The Company's four property and casualty insurance subsidiaries and two subsidiaries and an affiliate of Employers Mutual are parties to reinsurance pooling agreements with Employers Mutual (collectively the "pooling agreement"). Under the terms of the pooling agreement, each company cedes to Employers Mutual all of its insurance business, with the exception of any voluntary reinsurance business assumed from nonaffiliated insurance companies, and assumes from Employers Mutual an amount equal to its participation in the pool. All premiums, losses, settlement expenses and other underwriting and administrative expenses, excluding the voluntary reinsurance business assumed by Employers Mutual from nonaffiliated insurance companies, are prorated among the parties on the basis of participation in the pool. Employers Mutual negotiates reinsurance agreements that provide protection to the pool and each of its participants, including protection against losses arising from catastrophic events.
Effective January 1, 2005, the Company's aggregate participation in the pooling agreement increased from 23.5 percent to 30.0 percent. In connection with this change in the pooling agreement, the Company's liabilities increased $115,042,000, invested assets increased $107,801,000 and other assets increased $722,000. The Company reimbursed Employers Mutual $6,519,000 for expenses that were incurred to generate the additional business assumed by the Company, but this expense was offset by an increase in deferred policy acquisition costs. The Company also received $275,000 in interest income from Employers Mutual as the actual cash settlement did not occur until February 15, 2005.
The Company's reinsurance subsidiary assumes a 100 percent quota share portion of Employers Mutual's assumed reinsurance business, exclusive of certain reinsurance contracts. This includes all premiums and related losses, settlement expenses, and other underwriting and administrative expenses of this business, subject to a maximum loss of $1,500,000 per event. The reinsurance subsidiary does not directly reinsure any of the insurance business written by Employers Mutual; however, the reinsurance subsidiary assumes reinsurance business from the Mutual Reinsurance Bureau (MRB) pool and this pool provides a very small amount of reinsurance protection to the EMC Insurance Companies. As a result, the reinsurance subsidiary's assumed exposures include a very small portion of the EMC Insurance Companies' direct business, after ceded reinsurance protections purchased by the MRB pool are applied. In addition, the reinsurance subsidiary does not reinsure any "involuntary" facility or pool business that Employers Mutual assumes pursuant to state law. Operations of the quota share agreement give rise to inter- company balances with Employers Mutual, which are settled on a quarterly basis. The investment and income tax activities of the reinsurance subsidiary are not subject to the quota share agreement.
In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation of the interim financial statements have been included. The results of operations for the interim periods reported are not necessarily indicative of results to be expected for the year.
In addition to an ongoing review of claim files in the normal course of business, the Company has for many years required each of its 16 branch offices to perform a complete inventory of its open claim files during the fourth quarter of each year and to review the adequacy of each carried reserve based on current information. This fourth quarter review process has not historically resulted in a significant increase in carried reserves; however, because of heightened emphasis placed on case reserve adequacy during 2004, the review performed in the fourth quarter of 2004 generated a significant and unanticipated increase in carried reserves and a corresponding increase in settlement expense reserves. In an effort to minimize the likelihood of this occurring in the future, beginning in 2005 the branch offices are required to perform a complete inventory and review of their open claim files semi- annually rather than annually as previously required. The first review is to be completed by the end of May and the second review is to be completed by the end of November each year. This new procedure is designed to help assure that necessary reserve adjustments are implemented on a timely basis.
Catastrophe and storm losses ......................... $ 861 $ 145 ======== ========
Loss and settlement expense ratio .................... 62.0% 61.1% Acquisition expense ratio ............................ 32.6 32.7 -------- -------- Combined ratio ....................................... 94.6% 93.8% ======== ========
Catastrophe and storm losses ......................... $ 2,625 $ 1,015 ======== ========
Premiums earned increased 21.4 percent to $101,294,000 in the first quarter of 2005 from $83,458,000 in the first quarter of 2004. This increase is primarily attributed to the Company's increased participation in the pooling agreement, but also reflects the impact of rate increases that were implemented during 2004. On an overall basis, rate competition increased moderately in the property and casualty insurance marketplace during the first quarter of 2005. However, there were indications of more intense rate competition in select territories and lines of business, and the Company expects market conditions to remain competitive for the remainder of the year. The Company will continue to implement rate increases in those lines of business and/or territories where such action is warranted, but the overall level of these rate increases is expected to be smaller than those implemented during 2004.
Premiums earned for the property and casualty insurance segment increased 29.9 percent to $79,718,000 in the first quarter of 2005 from $61,360,000 in the first quarter of 2004, primarily as a result of the change in the pooling agreement. To better understand the first quarter results, it is helpful to look at the net pool numbers, which are not impacted by the pool change. Comparing first quarter 2005 to first quarter 2004, net premiums earned increased 2.9 percent as a result of rate increases implemented during the last two years. Premium rate levels for most lines of business were considered to be at, or near, adequate levels at the end of 2002. Accordingly, progressively smaller and more targeted rate increases were implemented during 2003 and 2004 and the first quarter of 2005. This fine tuning of the Company's rate structure has been directed toward specific accounts, territories and lines of business where additional rate increases were warranted. Due to the timing of policy renewals and the earning of premiums ratably over the terms of the underlying policies, a time delay exists for implemented rate increases to have a noticeable impact on premiums earned.
As previously reported, the board of directors of the MRB pool, of which Employers Mutual is a member, has authorized management to pursue the addition of one or two new assuming companies to the pool. No action was taken during the first quarter of 2005 and the earliest that a new member could begin participating in the pool would therefore be January 2006. If additional assuming companies are added to the pool, Employers Mutual's participation will be reduced and the reinsurance segment's premium volume will decline in the short-term; however, this action will strengthen MRB's surplus base and should favorably impact their ability to attract new business.
The loss and settlement expense ratio for the property and casualty insurance segment decreased slightly to 59.1 percent in the first quarter of 2005 from 59.3 percent in the first quarter of 2004. An increase in the amount of favorable development experienced on prior years' reserves more than offset increases in claim severity and catastrophe and storm losses. The rise in claim severity in the first quarter of 2005 is generally attributed to the establishment of more adequate case reserves on current accident year losses. Overall loss frequency continued to trend downward in the first quarter of 2005; however, there are some signs that loss frequency may be leveling out, especially in the workers' compensation line of business.
Acquisition and other expenses increased 20.7 percent to $32,938,000 in the first quarter of 2005 from $27,283,000 in the first quarter of 2004. This increase is primarily attributed to the Company's increased participation in the pooling agreement. The expense ratio (acquisition and other expenses expressed as a percentage of premiums earned) decreased slightly to 32.6 percent in 2005 from 32.7 percent in 2004, primarily due to lower commission expenses in the reinsurance segment.
For the reinsurance segment, the expense ratio decreased to 25.8 percent in the first quarter of 2005 from 28.8 percent in the first quarter of 2004. This decrease is attributed to a decline in both commission and contingent commission expense reported by the MRB pool. The commission expense for 2004 includes $1,033,000 related to an increase in participation in the MRB pool from 25 percent to 33 percent; however, this expense was partially offset by an increase in the asset for deferred policy acquisition costs.
Income tax expense increased 1.7 percent to $4,082,000 in the first quarter of 2005 from $4,014,000 in the first quarter of 2004. The effective tax rate declined to 28.0 percent for the first quarter of 2005 from 32.5 percent for the same period of 2004. The decrease in the effective tax rate primarily reflects the Company's increased emphasis on tax-exempt securities.
Liquidity is a measure of a company's ability to generate sufficient cash to meet cash obligations as they come due. The Company generated positive cash flows from operations of $110,725,000 during the first quarter of 2005 compared to $4,332,000 for the first quarter of 2004. Included in cash flows from operations for the first quarter of 2005 is $107,801,000 received from Employers Mutual in connection with the change in the pooling agreement. Excluding this amount, cash flows from operations for the first quarter of 2005 amounted to $2,924,000. The Company typically generates substantial positive cash flows from operations because cash from premium payments is generally received in advance of cash payments made to settle claims. These positive cash flows provide the foundation of the Company's asset/liability management program and are the primary drivers of the Company's liquidity. When investing funds made available from operations, the Company invests in securities with maturities that approximate the anticipated payments of losses and settlement expenses of the underlying insurance policies. In addition, the Company maintains a portion of its investment portfolio in relatively short-term and highly liquid assets as a secondary source of liquidity should net cash flows from operating activities prove inadequate to fund current operating needs. As of March 31, 2005, the Company did not have any significant variations between the maturity dates of its investments and the expected payments of its loss and settlement expense reserves.
The Company maintains a portion of its investment portfolio in relatively short term and highly liquid investments to ensure the availability of funds to pay claims and expenses. The remainder of the investment portfolio, excluding investments in equity securities, is invested in securities with maturities that approximate the anticipated liabilities of the insurance written. At March 31, 2005, approximately 39 percent of the Company's fixed maturity securities were in U.S. government or U.S. government agency issued securities. A variety of maturities are maintained in the Company's portfolio to assure adequate liquidity. The maturity structure of the fixed maturity investments is also established by the relative attractiveness of yields on short, intermediate and long-term securities. The Company does not invest in high-yield, non-investment grade debt securities; however, an exception was made to this policy in 2004 when non-investment grade MCI debt securities were sold and then repurchased in order to recognize a current income tax benefit.
March 31, 2005 --------------------------------------------- Amortized Total at Carrying ($ in thousands) Cost Fair Value Fair Value Value --------- ---------- ---------- -------- Fixed maturities, held-to-maturity ........ $ 20,058 $ 21,020 2.3% $ 20,058 Fixed maturities, available-for-sale ...... 694,474 710,913 78.8% 710,913 Equity securities, available-for-sale ...... 60,571 79,855 8.8% 79,855 Cash ...................... 119 119 - 119 Short-term investments .... 85,339 85,339 9.5% 85,339 Other long-term investments ............. 5,542 5,542 0.6% 5,542 -------- -------- ----- -------- $866,103 $902,788 100.0% $901,826 ======== ======== ===== ========
December 31, 2004 --------------------------------------------- Amortized Total at Carrying ($ in thousands) Cost Fair Value Fair Value Value --------- ---------- ---------- -------- Fixed maturities, held-to-maturity ........ $ 29,206 $ 30,594 3.9% $ 29,206 Fixed maturities, available-for-sale ...... 595,791 619,654 79.4 619,654 Equity securities, available-for-sale ...... 59,589 78,693 10.1 78,693 Cash ...................... 61 61 - 61 Short-term investments .... 46,239 46,239 5.9 46,239 Other long-term investments ............. 5,550 5,550 0.7 5,550 -------- -------- ----- -------- $736,436 $780,791 100.0% $779,403 ======== ======== ===== ========
The amortized cost and estimated fair value of fixed maturity and equity securities at March 31, 2005 were as follows:
Held-to maturity ---------------------------------------------- Gross Gross Estimated Amortized unrealized unrealized fair ($ in thousands) cost gains losses value --------- ---------- ---------- --------- U.S. treasury securities and obligations of U.S. government corporations and agencies ............. $ 19,031 $ 877 $ - $ 19,908 Mortgage-backed securities 1,027 85 - 1,112 --------- ---------- ---------- --------- Total securities held-to-maturity ..... $ 20,058 $ 962 $ - $ 21,020 ========= ========== ========== =========
Available-for sale ---------------------------------------------- Gross Gross Estimated Amortized unrealized unrealized fair cost gains losses value --------- ---------- ---------- --------- U.S. treasury securities and obligations of U.S. government corporations and agencies ............. $ 273,088 $ 138 $ 1,037 $ 272,189 Obligations of states and political subdivisions ... 255,293 8,660 452 263,501 Mortgage-backed securities 10,893 588 - 11,481 Public utilities ........... 9,196 1,054 - 10,250 Debt securities issued by foreign governments ...... 7,145 149 - 7,294 Corporate securities ....... 138,859 8,094 754 146,199 ---------- ---------- ---------- --------- Total fixed maturity securities ........... 694,474 18,683 2,243 710,914 ---------- ---------- ---------- --------- Equity securities .......... 60,571 19,903 619 79,855 ---------- ---------- ---------- --------- Total securities available-for-sale $ 755,045 $ 38,586 $ 2,862 $ 790,769 ========== ========== ========== =========
The Company's insurance and reinsurance subsidiaries have $36,000,000 of surplus notes issued to Employer Mutual. These surplus notes have an annual interest rate of 3.09 percent and do not have a maturity date. Payment of interest and repayment of principal can only be made out of the applicable subsidiary's statutory surplus and is subject to prior approval by the insurance commissioner of the respective state of domicile. The surplus notes are subordinate and junior in right of payment to all obligations or liabilities of the applicable insurance subsidiaries. The Company's subsidiaries incurred $278,000 of interest expense on these surplus notes in the first quarter of 2005 and 2004. At December 31, 2004, the Company's subsidiaries had received approval for the payment of interest accrued on the surplus notes during 2004.
As of March 31, 2005, the Company had no material commitments for capital expenditures.
At March 31, 2005, the Company had unrealized losses on held-to-maturity and available-for-sale securities as presented in the table below. The estimated fair value is based on quoted market prices, where available, or on values obtained from independent pricing services. None of these securities are considered to be in concentrations by either security type or industry. The Company uses several factors to determine whether the carrying value of an individual security has been other-than-temporarily impaired. Such factors include, but are not limited to, the security's value and performance in the context of the overall markets, length of time and extent the security's fair value has been below carrying value, key corporate events and collateralization of fixed maturity securities. Based on these factors, and the Company's ability and intent to hold the fixed maturity securities until maturity, it was determined that the carrying value of these securities was not other-than-temporarily impaired at March 31, 2005. Risks and uncertainties inherent in the methodology utilized in this evaluation process include interest rate risk, equity price risk and the overall performance of the economy, all of which have the potential to adversely affect the value of the Company's investments. Should a determination be made at some point in the future that these unrealized losses are other-than-temporary, the Company's earnings would be reduced by approximately $1,860,000, net of tax; however, the Company's financial position would not be affected due to the fact that unrealized losses on available-for-sale securities are reflected in the Company's financial statements as a component of stockholders' equity, net of deferred taxes.
Following is a schedule of the length of time securities have continuously been in an unrealized loss position as of March 31, 2005.
Gross Book Sales realized ($ in thousands) value price loss --------- --------- --------- Equity securities: Three months or less ............... $ 6,212 $ 5,735 $ 477 Over three months to six months .... 342 283 59 Over six months to nine months ..... - - - Over nine months to twelve months .. 297 254 43 Over twelve months ................. - - - --------- --------- --------- $ 6,851 $ 6,272 $ 579 ========= ========= =========
The increase in the Company's aggregate participation in the pooling agreement effective January 1, 2005 had a significant affect on its contractual obligations for expected payments in the settlement of its loss reserves and its share of real estate operating leases and software operating leases expensed through the pool. The Company's contractual obligation for long-term debt did not change from that presented in the Company's 2004 Form 10-K. The following table reflects the Company's contractual obligations as of March 31, 2005.
Payments due by period ----------------------------------------------- Less More than 1-3 4-5 than Total 1 year years years 5 years -------- -------- ------- ------- -------- ($ in thousands) Contractual Obligations Loss and settlement expense reserves (1) ............. $520,249 $207,215 $190,255 $64,147 $ 58,632 Long-term debt ............. 36,000 - - - 36,000 Real estate operating leases 9,506 1,063 2,675 2,164 3,604 Software operating leases .. 479 479 - - - -------- -------- -------- ------- --------- Total ...................... $566,234 $208,757 $192,930 $66,311 $ 98,236 ======== ======== ======== ======= ========
(1) The amounts presented are estimates of the dollar amounts and time period in which the Company expects to pay out its gross loss and settlement expense reserves. These amounts are based on historical payment patterns and do not represent actual contractual obligations. The actual payment amounts and the related timing of those amounts could differ significantly from these estimates.
Estimated guaranty fund assessments of $1,238,000 and $1,207,000, which are used by states to pay claims of insolvent insurers domiciled in that state, have been accrued as of March 31, 2005 and December 31, 2004, respectively. The guaranty fund assessments are expected to be paid over the next two years with premium tax offsets of $1,629,000 expected to be realized within ten years of the payments. Estimated second injury fund assessments of $1,620,000 and $1,390,000, which are designed to encourage employers to employ a worker with a pre-existing disability, have been accrued as of March 31, 2005 and December 31, 2004, respectively. The second injury fund assessment accruals are based on projected loss payments. The periods over which the assessments will be paid is not known.
On May 5, 2005 Standard & Poors downgraded the credit rating of General Motors Corporation to non-investment grade status. The Company has $3,000,000 of General Motors Acceptance Corporation bonds that mature in September 2006 and an additional $3,000,000 of bonds that mature in September 2016. Management does not believe that any of these securities are other-than- temporarily impaired at this time, but will continue to monitor this situation closely.
(b) 31.1 Certification of President and Chief Executive Officer as required by Section 302 of the Sarbanes-Oxley Act of 2002.
31.2 Certification of Senior Vice President and Chief Financial Officer as required by Section 302 of the Sarbanes-Oxley Act of 2002.
32.1 Certification of President and Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2 Certification of Senior Vice President and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.