(a) Net Realized Investment Gains (Losses) in 2007, 2006, 2005, 2004, 2003 and 2002 include the effect of SFAS 133 adjustments of $0.2 million, $1.0 million, $0.4 million, $0.8 million, $0.8 million, and $(0.2) million, respectively.
(d) The Company adopted SFAS 123(R) in 2005 which resulted in stock option expense of $3.0 million, $2.5 million and $1.9 million in 2007, 2006 and 2005, respectively. Net income (after tax) was reduced by $2.0 million, $1.6 million and $1.2 million, or $0.10, $0.08 and $0.06 per share (diluted and basic), in 2007, 2006 and 2005, respectively. Prior year results were not restated.
Our residential property segment includes primarily manufactured housing and site-built dwelling insurance products. Approximately 36% of American Modern’s property and casualty and credit life gross written premium relates to physical damage insurance and related coverages on manufactured homes, generally written for a term of 12 months with many coverages similar to homeowner’s insurance policies. Our recreational casualty segment includes specialty insurance products such as motorcycle, watercraft, recreational vehicle, collector car and snowmobile. Our financial institutions segment includes specialty insurance products such as mortgage fire, collateral protection and debt cancellation, which are sold to financial service institutions or their customers. The all other insurance segment includes products such as credit life, long-haul truck physical damage, commercial, excess and surplus lines and also includes the results of our fee producing subsidiaries.
Our specialty insurance operations are conducted through our wholly-owned American Modern subsidiary which controls eight property and casualty insurance companies, seven credit life insurance companies, three licensed insurance agencies and three service companies. American Modern is licensed, through its subsidiaries, to write insurance premiums in all 50 states and the District of Columbia.
On February 15, 2008, The Midland Company, an Ohio corporation (“Midland” or the “Company”) entered into a Stock Purchase Agreement (“Agreement”) with M/G Transport Holdings LLC, a Delaware limited liability company and affiliate of Brooklyn NY Holdings LLC (the “Buyer”) pursuant to which the Company agreed to sell all of its shares of capital stock of M/G Transport Services, Inc., an Ohio corporation (“M/G Transport”) and MGT Services, Inc., an Ohio corporation (“M/G Services,” and collectively with M/G Transport, the “Barge Companies”). Pursuant to this Stock Purchase Agreement the Barge Companies would be sold to Buyer for an aggregate purchase price of approximately $112.8 million, subject to a working capital adjustment. The transactions contemplated by the Agreement are conditional upon the consummation of the transactions contemplated by the Agreement and Plan of Merger among Midland, Munich-American Holding Corporation and Monument Corporation dated October 16, 2007 which are expected to occur in April 2008, clearance under the Hart-Scott-Rodino Antitrust Improvements Act, as well as other customary closing conditions.
American Modern’s catastrophe reinsurance program is a significant aspect of our exposure management. Our 2007 catastrophe reinsurance program was similar to the 2006 structure, but includes an additional $50 million layer of protection on top of our previous $150 million cover. In addition, in August we added an additional $50 million layer of protection on top of our $200 million coverage in place for 2007. This increase, along with the additional cover, adversely impacted our 2007 pre-tax earnings by approximately $9.0 million, or $0.29 per share (diluted). We have already begun efforts to recoup these costs through appropriate rate increases, commission adjustments and/or product changes. However, this is a process that takes some time, including additional time after state approvals to get the new rates and product changes into place within the renewal book and earned premium.
RESULTS OF OPERATIONS YEAR ENDED DECEMBER 31, 2007 COMPARED TO YEAR ENDED DECEMBER 31, 2006
The following chart is an overview of the results of operations of the Company’s residential property segment (in 000’s).
The following chart is an overview of the results of operations of the Company’s recreational casualty segment (in 000’s).
Income before taxes decreased due to the decrease in underwriting profit from our motorcycle product. Our motorcycle product combined ratio increased to 111.7% in 2007 compared to 93.4% in 2006. The increase is due primarily to an increase in claims frequency related to specific classes of risks. The Company has implemented rate increases and other corrective underwriting actions to address the increases in losses.
The following chart is an overview of the results of operations of the Company’s financial institutions insurance segment (in 000’s).
The increase in direct and assumed written premiums for our financial institutions insurance products was driven primarily by the mortgage fire and collateral protection products which increased $82.3 million and $29.7 million, respectively, compared to the prior year. The increase in mortgage fire and collateral protection premiums is due to the continued growth of several larger accounts throughout the year. Income increased for our financial institutions insurance products due to the profits generated from the increased written premiums.
Although net investment income is allocated to segments and product lines, the investment portfolio is generally managed as a whole and therefore is more meaningfully discussed in total. Net investment income increased to $47.4 million in 2007 from $42.2 million in 2006. This increase was due primarily to an increase in investment yield combined with an increase in invested assets, which increased $66.4 million to $1,097.8 million at December 31, 2007 from $1,031.4 million at December 31, 2006. The annualized pre-tax equivalent investment yield, on a cost basis, of the Company’s fixed income portfolio was 6.0% in 2007 compared to 5.9% in 2006.
Overall, American Modern’s losses and loss adjustment expenses increased 6.9% in 2007 to $328.9 million from $307.5 million in 2006. The increase was due primarily to the related 12.4% increase in earned premiums in 2007 compared to 2006 offset by slight decreases in loss ratios related to the decrease in catastrophe losses during 2007. American Modern’s property & casualty loss ratios decreased to 43.4% in 2007 from 45.5% in 2006.
The manufactured housing combined ratio, including catastrophe losses, increased slightly to 95.8% in 2006 compared to 94.4% in 2005. Excluding catastrophe losses for both years, the combined ratio was 86.3% in 2006 compared to 84.7% in 2005. The increase in combined ratio was due to the substantial increase in American Modern’s reinsurance program costs in 2006 compared to 2005 resulting from the significant hurricane activity in 2005. The site-built dwelling combined ratio improved to 97.6% in 2006 compared to 98.3% in 2005.
Although net investment income is allocated to segments and product lines, the investment portfolio is generally managed as a whole and therefore is more meaningfully discussed in total. Net investment income increased to $42.2 million in 2006 from $40.5 million in 2005. This increase was due primarily to an increase in investment yield combined with an increase in invested assets. The annualized pre-tax equivalent investment yield, on a cost basis, of the Company’s fixed income portfolio was 5.9% in 2006 compared to 5.5% in 2005.
M/G Transport, Midland’s transportation subsidiary, contributed $7.8 million of income, before taxes, in 2006 compared to $4.9 million in 2005. In addition, M/G Transport’s revenues increased to $49.8 million in 2006 compared to $42.2 million in 2005. The increases in transportation revenues and pre-tax income are due primarily to an improved freight rate environment.
We have certain obligations and commitments to make future payments under contracts. As of December 31, 2007, the aggregate obligations on a consolidated basis were as follows (amounts in 000’s):
The interest rates related to portions of the long-term debt in the above table are variable in nature and the interest payments included in the table have been calculated using the rates in effect at December 31, 2007.
Based on the above valuations and the consistent application of our other-than-temporary impairment policy criteria, which is more fully discussed in the Critical Accounting Policies section below, we believe the declines in fair value are temporary at December 31, 2007. However, the facts and circumstances related to these securities may change in future periods, which could result in “other-than-temporary” impairment in future periods.
The amounts expended for the development costs capitalized in connection with the development of modernLINK®, our proprietary information systems and web enablement initiative, amounted to $14.6 million in 2007 and a total of $54.9 million from inception in 2000 through December 31, 2007. The initiative is being designed, developed and implemented in periodic phases to ensure its cost effectiveness and functionality. This project may involve future cash expenditures in the range of $30 million to $35 million over the next four years, with additional spending thereafter to expand system compatibility and functionality. A portion of such expenditures will be capitalized and amortized over the useful life. However, actual costs may be more or less than what we estimate. The cost of the development and implementation is expected to be funded out of operating cash flow. Significant changes to the technology interface between American Modern and its distribution channel participants and policyholders, while unlikely, could significantly disrupt or alter our distribution channel relationships. If the new information systems are ultimately deemed ineffective, it could result in an impairment charge to our capitalized costs. The unamortized balance of modernLINK®’s software development costs was $41.5 million at December 31, 2007.
American Modern has a $72.0 million long-term credit facility available on a revolving basis at various rates. As of December 31, 2007, there was $36.0 million outstanding under these facilities.
The increase in reinsurance recoverables of $3.2 million at December 31, 2007 compared to 2006 is attributable primarily to the increased premium volume during 2007 offset by the decrease in recoverables from catastrophes. The prepaid reinsurance premiums remained relatively consistent between years.
Changes in net unrealized gains on marketable securities result from both market conditions and realized gains recognized in a reporting period. The interest rate swap agreement expired on December 1, 2005. While the interest rate swap agreement was in place, its after-tax fair value varied according to the current interest rate environment relative to the fixed rate of the swap agreement. Changes in the pension liability are actuarially determined based on the funded status of the plans and current actuarial assumptions.
Our loss reserves are comprised of two main components, case base loss reserves and incurred-but-not-reported loss reserves. Loss reserves include both loss and loss adjustment expense and are reported net of salvage and subrogation.
Trends or patterns noted in management’s regular discussions with internal and external consulting actuaries. We meet with our external actuary on a quarterly basis and have ongoing discussions as necessary. We also consider the summarized statistical results from previous meetings with our external actuary in refining our IBNR reserves.
Based on the factors considered above, management adjusts the recorded balance of loss reserves, as necessary, to reflect their best estimate, which is recorded in the financial statements. In considering whether any adjustments are necessary to the incurred-but-not-reported loss reserve, we contemplate our loss reserves in total.
We have considered the acceptable actuarial range. The range is based on a “reasonable best case” and “reasonable worst case” with varying development patterns across our lines of business.
With the benefit of hindsight, including one year of actual development patterns observed during 2007, our 2006 loss reserves were subsequently re-estimated to be $130.5 million. This produced a net cumulative redundancy, after one year of development, of $8.4 million due primarily to favorable loss reserve development related to its personal liability lines and motorcycle products.
Although we have experienced better than expected claim activity in 2004 and 2005, we believe that several of our lines of business (including excess and surplus lines and personal liability) may still experience additional development in the future because of the liability components that are underwritten.
The excess and surplus lines are newer lines of business to the Company. We began writing excess and surplus in 2002 and we therefore do not have a large amount of historical development data. Additionally, the excess and surplus lines contain a higher degree of liability risks and the reserving methodology is more dependent on longer term development patterns.
Essentially, in each of these lines we experienced more favorable development in 2007 than our historical development and baseline industry data would have indicated. The favorable development in 2007 was the result of a combination of redundant case base reserves, where claims were settled for less than the reserved amount, and lower non-catastrophe related frequency patterns than we have historically experienced. We estimate that redundant case base reserves accounted for approximately 40% of our favorable development with the remaining redundancy attributed primarily to the re-estimate of incurred-but-not-reported loss reserves, after an additional year of development. As discussed above, we believe this IBNR development was caused, in part, by lower non-catastrophe related frequency patterns than we have experienced historically, a higher level of case base redundancies, and favorable loss development in our newer lines of business. The case base redundancy was due in part to our response to the loss reserve deficiencies for the December 31, 2002 loss reserves that were ultimately discovered during 2003. Both our property and liability lines developed a deficiency in 2003. Collectively, the December 31, 2002 loss reserves developed a deficiency of approximately 10 percent, or $12 million, in 2003. This was due in part to the newer lines of business and the more volatile park and dealer liability lines, which we exited in 2001. In response to deficient development of reserves, management strengthened the company’s loss reserves to reflect these changing development trends arriving at a best estimate of how these losses would ultimately settle. The higher levels of loss reserves, and their potential redundancy, were not fully contemplated in the incurred-but-not-reported loss reserves, because our experience had not been validated over an appropriate period of time.
Historical loss reporting pattern is applied directly to the latest cumulative reported losses (paid plus case reserves) to estimate ultimate losses.
May inaccurately react to a change in the adequacy of case reserves.
Historical loss development growth will be consistent from year to year. Often an average growth development factor will be utilized.
Estimates of ultimate losses are independent of case reserve adequacy and are unaffected by changes in case reserving practices.
The nature of liability payment patterns requires the application of large development factors to relatively small payments in most immature years.
Principally used for liability lines. It is more applicable in middle maturity accident years. This model is also used if there has been a change in case reserving philosophies.
An estimate of the remaining reserves is divided by the number of open claims. These average claims costs are trended forward. From this average remaining claim cost we subtract the current average pending claim and then multiply the difference by the number of open claims. The result is a projection of IBNR.
Ultimate settlement of open claims is consistent with historical trends. Claims closing rates are consistent.
This method is less sensitive than the incurred loss development method to the volatility that is present in the reported losses in the early stages of development.
Principally used for liability lines of business, although it may also be used for property lines of business for high catastrophe periods and lines of business that are less mature.
In determining the appropriate models to utilize for our various lines of business, our consulting actuary considers the following factors:
IBNR loss reserves are approximately 25 percent of the net property and casualty loss reserves, while case base loss reserves represent approximately 75 percent of the net property and casualty reserve balance. The primary criteria that management considers in determining its best estimate for loss reserves includes trends and patterns in the actual claims settling process, historical development patterns, trends and patterns noted in regular discussion with internal and external actuaries, and changes in our business, product mix or our case base claims reserving process.
Based on the considerations noted above, and our historical loss reserve development patterns, we believe it is reasonably likely that our December 31, 2007 net property and casualty loss reserves will develop with a redundancy in the range of 5 percent to 15 percent, although it is possible that the actual development will be more or less. A chart outlining the after-tax earnings impact of reasonably likely redundancies is shown below. The potential earnings impact of the 2007 loss reserves redundancy on our 2008 after-tax earnings assumes no development, positive or negative, relative to the December 31, 2007 loss reserves.
2. To provide financial capacity to accept risks and policies involving amounts larger than could otherwise be accepted.
Excess of Loss per occurrence reinsurance requires the insurer to pay all claims up to a stated amount or retention limit on all losses arising from a single occurrence. The reinsurer pays claims in excess of the retention limits. The primary purpose of this reinsurance for American Modern is to protect the Company from the accumulation of losses arising from hurricanes or any other widespread weather related disaster. This reinsurance is also known as catastrophe reinsurance.
While the hurricane activity over the past couple of years has significantly increased the cost of obtaining reinsurance, our strong relationships with our reinsurers have allowed us to provide exposure management that is consistent with our overall risk management strategy. In addition, our strong relationships with our reinsurers and our disciplined overall exposure management philosophy, combined with the financial strength of these reinsurers (as of December 31, 2007, approximately 98% of the Company’s catastrophe reinsurers had an A.M. Best rating of “A-” or better), allow us to be confident that we will be able to effectively manage our exposures in the future.
If a reinsurer fails to honor its obligations, American Modern could suffer additional losses as the reinsurance contracts do not relieve American Modern of its obligations to policyholders. American Modern and its independent reinsurance broker regularly conduct “market security” evaluations of both its current and prospective reinsurers. Such evaluations include a complete review of each reinsurer’s financial condition along with an assessment of credit risk concentrations arising from similar geographic regions, activities or economic characteristics of the reinsurers to minimize its exposure to significant losses from reinsurer insolvencies. The specific evaluation procedures include, but are not limited to, reviewing the periodic financial statements and ratings assigned to each reinsurer from rating agencies such as S&P, Moody’s and A.M. Best.
In addition, American Modern may, in some cases, require reinsurers to establish trust funds and maintain letters of credit to further minimize possible exposures. All reinsurance amounts owed to American Modern are current and management believes that no allowance for uncollectible accounts related to this recoverable is necessary. Management also believes there is no significant concentration of credit risk arising from any single reinsurer. The Company also assumes a limited amount of business on certain reinsurance contracts. Related premiums and loss reserves are recorded based on records supplied by the ceding companies.
When a security is considered other-than-temporarily impaired, we monitor trends or circumstances that may impact other material investments in our portfolio. For example, we review any other securities that are held in the portfolio from the same issuer and also consider any circumstances that may impact other securities of issuers in the same industry. At December 31, 2007, we had no significant concentration of unrealized losses in any one issuer, industry or sector.
The investment portfolio is comprised of various asset classes which are independently managed by external professional portfolio managers under the oversight and guidelines established by our investment committee. We evaluate the performance of the portfolio managers relative to benchmarks we believe appropriate given the asset class. Investment managers will manage the portfolio under these guidelines to maximize the return on their investment class. As part of their investment strategy, the investment managers will buy and sell securities based on changes in the availability of, and the yield on, alternative investments. Investment managers may also buy and sell investments to diversify risk, attain a specific characteristic such as duration or credit quality, rebalance or reposition the portfolio or for a variety of other reasons.
It is our intent, and thus the intent of our investment managers, to hold securities that have an unrealized gain or loss. For the securities with an unrealized loss, which in our judgment we believe to be temporary, it is our intent to hold the security for a period of time that will allow the security to recover in value. While the Company has the ultimate authority regarding sales of securities, investment managers may sell certain securities and reinvest the proceeds if they believe returns would be enhanced by doing so, in which case the unrealized gain or loss will be recognized as a realized gain or loss. As part of our comprehensive quarterly review for other than temporary impairment, the Company asks investment managers to identify any securities in which they have the intent to sell in the near term. In the case where investment managers have indicated their intent to sell a security in the near term and there is an unrealized loss, we record an other-than-temporary impairment at the balance sheet date, if such date is prior to the sale of the security. At December 31, 2007, we had no securities with an unrealized loss for which a decision was made to sell in the near term.
In September 2006, the FASB issued Statement of Financial Accounting Standards No. 157, “Fair Value Measurements” (“SFAS 157”). This Standard defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007 and interim periods within those years. Two FASB Staff Positions on SFAS 157 were subsequently issued. On February 12, 2007, FSP No. 157-2 delayed the effective date of SFAS 157 for non-financial assets and non-financial liabilities that are recognized or disclosed at fair value in the financial statements on a nonrecurring basis. This FSP is effective for fiscal years beginning after November 15, 2008. On February 14, 2007, FSP No. 157-1 excluded FASB No. 13 Accounting for Leases and other accounting pronouncements that address fair value measurements for purposes of lease classification or measurement under FASB No. 13. However, this scope exception does not apply to assets acquired and liabilities assumed in a business combination that are required to be measured at fair value under FASB Statement No. 141, Business Combinations or FASB No. 141R, Business Combinations. This FSP is effective upon initial adoption of SFAS No. 157. The Company is assessing the impact that SFAS 157 will have on its consolidated financial statements.
In December 2007, the FASB issued SFAS No. 141(R), “Business Combinations,” (SFAS No. 141(R)”), which requires the Company to record fair value estimates of contingent consideration and certain other potential liabilities during the original purchase price allocation, expense acquisition costs as incurred and does not permit certain restructuring activities previously allowed under Emerging Issues Task Force Issue No. 95-3 to be recorded as a component of purchase accounting. This statement applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning after December 15, 2008, and early adoption is prohibited. The Company is assessing the impact that SFAS No. 141(R) will have on its consolidated financial statements.
In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements - an amendment of ARB No. 51,” (“SFAS No. 160”), which causes noncontrolling interest in subsidiaries to be included in the equity section of the balance sheet. The statement is effective for financial statements issued for fiscal years and interim periods within those fiscal years, beginning after December 15, 2008. The Company is assessing the impact that SFAS No. 160 will have on its consolidated financial statements.
As discussed in Note 1, the Company adopted the recognition and related disclosure provisions of Financial Accounting Standards Board Interpretation No. 48, Accounting for Uncertainty in Income Taxes - an Interpretation of FASB Statement No. 109, on January 1, 2007 and Statement of Financial Accounting Standards No. 158, Employers’ Accounting for Defined Benefit Pension Plan and Other Postretirement Benefit Plans - an amendment of FASB Statements No. 87, 88, 106, and 132(R), on December 31, 2006.
Treasury stock issued under the Company’s performance stock award plan amounted to $2,382, $1,978 and $1,155 for 2007, 2006 and 2005, respectively.
Property and Depreciation - Property, plant and equipment are recorded at cost. The Company periodically measures fixed assets for impairment. Depreciation and amortization are generally calculated over the estimated useful lives of the respective properties (buildings and equipment - 15 to 39 years, furniture and equipment - 3 to 7 years, software development - 4 to 10 years and barges - 23 years).
The Company has implemented several modules and is continuing the process of developing an information technology system for its insurance operations. The system is known as modernLINK® and its development began in 2000 and will continue over the next several years. Certain costs that are directly related to this system are capitalized. As components of the system are implemented and placed into service, depreciation commences using the straight-line method over periods ranging from four to ten years.
As a result of this acquisition, the Company recorded $3.2 million in goodwill and $1.7 million in other intangible assets. The other intangible assets will be amortized over periods ranging from five to fifteen years. Future amortization expense will equal (amounts in 000’s): $127 - 2008; $127 - 2009; $127 - 2010; $117 - 2011; $107 in 2012 and $949 - thereafter.
The Company files a consolidated federal income tax return which includes all subsidiaries except subsidiaries acquired in connection with the acquisition of Southern Pioneer Life Insurance Company in 2006. These entities file separate federal tax returns.
Insurance Loss Reserves - Unpaid insurance losses and loss adjustment expenses include an amount determined from reports on individual cases and an amount, based on past experience and other assumptions, for losses incurred but not reported. Such liabilities are necessarily based on estimates and, while management believes that the amounts are fairly stated, the ultimate liability may be in excess of or less than the amounts provided. The methods of making such estimates and for establishing the resulting liabilities are continually reviewed and any adjustments resulting there from are included in earnings currently. Insurance loss reserves also include an amount for claim drafts issued but not yet paid. In addition, insurance loss reserves are presented net of amounts recoverable from salvage and subrogation and include amounts recoverable from reinsurance for which receivables are recognized.
American Modern and its independent reinsurance brokers regularly conduct “market security” evaluations of both its current and prospective reinsurers. Such evaluations include a complete review of each reinsurer’s financial condition along with an assessment of credit risk concentrations arising from similar geographic regions, activities or economic characteristics of the reinsurers to minimize its exposure to significant losses from reinsurer insolvencies. The specific evaluation procedures include, but are not limited to, reviewing the periodic financial statements and ratings assigned to each reinsurer from rating agencies such as S&P, Moody’s and A.M. Best. During 2007, approximately 98% of the Company’s catastrophe reinsurers had an A.M. Best or S&P rating of “A-” or higher.
In addition, American Modern may, in some cases, require reinsurers to establish trust funds and maintain letters of credit to further minimize possible exposures. All reinsurance amounts owed to American Modern are current and management believes that no allowance for uncollectible accounts related to this recoverable is necessary. Management also believes there is no significant concentration of credit risk arising from any single reinsurer.
Transportation Revenues - Revenues for river transportation activities are recognized when earned. If freight services are in process at the end of a reporting period, an allocation of revenue between reporting periods is made based on relative transit time in each reporting period with expenses recognized as incurred. (See Note 19)
Derivative Instruments - The Company accounts for its derivatives under Statement of Financial Accounting Standards (“SFAS”) 133, Accounting for Derivative Instruments and Hedging Activities, as amended. The standard requires recognition of all derivatives as either assets or liabilities in the balance sheet and requires measurement of those instruments at fair value through adjustments to either accumulated other comprehensive income or current earnings or both, as appropriate. During 2002, the Company entered into a series of interest rate swaps to convert $30 million of floating rate debt to a fixed rate. The interest rate swaps were designated as a cash flow hedge and were deemed to be 100% effective. Thus, the changes in the fair value of the swap agreements are recorded as a separate component of shareholders’ equity and have no impact on the Consolidated Statements of Income. The interest rate swap agreements ended during 2005 and, therefore, no balances were outstanding related to these derivatives at December 31, 2007 or 2006. In addition, the company held certain investment with embedded derivative features, these are described more fully in Note 2.
New Accounting Standards - In September 2006, the FASB issued Statement of Financial Accounting Standards No. 157, Fair Value Measurements (“SFAS 157”). This Standard defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007 and interim periods within those years. Two FASB Staff Positions on SFAS 157 were subsequently issued. On February 12, 2007, FSP No. 157-2 delayed the effective date of SFAS 157 for non-financial assets and non-financial liabilities that are recognized or disclosed at fair value in the financial statements on a nonrecurring basis. This FSP is effective for fiscal years beginning after November 15, 2008. On February 14, 2007, FSP No. 157-1 excluded FASB No. 13 Accounting for Leases and other accounting pronouncements that address fair value measurements for purposes of lease classification or measurement under FASB No. 13. However, this scope exception does not apply to assets acquired and liabilities assumed in a business combination that are required to be measured at fair value under FASB Statement No. 141, Business Combinations or FASB No. 141R, Business Combinations. This FSP is effective upon initial adoption of SFAS No. 157. The Company is assessing the impact that SFAS 157 will have on its consolidated financial statements.
In February 2007, the FASB issued Statement of Financial Accounting Standards No. 159, The Fair Value Option for Financial Assets and Financial Liabilities (“SFAS 159”). This Standard allows the valuation of certain financial assets and liabilities to be measured at fair value. SFAS 159 is effective for financial statements issued for fiscal years beginning after November 15, 2007 and interim periods within those years. The Company is assessing the impact that SFAS 159 will have on its consolidated financial statements.
In May 2007, the FASB issued FASB Staff Position No. FIN 48-1, Definition of Settlement in FASB Interpretation No. 48 (FSP FIN 48-1). This FSP amends FASB Interpretation No. 48 to provide guidance on how an enterprise should determine whether a tax position is effectively settled for the purpose of recognizing previously unrecognized tax benefits. The interpretation is effective upon initial adoption of FIN 48. As the Company had applied Interpretation 48 in a manner consistent with the provisions of this FSP there was no impact of this new pronouncement on its consolidated financial statements.
In December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in Consolidated Financial Statements - an amendment of ARB No. 51, (“SFAS No. 160”), which causes noncontrolling interest in subsidiaries to be included in the equity section of the balance sheet. The statement is effective for financial statements issued for fiscal years and interim periods within those fiscal years, beginning after December 15, 2008. The Company is assessing the impact that SFAS No. 160 will have on its consolidated financial statements.
At December 31, 2007 and 2006, the fair value of the Company’s investment in the common stock of US Bancorp, which exceeded 10% of the Company’s shareholders’ equity, was $76.1 million and $88.8 million, respectively. Also, at December 31, 2007 and 2006, the market value of the Company’s investment portfolio includes approximately $12.0 million and $24.2 million, respectively, of convertible securities, some of which contain derivatives features.
Included in Net Realized Investment Gains (Losses) for 2007, 2006 and 2005 is the change in the fair value of derivative features of (amounts in 000’s) $160, $1,041, and $392 respectively.
The cost or amortized cost and approximate fair value of debt securities held at December 31, 2007, summarized by contractual maturities, are shown below. Actual maturities may differ from contractual maturities when there exists a right to call or prepay obligations with or without call or prepayment penalties (amounts in 000’s).
The Company’s fixed income portfolio primarily consists of high quality investment grade securities and has an “AA” Standard & Poor’s average quality rating at December 31, 2007. The Company performs quarterly comprehensive reviews of individual fixed income and equity portfolio holdings that have a market value less than their respective carrying value. The Company, with the assistance of its external professional money managers, applies both quantitative and qualitative criteria in its evaluation of possible other-than-temporary impairment, including facts specific to each individual investment, including, but not limited to, the length of time the fair value has been below carrying value, the extent of the decline, the Company’s intent to hold or sell the security, the expectation for each security’s performance as well as prospects for recovery, the credit worthiness and related liquidity of the issuer and the issuer’s business sector.
The following table shows the Company’s investments’ gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at December 31, 2007 and 2006 (amounts in 000’s):
At December 31, 2007 and 2006, the Company had outstanding receivables, all of which were current, from one of its customers of $21.8 million and $20.0 million, respectively.
At December 31, 2007 and 2006, property, plant and equipment stated at original cost less accumulated depreciation and amortization consist of the following (amounts in 000’s):
Included in Software Development in the above table is $32.5 million and $25.6 million of construction in progress for 2007 and 2006, respectively, related to the development of modernLINK, the Company’s proprietary information systems and web enablement initiative. The construction in progress amount includes $3.5 million and $1.9 million of capitalized interest for 2007 and 2006, respectively. As of December 31, 2007 and 2006, the unamortized balance of modernLINK’s software development costs was $41.5 million and $28.3 million, respectively.
Depreciation expense recorded in 2007, 2006 and 2005 was (amounts in 000’s): $9,321, $8,978, and $10,250, respectively. Included in the amounts are $1,963, $1,979, and $2,473 of depreciation expense related to discontinued operations (See Note 19).
Acquisition costs capitalized during 2007, 2006, and 2005 amounted to $213.3 million, $178.2 million, and $164.0 million, respectively. Amortization of deferred acquisition costs was $201.0 million, $167.3 million, and $166.1 million for 2007, 2006, and 2005, respectively.
The aggregate amount of repayment requirements on long-term debt for the five years subsequent to 2007 are (amounts in 000’s): 2008 - $14,390; 2009 - $562; 2010 - $36,593; 2011 and thereafter - $8,045.
The provision for federal income tax is summarized as follows (amounts in 000’s):
The Company recognizes interest and penalties accrued related to unrecognized tax benefits as a part of income tax expense. During the year ended December 31, 2007, the Company recognized approximately $15,000 in interest and penalties expense, net of the federal tax benefit, and also recognized interest income, net of tax, of $177,000 attributable primarily to statue expirations for unrecognized tax benefits. The Company had accrued approximately $609,000 and $770,000 for interest and penalties at December 31, 2007, and January 1, 2007, respectively included in other payables and accruals.
The federal income tax provision for the years ended December 31, 2007, 2006, and 2005 is different from amounts derived by applying the statutory tax rates to income before federal income tax as follows (amounts in 000’s):
The net earned premium for the property and casualty group for 2007, 2006, and 2005 was $739,080, $659,379, and $621,230, respectively.
The amounts of recoveries pertaining to property and casualty reinsurance contracts that were deducted from losses incurred during 2007, 2006, and 2005 were (amounts in 000’s): $37,823, $30,722, and $189,407, respectively.
In 2005 incurred losses related to prior years benefited from claims settling in 2005 for less than the case base reserve amounts that were estimated at the end of the previous respective years.
Loss reserves, net of reinsurance, for Life and Other totaled $6.7 million, $7.4 million, and $6.0 million at December 31, 2007, 2006, and 2005 respectively.
The Company has a qualified 401(k) savings plan, a funded non-qualified savings plan and a funded non-qualified self-directed retirement plan. The Company contributed (amounts in 000’s) $1,384, $1,412, and $1,256 to the qualified 401(k) savings plan and $156, $202, and $250 to the non-qualified savings plan for the years 2007, 2006, and 2005, respectively. The Company also has an unfunded non-qualified defined benefit pension plan.
At December 31, 2007, the actuarial loss and prior service cost recognized in accumulated other comprehensive income and not yet recognized as a component of net periodic benefit cost consist of (in 000’s) $6,740 and $242, respectively.
The Company’s qualified defined benefit pension plan had projected benefit obligations, accumulated benefit obligations and fair value of plan assets amounting to (in 000’s) $29,843, $25,432 and $23,645 in 2007 and $30,726, $25,334 and $21,771 in 2006, respectively. The Company’s non-qualified defined benefit plan had projected benefit obligations, accumulated benefit obligations and fair value of plan assets amounting to (in 000’s) $2,052, $1,770 and $0 in 2007 and $1,686, $1,763 and $0 in 2006, respectively.
The Company made a cash contribution of $1.5 million in 2007 which exceeded its required cash contribution of $0.6 million. The Company’s expected pension benefit payments, which reflect expected future service, for the next ten years are as follows (amounts in 000’s): 2008 - $1,329; 2009 - $1,372; 2010 - $1,420; 2011 - $1,512; 2012 - $1,710; 2013 through 2017 - $11,230.
In September 2006, the FASB issued Statement of Financial Accounting Standards No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans - an amendment of FASB Statement No. 87, 88, 106 and 132(R)” (“SFAS 158”). This Standard requires recognition of the funded status of a benefit plan in the statement of financial position. The following table illustrates the incremental effect of applying SFAS 158 on individual line items on the Consolidated Balance Sheet at December 31, 2006 (amounts in 000’s):
Midland’s equity compensation plans include plans for performance shares and non-qualified stock options.
In 2000, the Company established a performance stock award program. Under this program, shares vest after a three-year performance measurement period and will only be awarded if pre-established performance levels have been achieved. Shares are awarded at no cost and the recipient must have been employed throughout the entire three-year performance period. In 2007, 55,000 shares were issued under this program, 46,000 shares have been earned and are scheduled for distribution in 2008, and a maximum of 82,000 and 69,000 shares could potentially be issued in 2009 and 2010, respectively, related to this program. The expected fair value of these awards is charged to compensation expense over the performance period. Compensation expense for 2007, 2006 and 2005 amounted to (amounts in 000’s) $4,149, $3,085, and $2,215, respectively.
At December 31, 2007, options exercisable have exercise prices between $11.38 and $44.11 and an average contractual life of approximately 4.74 years.
During the fourth quarter of 2005, the Company elected to early adopt SFAS 123 (Revised 2004), Share-Based Payment (“SFAS 123(R)”) under the modified retrospective approach, restating only prior interim periods in fiscal 2005. The Company recognized $3.0 million, $2.5 million and $1.9 million of expense in 2007, 2006 and 2005, respectively, related to its stock option program.
Various litigation and claims against the Company and its subsidiaries are in process and pending. Based upon a review of open matters with legal counsel, management believes that the outcome of such matters will not have a material effect upon the Company’s consolidated financial position, results of operations or cash flows. The Company also has credit exposure with customers, generally in the form of premiums receivable. Management monitors these exposures on a regular basis. However, as collectibility of such receivables is dependent upon the financial stability of the customers, the Company cannot assure collections in full. Where appropriate, the Company has provided a reserve for such exposures.
The insurance subsidiaries are subject to state regulations which limit by reference to statutory net income and policyholders’ surplus the dividends that can be paid to their parent company without prior regulatory approval. Dividend restrictions vary between the companies as determined by the laws of the domiciliary states. Under these restrictions, the maximum dividends that may be paid by the insurance subsidiaries in 2008 without regulatory approval total (amounts in 000’s): $58,833; such subsidiaries paid cash dividends of $43,396 in 2007, $13,835 in 2006 and $23,030 in 2005.
The Company has a commercial paper program under which qualified purchasers may invest in the short-term unsecured notes of Midland. Many of the investors in this program are executive officers and directors of the Company. Total commercial paper debt outstanding at December 31, 2007 and 2006 was $8.3 million and $7.9 million, respectively, of which $6.9 million and $6.6 million at those respective dates represented notes held either directly or indirectly by the executive officers and directors of the Company. The effective annual yield paid to all participants in this program was 4.9% as of December 31, 2007, a rate that is considered to be competitive with the market rate for similar instruments.
insurance and related coverages on manufactured homes, generally written for a term of 12 months with many coverages similar to homeowner’s insurance policies. The recreational casualty segment includes specialty insurance products such as motorcycle, watercraft, recreational vehicle, collector car and snowmobile. The financial institutions segment includes specialty insurance products such as mortgage fire, collateral protection and debt cancellation, which are sold to financial institutions or their customers. The all other insurance segment includes products such as credit life, long-haul truck physical damage, commercial, excess and surplus lines and also includes the results of our fee producing subsidiaries.
The Company writes insurance throughout the United States with larger concentrations in the southern and southeastern states. Transportation includes barge chartering and freight brokerage operations primarily on the lower Mississippi River and its tributaries. Transportation has been classified as discontinued operations for all periods presented. (See Note 19.)
Listed below is financial information required to be reported for each industry segment. The accounting policies used for segment reporting are the same as the accounting policies for the consolidated financial statements. Certain amounts are allocated and certain amounts are not allocated (e.g., assets and investment gains) to each segment for management review. Operating segment information based upon how it is reviewed by the chief operating decision maker, the Company’s President and Chief Executive Officer, is as follows for the years ended December 31, 2007, 2006 and 2005 (amounts in 000’s):
The amounts shown for residential property, recreational casualty, financial institutions, all other insurance and unallocated insurance comprise the consolidated amounts for Midland’s insurance operations subsidiary, American Modern Insurance Group, Inc. Intersegment revenues were not significant for 2007, 2006, or 2005.
On October 16, 2007, the Company entered into a Definitive Merger Agreement (the “Merger”) with certain affiliates of the Munich Re Group. In connection with the Merger, the Company began a plan to sell the Company’s transportation subsidiary. As a result, transportation assets and liabilities are classified as held for sale and the operations of the Transport business are classified as discontinued operations for all periods presented.
The transactions contemplated by the Agreement are conditional upon the consummation of the transactions contemplated by the Agreement and Plan of Merger among Midland, Munich-American Holding Corporation and Monument Corporation dated October 16, 2007 which are expected to occur in the first half of 2008, clearance under the Hart-Scott-Rodino Antitrust Improvements Act, as well as other customary closing conditions.
The operating results of discontinued operations included in the accompanying consolidated statements of income are as follows: (amounts in 000’s)
The components of assets and liabilities held for sale at December 31, 2007 and 2006 are as follows: (amounts in 000’s)