.2 million in 2009, and $3.0 million in 2008. The majority of this development relates to the west coast commercial automobile liability book of business.
The favorable development on the commercial automobile line of business was due to a reduction in claims frequency for the recent accident years and a lower than expected emergence of losses, particularly on the Group’s heavy truck programs. Additionally, in 2010, the favorable development on the 2009 and 2008 accident year was impacted by better than expected case reserve development.
The remaining lines of business collectively contributed approximately $3.9 million in adverse development in 2010, $1.0 million in favorable development in 2009 and adverse development of $0.4 million in 2008.. The adverse development in 2010 was mainly due to the $2.2 million in adverse development on Surety which reflects increased claim activity related to the economic downturn. There also was $1.5 million in adverse development on Homeowners, primarily on the 2005 accident year reflecting emergence of losses related to residential underground oil tanks. At December 31, 2010, Surety recorded reserves, net of reinsurance, totaled $6.0 million or 3 % of net loss and loss adjustment reserves and Homeowners recorded reserves, net of reinsurance, totaled $ 7.3 million or 3% of net loss and loss adjustment reserves.
During the fourth quarter of 2008, the Group commuted all reinsurance agreements with St. Paul Fire and Marine Insurance Company. These reinsurance agreements included participation in the property quota share and casualty excess of loss treaties. As a result of the commutation the Group received a cash payment of $2.5 million, and recorded a pre-tax net gain on commutation of $0.9 million.
The Group maintains a 401(k) qualified retirement savings plan covering substantially all employees. Benefits are based on an employee’s annual compensation, with new employees participating after a six-month waiting period. The Group matches a percentage of each employees’ pre-tax contribution and also contributes an amount equal to 2% of each employee’s annual compensation. Deferral amounts in excess of the qualified plan limitations, as well as Group contributions on such compensation, are funded into nonqualified plans benefiting affected individuals. The cost for these benefits was $591, $628 and $628 for 2010, 2009 and 2008, respectively. In addition, the Group may make a discretionary contribution each year, based on Group profitability, to both the qualified 401(k) plan, and, where applicable, to the nonqualified plans. The cost for this portion of the retirement plan was $0, $0 and $492 for 2010, 2009 and 2008, respectively.
The Group also maintains nonqualified deferred compensation plans for its directors and officers. Under the plans, participants may elect to defer receipt of all or a portion of their fees or salary or bonus amounts, but without any match by the Group. Amounts deferred by directors and officers, together with accumulated earnings, are distributed either as a lump sum or in installments over a period of not greater than ten years. Deferred compensation, including accumulated earnings, amounted to $2,005 and $1,764 at December 31, 2010 and 2009, respectively.
Actual income tax expense differed from expected tax expense, computed by applying the United States federal corporate income tax rate of 34% to income before income taxes, as follows:
Amortization expense for intangible assets subject to amortization was $47, $114, and $73, in 2010, 2009 and 2008, respectively. Estimated amortization expense for 2010 and future years is as follows:
The Group carries goodwill on its balance sheet in connection with the acquisitions of FIC and FPIG. There was no change in the carrying amount of goodwill for these acquisitions for the years ended December 31, 2010 and 2009, with $5,416 carried as of each of those dates.
Compensation remaining to be recognized for unvested restricted stock at December 31, 2010 (millions)
Information regarding stock option activity in the Plan in 2009 is presented below:
Compensation remaining to be recognized for unvested stock options at December 31, 2008 (millions)
Compensation remaining to be recognized for unvested restricted stock at December 31, 2009 (millions)
The Group becomes involved with certain claims and legal actions arising in the ordinary course of business operations. Such legal actions involve disputes by policyholders relating to claims payments as well as other litigation. In addition, the Group’s business practices are regularly subject to review by various state insurance regulatory authorities. These reviews may result in changes or clarifications of the Group’s business practices, and may result in fines, penalties or other sanctions. In the opinion of management, while the ultimate outcome of these actions and these regulatory proceedings cannot be determined at this time, they are not expected to result in net liability for amounts material to the financial condition, results of operations, or liquidity, of the Group.
The Group is party to a consolidated lawsuit associated with the Merger Agreement. The lawsuit alleged that Mercer’s board of directors breached their fiduciary duties, that United Fire aided and abetted such breaches of fiduciary duty and that the proxy statement issued in connection with the Merger Agreement contained deficiencies in disclosure of information relating to the merger. The Group and the other defendants vigorously denied the allegations. Under the terms of a memorandum of understanding executed with the plaintiffs, the Group expects to settle the lawsuit, including the payment of plaintiffs’ counsel fees. Such fees will either be agreed upon by the parties or determined via the Superior Court of New Jersey of Mercer County, Chancery Division, subject to the terms of the memorandum of understanding. The Group carries directors and officers liability insurance, that provides a primary liability limit of $5 million, which includes defense costs, subject to a $250 thousand deductible. It is expected that the settlement of plaintiffs’ counsel fees associated with this lawsuit will be within the limits of liability provided by the directors’ and officers’ liability insurance.
Rental expenses of $74, $414, and $422 were incurred for the years ended December 31, 2010, 2009, and 2008, respectively.
Van Rensselaer, Ltd., which is owned by William V.R. Fogler, a director, has provided equities investment management services to the Group since the year 1980. Fees to Van Rensselaer, Ltd. amounted to $79, $79 and $124 in 2010, 2009 and 2008, respectively.
Thomas, Thomas & Hafer of Harrisburg, PA is a law firm the Group uses for claims handling assistance. The brother of the Chief Executive Officer of the Group is a partner of the firm. Fees to Thomas, Thomas & Hafer amounted to $32, $56 and $77 in 2010, 2009 and 2008, respectively.
Financial Pacific Statutory Trust III (Trust III) is a Delaware statutory business trust. The Trust issued 7,500 shares of the Trust preferred securities at a price of $1 per share for $7,500. The Trust purchased $7,740 in Junior Subordinated Debentures from the Group that mature on September 30, 2033. The annual effective rate of interest at December 31, 2010 is 8.89%.
The Group had the following interest rate swaps outstanding as of December 31, 2010:
The Group has interest-rate related hedging instruments to manage its exposure on its debt instruments. The type of hedging instruments utilized by the Group are interest rate swap agreements (swaps). Interest differentials to be paid or received because of swap agreements are reflected as interest expense in the consolidated statement of earnings, and changes in the fair value of the swap over the swap period and are recorded as realized gains or losses. By using hedging financial instruments to hedge exposures to changes in interest rates, the Group exposes itself to market risk. The estimated fair value of the interest rate swaps is based on the valuation received from the financial institution counterparty.
As of December 31, 2010 and 2009 the Group was party to interest-rate swap agreements with an aggregate notional principal amount of $15,500. For the year ended December 31, 2010 and 2009, the Group recognized the change in the estimated fair value of the interest rate swap agreements which is recognized in the consolidated statement of earnings as a realized gain or (loss) of $(106) and $519, respectively. The estimated fair value of the interest-rate swap was a liability of $1,466 and $1,360 as of December 31, 2010 and 2009, respectively.
A summary of the fair values of interest rate swaps outstanding as of December 31, 2010 and 2009 follows:
A summary of the effect of derivative instruments on the consolidated statements of earnings for the years ended December 31, 2010, 2009, and 2008:
Level 1 - Valuations based on unadjusted quoted market prices in active markets for identical assets that the Group has the ability to access. Since the valuations are based on quoted prices that are readily and regularly available in an active market, valuation of these securities does not entail a significant amount or degree of judgment.
Level 3 - Valuations that are derived from techniques in which one or more of the significant inputs are unobservable, including broker quotes which are non-binding.
The fair value estimates of most fixed maturity investments are based on observable market information rather than market quotes. Accordingly, the estimates of fair value for such fixed maturities, other than U.S. Treasury securities, provided by the pricing service are included in the amount disclosed in Level 2 of the hierarchy. The estimated fair values of U.S. Treasury securities are included in the amount disclosed in Level 1 as the estimates are based on unadjusted market prices. The Group determined that Level 2 securities would include corporate bonds, mortgage backed securities, municipal bonds, asset-backed securities, certain U.S. government agencies, non-U.S. government securities, certain short-term securities and investments in mutual funds.
Securities are generally assigned to Level 3 in cases where non-binding broker/dealer quotes are significant inputs to the valuation and there is a lack of transparency as to whether these quotes are based on information that is observable in the marketplace. The Group’s Level 3 securities consist of three holdings totaling $1.5 million, or less than 0.37% of the Group’s total investment portfolio. These three securities were valued primarily through the use of non-binding broker quotes.
The balances of each component of accumulated other comprehensive income at December 31 are as follows:
The Group accepts various forms of collateral for issuance of its surety bonds including cash, irrevocable letters of credit and certificates of deposit. The Group’s policy is to record in the accompanying consolidated financial statements only those funds received as cash deposits. The off-balance sheet collateral held by the Group consists solely of irrevocable letters of credit totaling $128 and $138 as of December 31, 2010 and 2009, respectively.