The Company does not own any real property; however, one of the property and casualty insurance subsidiaries, Dakota Fire, leases from EMC National Life Company (an affiliate of Employers Mutual) approximately 18,000 square feet of office space in which the Bismarck, North Dakota branch office is located. The Company’s home office, which also serves as the home office of Employers Mutual, is located in three office buildings containing approximately 695,000 square feet of space in Des Moines, Iowa, all of which are owned by Employers Mutual. Employers Mutual also owns office buildings in which the Milwaukee and Lansing branch offices operate. Employers Mutual leases approximately 235,000 square feet of office space in 16 other locations where other branch offices and service centers are located.
The Company, a majority owned subsidiary of Employers Mutual Casualty Company (Employers Mutual), is an insurance holding company with operations in property and casualty insurance and reinsurance. The operations of the Company are highly integrated with those of Employers Mutual through participation in a property and casualty reinsurance pooling agreement (the "pooling agreement"), a reinsurance retrocessional quota share agreement (the "quota share agreement") and an excess of loss reinsurance agreement (the “excess of loss agreement”). All transactions occurring under the pooling agreement, quota share agreement and excess of loss agreement are based on statutory accounting principles. Certain adjustments are made to the statutory-basis amounts assumed by the property and casualty insurance subsidiaries and the reinsurance subsidiary to bring the amounts into compliance with U.S. generally accepted accounting principles (GAAP).
Insurance pricing has historically been cyclical in nature. Periods of excess capital and increased competition encourage price reductions and liberal underwriting practices (referred to as a soft market) as insurance companies compete for market share, while attempting to cover the inevitable underwriting losses from these actions with investment income. A prolonged soft market generally leads to a reduction in the adequacy of capital in the insurance industry. To cure this condition, underwriting practices are tightened, premium rate levels increase and competition subsides as companies strive to strengthen their balance sheets (referred to as a hard market). At the end of 2013, premium rate level increases were beginning to decline, after increasing consistently during the three previous years, and this trend continued during 2014. It is important to note that the hardening of the market that occurred during 2011, 2012 and 2013 was somewhat unusual in that it was not driven by a reduction in capital adequacy, but rather by a persistent decline in investment income and an increase in severe weather events. The outlook for 2015 is that overall premium rate levels will continue to increase, though the increases are expected to be smaller than those implemented during 2014.
A substantial determinant of an insurance company’s underwriting results is its loss and settlement expense reserving practices. Insurance companies must estimate the amount of losses and settlement expenses that will ultimately be paid to settle claims that have occurred to date (loss and settlement expense reserves). This estimation process is inherently subjective with the possibility of widely varying results, particularly for certain highly volatile types of claims (i.e., asbestos, environmental and various casualty exposures, such as products liability, where the loss amount and the parties responsible are difficult to determine). During a soft market, inadequate premium rates put pressure on insurance companies to under-estimate their loss and settlement expense reserves in order to report better results. Correspondingly, inadequate reserves can play an integral part in bringing about a hard market, because increased profitability from higher premium rate levels can be used to strengthen inadequate reserves.
The Company closely monitors the activities of the United States Congress and federal agencies through its membership in various organizations. In particular, our trade organizations are working to monitor and ensure appropriate implementation of the federal terrorism risk insurance program, to shape the activities of the Federal Insurance Office as it continues to evolve and exercise its authority to monitor the insurance industry, to pass appropriate tax reform legislation, and to extend the judicial relief from the remand to an exemption for property and hazard and homeowners insurance from application of the Department of Housing and Urban Development’s Disparate Impact Rule.
During the fourth quarter of 2013, Employers Mutual announced that effective January 1, 2015, it would be replacing its retiree healthcare plan with a new Employers Mutual-funded Health Reimbursement Arrangement. As a result of this plan amendment, the postretirement benefit plan's projected benefit obligation decreased $96,704 as of December 31, 2013. The Company's share of this decline in projected benefit obligation ($26,937) was recognized as other comprehensive income in its December 31, 2013 financial statements. The prior service credit resulting from this plan amendment is being amortized into net periodic benefit cost over ten years, beginning in 2014. As this amortization is reflected in net income, it is being reclassified out of accumulated other comprehensive income so that stockholders' equity is not impacted. In addition, the service cost and interest cost components of the net periodic benefit cost of the new plan declined significantly. The amortization of the prior service credit, coupled with declines in both the service cost and interest cost components of the new plan, generated net periodic benefit income of approximately $3,000 for the Company in 2014, compared to approximately $3,000 of net periodic benefit expense in 2013. A similar amount of net periodic benefit income is expected in 2015.
The interest rate environment has an influence on several operational areas that have the potential to materially impact the Company’s financial condition and results of operations. Following is a brief discussion of the major operational areas being monitored by management in light of the current low interest rate environment.
The low interest rate environment has resulted in a significant decline in the discount rates used to value the obligations the Company has under Employers Mutual’s pension and postretirement benefit plans during the past several years. During this time period, the projected benefit obligation of these plans has increased, which had a negative impact on the funded status of those plans and resulted in a higher level of annual cash contributions and net periodic benefit expenses. As a result of the moderate decrease in interest rates in 2014, the discount rates used in the December 31, 2014 actuarial valuations of those plans decreased approximately 60 basis points. This had a negative impact on the funded status of the plans; however, the plans remain in an over funded position. Although discount rates remain low by historical standards, the impact of the low discount rates on the actuarial valuations has been mitigated somewhat by the strong investment returns that have been earned on the plans' assets in recent years.
Approximately 14.2 percent of the Company’s investment portfolio is invested in equity securities. Net unrealized investment gains on the equity portfolio totaled approximately $47,492 at December 31, 2014, which is reflected as accumulated other comprehensive income in the Company’s financial statements and represents $3.50 per share of the Company’s December 31, 2014 book value of $37.08 per share. To help protect the Company from a sudden and significant decline in the value of its equity portfolio, management invested in limited partnership during the first quarter of 2014 to implement an equity tail-risk hedging strategy. This hedging strategy will help protect the Company from significant monthly downside price volatility in the equity markets. By implementing this hedging strategy, management was able to reduce the level of risk contained in the Company’s financial statements without reducing the size of the equity portfolio. While there is a cost associated with this protection, management views this cost similar to the cost of an insurance policy. The cost of the hedging strategy is equal to the decline in the carrying value of the limited partnership that the Company invested in to implement the strategy, and is reported as a realized investment loss in the Company's financial statements. The decline in the carrying value of the limited partnership primarily reflects the cost of hedging contracts that expired without value during the year, but also includes changes in the value of contracts that were still in effect at year-end.
Discontinuance of personal lines business in Rhode Island, Connecticut and Massachusetts
On February 20, 2015, management announced that personal lines business will be discontinued in the states of Rhode Island, Connecticut and Massachusetts. There are no plans to discontinue writing personal lines business in any other states. This change is being implemented in support of the Providence branch's five-year business plan, which identified the need to focus on commercial lines of business for future profitable growth in its territory. Management plans to continue writing personal lines business in the 20 remaining states where personal lines coverage is currently offered. Management is committed to profitably growing personal lines business, and is developing short and long-term strategies to accomplish this goal.
Prior to 2011, the Company’s overall premium rate level had declined for five consecutive years. Management was able to implement moderate rate level increases in the personal lines of business during this time period, but rate levels in the commercial lines of business, which accounted for more than 80 percent of the property and casualty insurance segment’s premium income at that time, remained very competitive. During 2011, in recognition of the above average amount of catastrophe and storm losses incurred during the prior three years and a projected decline in investment income due to the persistent low interest rate environment, the commercial lines marketplace began to harden and the Company was able to implement small rate level increases. Rate levels have steadily improved during the past three years, and management has worked diligently with the sixteen branch offices to stress the importance of achieving modest, but consistent, commercial lines rate level increases whenever possible. These efforts have been successful, as the Company was able to implement high-single-digit rate level increases during 2012 and 2013, and more modest increases during 2014. Commercial lines rate levels are expected to continue to increase in 2015, but at a lower level than experienced in 2014. Management will continue to work with the branch offices to ensure that all opportunities for additional rate level increases are pursued.
The Financial Accounting Standards Board (FASB) is expected to propose several significant changes to current GAAP during the next several years, including the prescribed accounting for leases and financial instruments. Depending on the outcome of these initiatives, the accounting rules and required disclosures for public companies could change significantly. Management is closely monitoring developments in this area and will evaluate any proposed accounting standards that are exposed for public comment during 2015. The evaluations will identify changes that would be required in the Company’s data/systems to comply with the new accounting standards, as well as the financial impact of any proposed changes.
For the reasons noted above, development amounts reported on prior accident years’ reserves are less meaningful under the property and casualty insurance segment’s reserving methodology than reserving methodologies utilized by other insurers. Accordingly, from management’s perspective, whether the Company has maintained a consistent level of overall reserve adequacy is more relevant to understanding the Company’s results of operations than the composition of the underwriting results between the current and prior accident years.
Catastrophe and storm losses. For the property and casualty insurance segment, catastrophe and storm losses include losses attributed to events that have occurred in the United States which have been assigned an occurrence number by the Property & Liability Resource Bureau (PLRB) Catastrophe Services. According to PLRB, an occurrence number is assigned when an event has produced conditions severe enough to have caused, or to be likely to have caused, property damage. For the reinsurance segment, catastrophe and storm losses include losses that have occurred in the United States, Puerto Rico and the U.S. Virgin Islands which have been designated as catastrophes by Property Claims Services (PCS), as well as non-U.S. catastrophe and storm losses reported by the ceding companies. According to PCS, catastrophe serial numbers are assigned to events that cause $25,000 or more in direct insured losses to property, and affect a significant number of policyholders and insurers.
The preparation of the Company's financial statements in conformity with GAAP requires management to adopt accounting policies and make estimates and assumptions that affect amounts reported in the consolidated financial statements and related disclosures. The Company's significant accounting policies are described in note 1, Summary of Significant Accounting Policies, of Notes to Consolidated Financial Statements under Part II, Item 8 of this Form 10-K. The following estimates and assumptions are considered by management to be critically important in the preparation and understanding of the Company's financial statements and related disclosures. The estimates and assumptions utilized are complex and require subjective judgment.
The goal of the claims department is to establish and maintain case loss reserves that are sufficient, but not excessive. Since specific guidelines are utilized for establishing case loss reserves, the claims department does not incorporate a provision for uncertainty (either implicitly or explicitly) when setting individual case loss reserve estimates. The Employers Mutual’s actuaries do, however, review the adequacy of the aggregate case loss reserves on a quarterly basis and, if deemed appropriate, make recommendations for adjustments to management. Management reviews all recommendations submitted by the actuaries and considers such recommendations in the determination of its best estimate of overall liability. Adjustments to the aggregate case loss reserves, when approved by management, are accomplished through the establishment of bulk case loss reserves in the applicable line(s) of business, which supplement the aggregate case loss reserves. For financial reporting purposes, bulk case loss reserves are included in case loss reserves.
At December 31, 2014, IBNR loss reserves accounted for $71,410, or 15.4 percent, of the property and casualty insurance segment’s total loss and settlement expense reserves, compared to $71,539, or 16.8 percent, at December 31, 2013. IBNR loss reserves are, by nature, less precise than case loss reserves. A five percent change in IBNR loss reserves at December 31, 2014 would equate to $2,321, net of tax, which represents 7.7 percent of the net income reported for 2014 and 0.5 percent of stockholders’ equity.
The property and casualty insurance segment’s formula IBNR loss reserves are established for each line of business by applying actuarially derived “IBNR factors” to the latest twelve months premiums earned. These factors are developed using a methodology that utilizes historical ratios of (1) actual IBNR claims that have emerged after prior year-ends to (2) corresponding prior years’ premiums earned that have been adjusted to the current level of rate adequacy. In order to minimize the volatility that naturally exists in the early stages of IBNR claims emergence, IBNR claims are not utilized in this process until 18 months after the end of a respective calendar year. For example, during 2014 the actual IBNR claims reported in the 18 months following year-end 2012 were compared to the adjusted 2012 premiums earned. The 2012 ratios, together with the ratios for several prior years, were then used to develop the 2014 “IBNR factors” that were applied to premiums earned for each line of business. Included in the rate adequacy adjustment noted above is consideration of current frequency and severity trends compared to the trends underlying prior years’ calculations. The selected trends are based on an analysis of industry and Company loss data.
One assumption underlying aggregate reserve estimation methods is that the claims inflation trends implicitly built into the historical loss and settlement expense development patterns will continue into the future. To estimate the sensitivity of the estimated ultimate loss and settlement expense payments to an unexpected change in inflationary trends, the actuarial department derived expected payment patterns separately for each major line of business. These patterns were applied to the December 31, 2014 loss and settlement expense reserves to generate estimated annual incremental loss and settlement expense payments for each subsequent calendar year. Then, for the purpose of sensitivity testing, an explicit annual inflationary variance of one percent was added to the inflationary trend that is implicitly embedded in the estimated payment pattern, and revised incremental loss and settlement expense payments were calculated. This unexpected claims inflation trend could arise from a variety of sources including a change in economic inflation, social inflation and, especially for the workers’ compensation line of business, the introduction of new medical technologies and procedures, changes in the utilization of procedures and changes in life expectancy. The estimated cumulative impact that this unexpected one percent variance in the inflationary trend would have on the Company’s results of operations over the lifetime of the underlying claims is shown below. A variance in the inflationary trend would also affect the Company’s financial position in that the Company’s equity would be impacted by an amount equivalent to the change in net income. A variance of this type would typically be recognized in loss and settlement expense reserves and, accordingly, would not have a material effect on liquidity because the claims have not been paid. A one percent variance in the projected inflationary trend is considered reasonably likely based on the range of actuarial indications developed during the analysis of the property and casualty insurance segment’s carried reserves.
The property and casualty insurance subsidiaries have exposure to environmental and asbestos claims arising primarily from the other liability line of business. These exposures are closely monitored by management, and IBNR loss reserves have been established to cover estimated ultimate losses. The asbestos IBNR loss reserves were increased in each of the last seven years based on examinations of the implied three-year survival ratio (ratio of loss and settlement expense reserves to the three-year average of loss and settlement expense payments), which has deteriorated due to an increase in both paid losses and paid settlement expenses. Settlement expense payments have increased significantly since 2008 and have been the primary driver behind recently implemented reserve increases.
Environmental IBNR loss reserves are established in consideration of the implied three-year survival ratio. Estimation of ultimate liabilities for these exposures is unusually difficult due to unresolved issues such as whether coverage exists, the definition of an occurrence, the determination of ultimate damages and the allocation of such damages to financially responsible parties. Therefore, any estimation of these liabilities is subject to greater than normal variation and uncertainty, and ultimate payments for losses and settlement expenses for these exposures may differ significantly from the carried reserves.
The reinsurance book of business is comprised of two major components. The first is HORAD, which includes the reinsurance business assumed by the reinsurance subsidiary through the quota share agreement and the business written directly by the reinsurance subsidiary outside of the quota share agreement. The second is MRB, which is a voluntary reinsurance pool in which Employers Mutual participates with four other unaffiliated insurers.
At December 31, 2014, there was no backlog in the processing of assumed reinsurance information. Approximately $129,143, or 65 percent, of the reinsurance segment’s carried reserves were reported by the ceding companies. Employers Mutual receives loss reserve and paid loss data from its ceding companies on individual excess of loss contracts. If a claim involves a single or small group of claimants, a summary of the loss and claim outlook is normally provided. Summarized data is provided for catastrophe claims and pro rata business, which is subject to closer review if inconsistencies are suspected.
Assumed reinsurance losses tend to be reported later than direct losses. This lag is reflected in loss projection factors for assumed reinsurance that tend to be higher than for direct business. The result is that assumed reinsurance IBNR loss reserves as a percentage of total reserves tend to be higher than for direct loss reserves. IBNR loss reserves totaled $101,805 and $101,804 at December 31, 2014 and 2013, respectively, and accounted for approximately 51 percent and 55 percent, respectively, of the reinsurance segment’s total loss and settlement expense reserves. IBNR loss reserves are, by nature, less precise than case loss reserves. A five percent change in IBNR loss reserves at December 31, 2014 would equate to $3,300, net of tax, which represents 11.0 percent of the net income reported for 2014 and 0.7 percent of stockholders’ equity.
Prior to 2008, actual losses paid for asbestos-related claims had been minimal due to the plaintiffs’ failure to identify an exposure to any asbestos-containing products associated with the pool participants’ current and former policyholders. However, paid losses and settlement expenses have increased significantly since 2008 as a result of claims attributed to one former policyholder. During the period 2009 through 2014, the Company's share of paid losses and settlement expenses attributed to this former policyholder, a furnace manufacturer, was $7,294 (primarily settlement expenses). The asbestos exposure associated with this former policyholder has increased in recent years, and this trend may possibly continue into the future with increased per plaintiff settlements. Settlement expense payments associated with this former policyholder have increased significantly since 2008 and have been the primary driver behind recently implemented reserve increases. The primary cause of this increase in paid settlement expenses is the retention of a national coordinating counsel in 2008 due to this former policyholder’s exposure in numerous jurisdictions. The national coordinating counsel has provided, and continues to provide, significant services in the areas of document review, discovery, deposition and trial preparation. Approximately 690 asbestos exposure claims associated with this former policyholder remain open. Whenever possible, the pool participants have participated in cost sharing agreements with other insurance companies to reduce overall expenses.
The Company’s current exposures to environmental claims include losses involving petroleum haulers, lead contamination, and soil and groundwater contamination in the State of Indiana. Claims from petroleum haulers are generally caused by overturned commercial vehicles and overfills at commercial and residential properties. Exposures for accident year losses preceding the 1980s include municipality exposures for closed landfills, small commercial businesses involved with disposing waste at landfills, leaking underground storage tanks and contamination from dry cleaning operations. As of December 31, 2014, all Methyl Tertiary Butyl Ether (“MTBE”) claims related to the pool participants’ policyholders had been dismissed.
During 2009, the Company completed a comprehensive policy search and coverage review, and began defending (pursuant to policies issued 1969-1975) a lawsuit filed against a municipalities’ sewerage commission in United States District Court in Wisconsin in 2008. The Company has a joint defense agreement with two other companies, but currently retains the majority share. The lawsuit is potentially one of the largest CERCLA actions pending against numerous parties in the United States and seeks in excess of $1.5 billion from the defendants. The pool participants reached a tentative settlement with the insured and issued payment for approximately $625 (the Company’s share) during 2014, but continues to wait for final court approval of the settlement.
At December 31, 2014, the Company carried asbestos and environmental reserves for direct insurance and assumed reinsurance business totaling $9,420, which represents 1.4 percent of total loss and settlement expense reserves. The asbestos and environmental reserves include $5,071 of case loss reserves, $2,556 of IBNR loss reserves and $1,793 of bulk settlement expense reserves. Ceded reinsurance on these reserves totaled $124. Loss and settlement expense reserves were increased in 2014 because of deterioration in the implied survival ratio.
The pool participants’ non-asbestos direct product liability claims are considered to be highly uncertain exposures due to the many uncertainties inherent in determining the loss, and the significant periods of time that can elapse between the occurrence of the loss and the ultimate settlement of the claim. The majority of the pool participants’ product liability claims arise from small to medium-sized manufacturers, contractors, petroleum distributors, and mobile home and auto dealerships. No specific claim trends are evident from the pool participants’ manufacturing clients, as the claims activity on these policies is generally isolated and can be severe. Specific product liability coverage is provided to the pool participants’ mobile home and auto dealership policyholders, and the claims from these policies tend to be relatively small. Certain construction defect claims are also reported under product liability coverage. During 2014, 40 of these claims were reported to the pool participants.
Following is a summary of loss and settlement expense reserves and payments associated with asbestos, environmental, products liability and casualty excess reinsurance exposures for 2014, 2013 and 2012:
The Company does not determine a range of estimates for all components of the loss and settlement expense reserve at the time the reserves are established. During each quarter, however, an actuarially determined range of estimates is developed for the major components of the loss and settlement expense reserves as of the preceding quarter-end. All reserves are reviewed with the exception of reserves for involuntary workers’ compensation pools, which are set by the National Council on Compensation Insurance (NCCI) and are assumed to be adequate (the impact of potential variability of this segment on overall reserve adequacy is considered immaterial). Shown below are the actuarially determined ranges of reserve estimates as of December 31, 2014 along with the statutory-basis carried reserves, which are displayed net of ceded reinsurance. The GAAP-basis loss and settlement expense reserves contained in the Company’s financial statements are reported gross of ceded reinsurance, and contain a small number of adjustments from the statutory-basis amounts presented here. The last two columns display the estimated after-tax impact on earnings if the reserves were moved to the high end-point or low end-point of the ranges.
Acquisition costs, consisting of commissions, premium taxes, and salary and benefit expenses of employees directly involved in the underwriting of insurance policies that are successfully issued, are deferred and amortized to expense as premium revenue is recognized. Deferred policy acquisition costs and related amortization are calculated separately for the property and casualty insurance segment and the reinsurance segment. The methodology followed in computing deferred policy acquisition costs limits the amount of such deferred costs to the estimated realizable value. In determining estimated realizable value, the computation gives effect to the premium to be earned, related investment income, anticipated losses and settlement expenses, anticipated policyholder dividends, and certain other costs expected to be incurred to administer the insurance policies as the premium is earned. The anticipated losses and settlement expenses are based on the segment’s projected loss and settlement expense ratios for the next twelve months, which include provisions for anticipated catastrophe and storm losses based on historical results adjusted for recent trends. Utilizing these projections, deferred policy acquisition costs for the property and casualty insurance segment and the reinsurance segment were not subject to limitation at December 31, 2014. Based on an analysis performed by management, the actuarial projections of the expected loss and settlement expense ratios for the next twelve months would have needed to increase 20.1 percentage points in the property and casualty insurance segment and 5.6 percentage points in the reinsurance segment before deferred policy acquisition costs would have been subject to limitation. Such increases in the expected loss and settlement expense ratios would likely be driven by many factors, including higher provisions for anticipated catastrophe and storm losses.
In accordance with GAAP, actuarial gains/losses contained in the valuations that result from (1) actual experience that differs from that assumed, or (2) a change in actuarial assumptions, is accumulated and, if in excess of a specified corridor, amortized to expense over future periods. As of December 31, 2014, all of the benefit plans had accumulated actuarial losses in excess of the corridor that will be partially amortized into expense in 2015. The Company’s share of the accumulated actuarial losses that will be amortized into expense during 2015 amounts to $1,135. Prior service costs/credits for plan amendments are also contained in the valuations, and are amortized into expense/income over the future service periods of the participants. As of December 31, 2014, the postretirement benefit plans have prior service credits that are being amortized into income in future periods, while the qualified defined benefit pension plan has prior service costs that are being amortized into expense in future periods. The net amount of prior service credit being amortized into income during 2015 is $3,307.
Premiums earned for the property and casualty insurance segment increased 7.6 percent to $422,381 in 2014 from $392,719 in 2013. The increase is primarily associated with renewal business, which increased seven percent during 2014 due to a combination of rate level increases, and to a lesser extent, growth in insured exposures. Renewal rates increased approximately 4.5 percent in commercial lines of business and 3.5 percent in personal lines during 2014, though it should be noted that the level of rate increases slowed as the year progressed, and this trend is expected to continue through 2015. The pool participants have not implemented broad-based rate level increases across the entire book of business, but have instead implemented rate level increases based on the loss history and risk exposures associated with each renewing policy, in order to achieve a more adequate overall rate level. This approach has allowed the property and casualty insurance segment to retain its core book of business, while working to improve underwriting margins. While renewal rates for personal lines of business increased, written premiums were down due to an intentional reduction in policy count to lessen exposure concentrations. During 2014, the overall policy retention rate continued to be strong at 85.9 percent (commercial lines at 86.7 percent and personal lines at 84.8 percent), which is slightly higher than the retention rate at the end of 2013. Although new business continues to account for a relatively small portion (just 14 percent) of the pool participants’ direct written premiums, the pool participants were able to capitalize on some new business opportunities outside of the core Midwest market to further diversify into areas less prone to weather-related events, while at the same time staying consistent with the industry and line of business mix of the existing book of business. New business in the Northwest, Southwest and Southeast parts of the United States grew, and is generally expected to continue to grow, at a slightly faster pace than other regions. New business premium increased six percent in the commercial lines of business (corresponding policy count was down), while personal lines new business premium was down six percent.
Premiums earned for the reinsurance segment declined 3.6 percent to $118,341 in 2014 from $122,787 in 2013. This decline was not caused by rate level decreases or a loss of business, but rather is generally attributed to a $7,733 reduction in the amount of EBNR premiums recognized on pro rata contracts in 2014, as discussed below. Without this reduction, earned premiums would have increased approximately 2.7 percent in 2014 due to growth in existing accounts and the addition of some new business. As previously reported, the premium recognition period of two large facility contracts in the property line of business was changed during the third quarter after it was determined that the vast majority of the underlying risks do not attach until January 1, 2015, or later. During the fourth quarter, the premium recognition period of all remaining pro rata contracts was reviewed on a contract-by-contract basis, and it was determined that the total amount of EBNR premiums established for those contracts, also primarily in the property line of business, should be reduced. The total of these corrections, which was partially offset by an increase in EBNR premiums in the marine line of business due to a difference in the timing of reports received from a ceding company, resulted in the reduction in EBNR premiums noted above. The reduction in EBNR premiums did not have a material impact on 2014 net income because corresponding corrections were made to IBNR loss reserves, commission expense reserves and the cost of the excess of loss reinsurance protection. These corrections do not impact the ultimate amount of premiums that will be earned.
The growth in existing accounts noted above primarily occurred in a pro rata casualty account first written in 2013. Premium growth was limited by a decline in rate levels for catastrophe excess of loss business (which comprises approximately 20 percent of the reinsurance segment's book of business). Rates-on-line for catastrophe excess of loss business declined approximately seven to eight percent during the January 1, 2014 renewal season, but those declines were partially offset by a slight increase in retentions and an increase in limits purchased by ceding companies. Other trends noted during the January 1, 2014 renewal season included the liberalization of contract terms generally favorable to the buyer, including, but not limited to, an expansion of the hours clause (which provides a longer time period for losses to be attributed to a named catastrophic event); expansion of terrorism coverage to include, in many contracts, all acts other than nuclear, biological, chemical and radiation; and multi-year commitments on pricing. Premiums earned for 2014 reflect a reduction in the cost of the excess of loss reinsurance protection provided by Employers Mutual, from 9.0 percent of total assumed reinsurance premiums written in 2013 to 8.0 percent in 2014.
Effective January 1, 2013, Church Mutual became a member of the MRB underwriting association. As a result, Employers Mutual became a one-fifth participant in MRB, down from its previous one-fourth participation. In connection with Employers Mutual’s decreased participation in MRB, the reinsurance segment recorded a $585 portfolio adjustment decrease in premiums written in the first quarter of 2013. This portfolio adjustment did not affect earned premium since there was a corresponding decrease in unearned premiums. Nine percent of this amount ($53) was recorded as a reduction in the cost of the excess of loss coverage provided by Employers Mutual, and the reinsurance segment recognized $223 of negative commission allowance (commission income) to compensate for the acquisition costs incurred to generate the business ceded to Church Mutual.
Losses and settlement expenses increased 15.7 percent to $385,474 in 2014 from $333,287 in 2013, and the loss and settlement expense ratio increased to 71.3 percent in 2014 from 64.7 percent in 2013. Both segments experienced increases in their loss and settlement expense ratios during 2014, but the increase was especially large in the reinsurance segment due to increases in both loss severity and catastrophe and storm losses, and the unusually low loss and settlement expense ratio reported for 2013. The improved premium rate adequacy achieved over the past several years helped reduce the impact that the elevated level of losses would have otherwise had on the loss and settlement expense ratios. The actuarial analysis of the Company’s carried reserves at December 31, 2014 indicates that the level of reserve adequacy is consistent with other recent evaluations. From management’s perspective, this measure is more relevant to an understanding of the Company’s results of operations than the composition of underwriting results between the current and prior accident years.
The loss and settlement expense ratio for the reinsurance segment increased to 73.9 percent in 2014 from 58.9 percent in 2013. While this increase is significant, it is important to note that the 2013 ratio was unusually low. The increase is primarily attributed to an increase in catastrophe and storm losses, as well as loss severity. Catastrophe and storm losses contributed 14.4 percentage points to the 2014 loss and settlement expense ratio, compared to 9.2 percentage points in 2013. The most significant loss event was a severe Midwest storm that slightly exceeded the $4,000 retention amount under the excess of loss agreement. The increase in loss severity is attributed to a number of fire losses, as well as some snow and ice collapse incidents. Favorable development on prior years’ reserves increased substantially during 2014, primarily due to a reduction in the amount of IBNR loss reserves carried for accident years 2010 and prior because the amount previously carried was no longer indicated in the actuarial analysis. The total amount of IBNR loss reserves carried at December 31, 2014 declined in conjunction with the decline in EBNR premiums noted above, however, this did not produce any meaningful impact on the loss and settlement expense ratio.
Net investment income increased 8.0 percent to $46,465 in 2014 from $43,022 in 2013. The increase reflects a higher average invested balance in fixed maturity securities and an increase in dividend income; however, the early payoff of a commercial mortgage-backed security during the first quarter of 2014 that was purchased at a significant discount to par value, which accelerated the accretion of the discount to par value and therefore increased investment income, also added to the increase. Current interest rate levels remain below the average coupon rate of the fixed maturity portfolio, and will therefore likely continue to limit future growth in net investment income. The average coupon rate on the fixed maturity portfolio, excluding interest-only securities, declined slightly to 3.9 percent at December 31, 2014 from 4.0 percent at December 31, 2013. The effective duration of the fixed maturity portfolio, excluding interest-only securities, decreased to 4.6 at December 31, 2014 from 5.7 at December 31, 2013, reflecting the decline in interest rates that occurred during 2014. The Company’s equity security holdings produced dividend income of $6,007 in 2014 compared to $4,619 in 2013.
The Company reported net realized investment gains of $4,349 in 2014 compared to $8,997 in 2013. Included in the 2014 amount is $2,846 of realized losses attributed to the decline in the carrying value of a limited partnership that the Company invested in during the first quarter of 2014 to help protect it from a sudden and significant decline in the value of its equity portfolio (an equity tail-risk hedging strategy). Also contributing to the decline in net realized investment gains was the fact that during the fourth quarter of 2013 the Company took advantage of the outsized equity returns that occurred during the year by selling some stocks. The Company recognized "other-than-temporary" impairment losses of $878 and $63 during 2014 and 2013, respectively.
Included in other income is foreign currency exchange gains and losses recognized on the reinsurance segment’s foreign currency denominated reinsurance business. The reinsurance segment had a foreign currency exchange gain of $2,180 in 2014 compared to a foreign currency exchange loss of $366 in 2013. The decline in interest expense during 2014 is due to a reduction in the interest rate on the property and casualty insurance segment's outstanding surplus notes from 3.60 percent to 1.35 percent that became effective February 1, 2013.
The Company reported net income of $43,519 ($3.33 per share) in 2013 compared to $37,966 ($2.95 per share) in 2012. The reinsurance segment produced exceptionally good results in 2013, and the property and casualty insurance segment's results were in line with expectations. The increase in net income was primarily attributed to an overall increase in premium rate adequacy in 2013 as a result of the rate level increases implemented during 2012 and 2013. High-single-digit rate level increases in the property and casualty insurance segment outpaced the industry average and the increase in loss costs. The Company continued to seek good opportunities for new business in the Northwest, Southwest and Southeast parts of the United States. This growth outside of the Company's core market in the Midwest, if achieved, will help diversify the Company's book of business geographically, while maintaining the current industry and line-of-business mix.
Premiums earned increased 12.3 percent to $515,506 in 2013 from $458,846 in 2012. In the property and casualty insurance segment, the majority of the increase was attributable to rate level increases on renewal business and growth in insured exposures on existing accounts. In the reinsurance segment, the increase was attributable to a large increase in the amount of premiums earned on the offshore energy and liability proportional account, moderate rate level increases and the addition of some new business. Premium rates in the property and casualty insurance market were expected to continue to rise in 2014, though at a somewhat lower level than seen during 2013. Premium rates in the reinsurance market were expected to decline during 2014, especially for catastrophe excess business; however, this business only accounted for approximately 20 percent of the reinsurance segment's total book of business. Despite the decline in premium rate levels, premium income for the reinsurance segment was expected to grow in 2014, but at a more modest level than 2013.
Premiums earned for the property and casualty insurance segment increased 10.0 percent to $392,719 in 2013 from $357,139 in 2012. The increase in premiums earned was primarily associated with renewal business, which increased nine percent, and reflected a combination of rate level increases, growth in insured exposures and an increase in retained policies. Renewal rates across both commercial and personal lines of business increased approximately seven percent during 2013, and were expected to continue to rise in 2014, though at a lower level. The pool participants did not implement broad-based rate level increases across the entire book of business, but had instead implemented rate level increases based on the loss history and risk exposures associated with each renewing policy, in order to achieve a more adequate overall rate level. This approach allowed the property and casualty insurance segment to retain its core book of business, while improving underwriting margins. While renewal rates for personal lines of business increased, premiums were down slightly due to an intentional reduction in policy count to lessen exposure concentrations. Due to the decrease in personal lines policy count and the continued emphasis on rate increases, overall policy retention declined slightly during 2013, but remained strong at 85.0 percent (commercial lines at 86.3 percent and personal lines at 83.5 percent). New business continued to account for a relatively small portion (just 14 percent) of the pool participants’ direct written premiums. New business premium increased eight percent in the commercial lines of business (policy count increased one percent), but total new business premium only increased six percent due to a significant decline in personal lines new business premium.
Premiums earned for the reinsurance segment increased 20.7 percent to $122,787 in 2013 from $101,707 in 2012. The increase was primarily attributed to a large increase in the amount of premiums earned on the offshore energy and liability proportional account, moderate rate level increases implemented during the January 1 renewal season, and the addition of some new business. Premiums earned during 2013 reflected a reduction in the cost of the excess of loss coverage provided by Employers Mutual from 10.0 percent of total assumed reinsurance premiums written in 2012 to 9.0 percent in 2013; however, the total amount of premiums ceded to Employers Mutual for this coverage increased due to a large increase in assumed reinsurance premiums written.
Effective January 1, 2013, Church Mutual became a member of MRB. As a result, Employers Mutual became a one-fifth participant in MRB, down from its previous one-fourth participation. This resulted in a 11.3 percent decline in earned premiums assumed from MRB in 2013. In connection with Employers Mutual’s decreased participation in MRB, the reinsurance segment recorded a $585 portfolio adjustment decrease in premiums written in the first quarter of 2013. This portfolio adjustment did not affect earned premium since there was a corresponding decrease in unearned premiums. Nine percent of this amount ($53) was recorded as a reduction in the cost of the excess of loss coverage provided by Employers Mutual, and the reinsurance segment recognized $223 of negative commission allowance (commission income) to compensate for the acquisition costs incurred to generate the business ceded to Church Mutual.
Losses and settlement expenses increased 9.9 percent to $333,287 in 2013 from $303,388 in 2012, but the loss and settlement expense ratio decreased to 64.7 percent in 2013 from 66.1 percent in 2012. The decrease in the loss and settlement expense ratio was attributed to an overall improvement in rate adequacy, as well as a decline in catastrophe and storm losses; however, these improvements were partially offset by a decline in favorable development on prior years' reserves. Development amounts can vary significantly from year to year depending on a number of factors, including the number of claims settled and the settlement terms, and should therefore not be considered a reliable factor in assessing the adequacy of the Company's carried reserves. The actuarial analysis of the Company's carried reserves as of December 31, 2013 indicated that the level of reserve adequacy was consistent with other recent evaluations.
The loss and settlement expense ratio for the property and casualty insurance segment increased to 66.4 percent in 2013 from 65.5 percent in 2012. This increase was primarily attributed to a decline in the implied amount of favorable development on prior years' reserves that had an impact on earnings, which totaled $755 (0.2 percent of earned premiums) in 2013 compared to $17,608 (4.9 percent of earned premiums) in 2012. The lower amount of favorable development in 2013 was primarily attributed to unfavorable outcomes on a few large prior year claims. The implied amounts of favorable development that had an impact on earnings did not include $6,526 of favorable development in 2013 and $4,551 of adverse development in 2012 that were included in the reported amounts of favorable development, because these amounts resulted solely from changes in the allocation of bulk reserves between the current and prior accident years, and therefore did not have an impact on earnings. Earnings are only impacted by changes in the total amount of carried reserves. The increase in the loss and settlement expense ratio was mitigated by an improvement in overall premium rate adequacy. Excluding the impact of catastrophe and storm losses, large losses, and related development, claims frequency increased 0.6 percent, and claims severity increased 2.9 percent during 2013. As a result, the increase in loss costs was more than offset by the rate level increases implemented during the year. Catastrophe and storm losses, while higher in amount, declined as a percentage of premiums earned (9.5 percentage points in 2013, compared to 9.6 percentage points in 2012 and 9.4 percentage points for the most recent 10-year average). Large losses (which the Company defines as losses greater than $500 for the EMC Insurance Companies’ pool, excluding catastrophe and storm losses) increased to $22,240 in 2013 (5.7 percent of premiums earned) from $21,241 in 2012 (5.9 percent of premiums earned).
The loss and settlement expense ratio for the reinsurance segment decreased to 58.9 percent in 2013 from 68.3 percent in 2012. This decrease was primarily attributed to significant declines in both crop reinsurance losses and catastrophe and storm losses; however, the impact of these declines on the loss and settlement expense ratio was partially offset by a decline in the amount of favorable development experienced on prior years' reserves. The decline in favorable development was primarily attributed to three factors. First, a large amount of favorable development was experienced in 2012 due to a reduction in the amount of IBNR reserves carried for the unusually large number of catastrophe and storm events that occurred in 2011. Second, reported losses associated with prior accident years were higher in 2013 than 2012. And third, the "expected loss ratios" used in the development methodologies applied to the 2012 contract year were somewhat lower than previous contract years due to an extensive actuarial study completed during 2012 (prior contract years' "expected loss ratios" were not adjusted). Carried reserves for the 2013 contract year were also established using the lower "expected loss ratios" produced by the new development methodology, and will continue to be used to establish carried reserves for subsequent contract years (pending actuarial review). This was expected to result in a decline in the amount of favorable development reported by the reinsurance segment in future years. Catastrophe and storm losses were above average in 2012, as the reinsurance segment had three events, including Superstorm Sandy, which exceeded the $4,000 retention amount under the excess of loss agreement. Losses from these three events totaled $23,722, with $12,000 retained by the reinsurance segment and the remaining $11,722 ($11,000 from Superstorm Sandy alone) ceded to Employers Mutual. During 2012, the reinsurance segment also incurred $6,057 of losses on U.S. multi-peril crop reinsurance programs that resulted from the severe drought conditions that existed in much of the United States. Because the losses from the crop reinsurance programs were not attributed to a specific event, they were not subject to the $4,000 cap on losses per event under the excess of loss agreement.
Acquisition and other expenses increased 11.4 percent to $171,346 in 2013 from $153,824 in 2012. However, the acquisition expense ratio decreased to 33.2 percent in 2013 from 33.5 percent in 2012. The increase in acquisition expenses was primarily attributed to an increase in commission expense (including contingent commissions) and policyholder dividend expense; however, the acquisition expense ratio declined due to the increase in premium income. The decrease in the acquisition expense ratio was limited somewhat by a large negative commission adjustment recorded in the reinsurance segment during the first quarter of 2012 in connection with the cancellation of a large MRB account.
For the property and casualty insurance segment, the acquisition expense ratio decreased to 36.3 percent in 2013 from 36.8 percent in 2012. This decrease was primarily attributed to the increase in premium income; however, the decrease was somewhat limited by higher policyholder dividend expense, and to a lesser extent, higher contingent commission expense. The higher policyholder dividend expense was produced by large increases in a few safety dividend groups that experienced improved underwriting results in 2013.
Net investment income decreased 2.5 percent to $43,022 in 2013 from $44,145 in 2012. This decline was primarily attributed to the prolonged low interest rate environment, but was mitigated by considerable growth in the fixed maturity portfolio, strong dividend earnings on the equity portfolio, and a slight increase in interest rates. Interest rate levels remained below the average coupon rate of the fixed maturity portfolio, and would therefore likely limit future growth in net investment income. It should be noted that the decline in investment income reported for 2013 reflected a $160 increase in the amount of funds received from settlements of securities litigation. Excluding this amount from the calculation, the decline in investment income would have been 2.9 percent. The average coupon rate on the fixed maturity portfolio, excluding interest-only securities, declined slightly to 4.03 percent at December 31, 2013 from 4.23 percent at December 31, 2012. Management was actively pursuing ways to minimize the decline in investment income without increasing overall risk, such as the implementation of the new equity strategy in 2012 that emphasized dividend income (see discussion below). The effective duration of the fixed maturity portfolio, excluding interest-only securities, increased to 5.65 at December 31, 2013 from 4.20 at December 31, 2012. Duration extended as interest rates rose during 2013.
At the end of the first quarter of 2012, management reinvested approximately $35,000 from the core equity portfolio and $10,000 of cash into a new equity portfolio with an emphasis on dividend income. In addition to a higher dividend return, this new equity strategy was expected to have less price volatility than the overall market. The Company’s equity security holdings produced dividend income of $4,619 in 2013 and $3,852 in 2012.
The Company reported net realized investment gains of $8,997 in 2013 compared to $8,017 in 2012. During the fourth quarter of 2013, the Company took advantage of the outsized equity returns realized during the year by selling some stocks. The Company experienced an unusually large amount of realized investment gains in the first quarter of 2012, primarily from the sale of securities from the core equity portfolio to fund the new equity portfolio that emphasized dividend income.
Included in other income was foreign currency exchange gains and losses recognized on the reinsurance segment’s foreign currency denominated reinsurance business. The reinsurance segment had foreign currency exchange losses of $366 and $25 in 2013 and 2012, respectively. The decline in interest expense during 2013 was due to a reduction in the interest rate on the property and casualty insurance segment's outstanding surplus notes from 3.60 percent to 1.35 percent that became effective February 1, 2013.
Income tax expense increased 26.8 percent to $17,334 in 2013 from $13,667 in 2012. The effective tax rate for 2013 was 28.5 percent, compared to 26.5 percent in 2012. The primary contributor to the differences between these effective tax rates and the United States federal corporate tax rate of 35 percent was tax-exempt interest income earned.
The Company is a holding company whose principal asset is its investment in its property and casualty insurance subsidiaries and its reinsurance subsidiary (“insurance subsidiaries”). As a holding company, the Company is dependent upon cash dividends from its insurance subsidiaries to meet all its obligations, including cash dividends to stockholders and the funding of the Company’s stock repurchase programs. State insurance regulations restrict the maximum amount of dividends insurance companies can pay without prior regulatory approval. The maximum amount of dividends that the insurance subsidiaries can pay to the Company in 2015 without prior regulatory approval is approximately $45,480. The Company received $378, $9,974 and $12,050 of dividends from its insurance subsidiaries and paid cash dividends to its stockholders totaling $12,588, $11,275 and $10,439 in 2014, 2013 and 2012, respectively.
The Company held $6,227 and $2,392 in minority ownership interests in limited partnerships and limited liability companies at December 31, 2014 and 2013, respectively. During the first quarter of 2014, the Company invested $4,367 in a limited partnership that is designed to help protect the Company from a sudden and significant decline in the value of its equity portfolio. This investment is included in "other long-term investments" in the Company's financial statements and is carried under the equity method of accounting.
Employers Mutual contributed $7,000, $14,000 and $15,000 to its qualified pension plan in 2014, 2013 and 2012, respectively, and plans to contribute approximately $7,000 to the qualified pension plan in 2015. The Company reimbursed Employers Mutual $2,161, $4,321 and $4,589 for its share of the pension contributions in 2014, 2013 and 2012, respectively. Employers Mutual contributed $500 and $1,500 to its postretirement benefit plans in 2013 and 2012, respectively, but did not make any contributions during 2014 and does not expect to make any contributions in 2015 due to the plan amendment that was announced during 2013. The Company reimbursed Employers Mutual $144 and $434 for its share of the postretirement benefit plan contributions in 2013 and 2012, respectively.
Capital resources consist of stockholders’ equity and debt, representing funds deployed or available to be deployed to support business operations. For the Company’s insurance subsidiaries, capital resources are required to support premium writings. Regulatory guidelines suggest that the ratio of a property and casualty insurer’s annual net premiums written to its statutory surplus should not exceed three to one. All of the Company’s property and casualty insurance subsidiaries were well under this guideline at December 31, 2014.
The Company’s total cash and invested assets at December 31, 2014 and 2013 are summarized as follows:
The amortized cost and estimated fair value of fixed maturity and equity securities at December 31, 2014 were as follows:
The Company’s property and casualty insurance subsidiaries have $25,000 of surplus notes issued to Employers Mutual. Effective February 1, 2013, the interest rate on the surplus notes was reduced to 1.35 percent from the previous rate of 3.60 percent. Reviews of the interest rate are conducted by the Inter-Company Committees of the boards of directors of the Company and Employers Mutual every five years, with the next review due in 2018. Payments of interest and repayments of principal can only be made out of the applicable subsidiary’s statutory surplus and are subject to prior approval by the insurance commissioner of the respective states of domicile. The surplus notes are subordinate and junior in right of payment to all obligations or liabilities of the applicable insurance subsidiaries. Total interest expense incurred on these surplus notes was $337, $384 and $900 in 2014, 2013 and 2012, respectively. At December 31, 2014, the Company’s property and casualty insurance subsidiaries had received approval for the payment of interest accrued on the surplus notes during 2014.
The Company recorded “other-than-temporary” investment impairment losses totaling $878 on three securities (two equity securities and one fixed maturity security) during 2014, compared to $63 on three equity securities during 2013.
The Company does not purchase non-investment grade fixed maturity securities. Any non-investment grade fixed maturity securities held are the result of rating downgrades that occurred subsequent to their purchase. At December 31, 2014, the Company held $7,768 of non-investment grade fixed maturity securities in a net unrealized gain position of $265.
The following table reflects the Company's contractual obligations as of December 31, 2014. Included in the table are the estimated payments that the Company expects to make in the settlement of its loss and settlement expense reserves and with respect to its long-term debt. One of the Company’s property and casualty insurance subsidiaries leases office facilities in Bismarck, North Dakota with lease terms that expired in 2014 (new lease agreement is in place for 2015 through 2024). Employers Mutual has entered into various leases for branch and service office facilities with lease terms expiring through 2024. All of these lease costs are included as expenses under the pooling agreement. Included in the following table is the Company's current 30.0 percent aggregate participation percentage of all operating lease obligations of the parties to the pooling agreement.
The valuation of the Company’s marketable equity portfolio is subject to equity price risk. In general, equities have more year-to-year price variability than bonds. However, returns from equity securities have been consistently higher over longer time frames. The Company invests in a diversified portfolio of readily marketable equity securities. A hypothetical 10 percent decrease in the S&P 500 index as of December 31, 2014 would result in a corresponding pre-tax decrease in the fair value of the Company’s equity portfolio of approximately $16,228. To help protect the Company from a sudden and significant decline in the value of its equity portfolio, management implemented an equity tail-risk hedging strategy during the first quarter of 2014 to protect the Company from significant monthly downside price volatility in the equity markets. The cost of this protection (recorded as a realized investment loss) totaled $2,846 during 2014. This hedging strategy may be discontinued in the future depending on market conditions and/or the cost of the protection.
Municipal fixed maturity securities, including taxable, tax-exempt and pre-refunded securities, totaled $326,058 as of December 31, 2014. Municipal securities are well diversified between general obligation and revenue bonds, as well as geographically. The Company’s credit analysis of municipal securities is predominantly based on the underlying credit quality of the obligor. Therefore, although a portion of the Company’s municipal securities are guaranteed by financial guaranty insurers, reliance is placed on the underlying obligor to pay all contractual cash flows. The ratings of insured municipal securities generally reflect the rating of the underlying primary obligor. The average quality of the municipal fixed maturity securities portfolio is Aa2/AA with over 99 percent of securities rated A3/A- or higher. Approximately $27,596 of the Company’s municipal securities have been pre-refunded, which means that funds have been set aside in escrow to satisfy the future interest and principal obligations of the securities.
Prepayment risk refers to changes in prepayment patterns that can shorten or lengthen the expected timing of principal repayments and thus the average life and the effective yield of a security. Such risk exists within the portfolio of mortgage-backed securities. Prepayment risk is monitored regularly through the analysis of interest rate simulations. At December 31, 2014, the effective duration of the mortgage-backed securities, excluding interest-only securities, is 3.6 with an average life of 4.6 years and a yield to worst of 2.5 percent. At December 31, 2013, the effective duration of the mortgage-backed securities, excluding interest-only securities, was 3.9, with an average life of 4.6 years and a yield to worst of 3.0 percent.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of EMC Insurance Group Inc. and Subsidiaries at December 31, 2014 and 2013, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2014, in conformity with U.S. generally accepted accounting principles.
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, as well as the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates. The Company has evaluated all subsequent events through the date the financial statements were issued.
Property and casualty insurance premiums are recognized as revenue ratably over the terms of the respective policies. Unearned premiums are calculated on the daily pro rata method. Both domestic and foreign assumed reinsurance premiums are recognized as revenues ratably over the terms of the related contracts and underlying policies. Amounts paid as ceded reinsurance premiums are reported as prepaid reinsurance premiums and are amortized over the remaining contract period in proportion to the amount of reinsurance protection provided. Reinsurance reinstatement premiums are recognized in the same period as the loss event that gave rise to the reinstatement premiums.
The method followed in computing deferred policy acquisition costs limits the amount of such deferred costs to the estimated realizable value. In determining estimated realizable value, the computation gives effect to the premium to be earned, related investment income, anticipated losses and settlement expenses, anticipated policyholder dividends, and certain other costs expected to be incurred to administer the insurance policies as the premium is earned. The anticipated losses and settlement expenses are not discounted and are based on the Company’s projected loss and settlement expense ratios for the next twelve months, which include catastrophe loads based on historical results adjusted for recent trends. The occurrence of a significant catastrophe, and/or accumulation of catastrophes would not have a direct impact on the determination of premium deficiencies; however, such occurrences would be included in the historical results that are used to establish the catastrophe loads. A premium deficiency is first recognized by expensing the amount of unamortized deferred policy acquisition costs necessary to eliminate the deficiency. If the premium deficiency is greater than the unamortized deferred policy acquisition costs, a liability is accrued for the excess deficiency. The Company did not record a premium deficiency for the years ended December 31, 2014, 2013 and 2012.
Employers Mutual has various employee benefit plans, including two defined benefit pension plans, and two postretirement benefit plans that provide retiree healthcare and life insurance benefits. Although the Company has no employees of its own, it is responsible for its share of the expenses and related prepaid assets and liabilities of these plans as determined under the terms of the pooling agreement, and the costs allocated by Employers Mutual to subsidiaries that do not participate in the pooling agreement (see note 2). Accordingly, the Company recognizes its share of the funded status of Employers Mutual’s pension and postretirement benefit plans on its balance sheet, with changes in the funded status of the plans recognized through “other comprehensive income.”
The Company’s reinsurance subsidiary is party to a quota share agreement and an excess of loss reinsurance agreement with Employers Mutual. Under the terms of the quota share agreement, the reinsurance subsidiary assumes 100 percent of Employers Mutual’s assumed reinsurance business, subject to certain exceptions. Under the terms of the excess of loss agreement (covering both business assumed from Employers Mutual through the quota share agreement, as well as business obtained outside the quota share agreement), the reinsurance subsidiary retains the first $4,000 of losses per event, and also retains 20.0 percent of any losses between $4,000 and $10,000 and 10.0 percent of any losses between $10,000 and $50,000. During 2012, all losses associated with any one event above $4,000 were ceded to Employers Mutual. The cost of the excess of loss reinsurance protection is 8.0 percent (9.0 percent in 2013 and 10.0 percent in 2012) of the reinsurance subsidiary’s total assumed reinsurance premiums written.
The reinsurance subsidiary does not directly reinsure any of the insurance business written by Employers Mutual or the other pool participants; however, Employers Mutual assumes reinsurance business from the Mutual Reinsurance Bureau underwriting association (MRB), which provides a small amount of reinsurance protection to the members of the EMC Insurance Companies pooling agreement. As a result, the reinsurance subsidiary’s assumed exposures include a small portion of the EMC Insurance Companies’ direct business, after ceded reinsurance protections purchased by MRB are applied. In addition, the reinsurance subsidiary does not reinsure any “involuntary” facility or pool business that Employers Mutual assumes pursuant to state law. The reinsurance subsidiary assumes all foreign currency exchange gain/loss associated with contracts incepting on January 1, 2006 and thereafter that are subject to the quota share agreement. Operations of the quota share agreement and excess of loss agreement give rise to inter-company balances with Employers Mutual, which are settled within 45 days after the end of each quarter. The investment and income tax activities of the reinsurance subsidiary are not subject to either the quota share agreement or the excess of loss agreement.
Under the terms of the quota share agreement, the reinsurance subsidiary receives reinstatement premium income that is collected by Employers Mutual from the ceding companies when reinsurance coverage is reinstated after a loss event; however, the cap on losses assumed per event contained in the excess of loss agreement is automatically reinstated without cost. The reinsurance subsidiary recognized $2,256, $2,542 and $2,344 of reinstatement premium in 2014, 2013 and 2012, respectively.
Premiums earned assumed by the reinsurance subsidiary from Employers Mutual, including reinstatement premiums, amounted to $122,064, $129,746 and $107,112 in 2014, 2013 and 2012, respectively. The reinsurance subsidiary ceded 8.0 percent (9.0 percent in 2013 and 10.0 percent in 2012) of its total assumed reinsurance premiums written to Employers Mutual as payment for the excess of loss protection, which totaled $10,339, $12,761 and $11,916 in 2014, 2013 and 2012, respectively. Losses and settlement expenses assumed by the reinsurance subsidiary from Employers Mutual amounted to $79,499, $66,126 and $74,832 in 2014, 2013 and 2012, respectively. Losses and settlement expenses ceded to Employers Mutual under the excess of loss agreement totaled ($720), $823 and $9,926 in 2014, 2013 and 2012, respectively.
The following table presents the reported amounts of favorable development experienced on prior years’ reserves and the portion of the reported development amounts that resulted solely from changes in the allocation of bulk reserves between the current and prior accident years in the property and casualty insurance segment (no impact on earnings). The result is an approximation of the implied amounts of favorable development that had an impact on earnings.
For the property and casualty insurance segment, the December 31, 2014 estimate of loss and settlement expense reserves for accident years 2013 and prior decreased $8,110 from the estimate at December 31, 2013. This decrease represents 1.9 percent of the December 31, 2013 gross carried reserves and is primarily attributed to better than expected outcomes on claims reported in prior years and favorable development on prior years' settlement expenses. No changes were made in the key actuarial assumptions utilized to estimate loss and settlement expense reserves during 2014; however, the accident year allocation factors applied to incurred but not reported (IBNR) loss, bulk case loss and a portion of defense and cost containment expense reserves were revised at December 31, 2014 as part of the annual review. This change resulted in the movement of $2,151 of reserves from prior accident years to the current accident year, and hence, was reported as favorable development on prior years' reserves. Development on prior years’ reserves resulting solely from changes in the allocation of bulk reserves between the current and prior accident years does not have an impact on earnings.
The Company has exposure to asbestos and environmental related claims associated with the insurance business written by the parties to the pooling agreement and the reinsurance business assumed from Employers Mutual by the reinsurance subsidiary. These exposures are not considered to be significant. Asbestos and environmental losses paid by the Company have averaged $1,720 per year over the past five years. Reserves for asbestos and environmental related claims for direct insurance and assumed reinsurance business totaled $9,420 and $9,643 ($9,296 and $8,950 net of reinsurance) at December 31, 2014 and 2013, respectively.
Statutory surplus of the Company’s insurance subsidiaries was $454,799 and $416,718 at December 31, 2014 and 2013, respectively. Statutory net income of the Company’s insurance subsidiaries was $32,159, $41,162 and $38,102 for 2014, 2013 and 2012, respectively.
The amount of dividends available for distribution to the Company by its insurance subsidiaries is limited by law to a percentage of the statutory unassigned surplus of each of the subsidiaries as of the previous December 31, as determined in accordance with accounting practices prescribed by insurance regulatory authorities of the state of domicile of each subsidiary. Subject to this limitation, the maximum dividend that may be paid within a 12 month period without prior approval of the insurance regulatory authorities is generally restricted to the greater of 10 percent of statutory surplus as regards policyholders as of the preceding December 31, or net income of the preceding calendar year on a statutory basis, not greater than earned statutory surplus. At December 31, 2014, $45,480 was available for distribution to the Company in 2015 without prior approval.
Short-term investments generally include money market funds, U.S. Treasury bills and commercial paper. Short-term investments are carried at fair value, which approximates cost, due to the highly liquid nature of the securities. Short-term securities are classified as Level 1 fair value measurements when the fair value can be validated by recent trades. When recent trades are not available, fair value is deemed to be the cost basis and the securities are classified as Level 2 fair value measurements.
Presented in the table below are the estimated fair values of the Company’s financial instruments as of December 31, 2014 and 2013.
Presented in the table below is a reconciliation of the assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the years ended December 31, 2014 and 2013. Any unrealized gains or losses on these securities are recognized in other comprehensive income. Any gains or losses from disposals or impairments of these securities are reported as realized investment gains or losses in net income.
The amortized cost and estimated fair value of securities available-for-sale as of December 31, 2014 and 2013 are as follows. All securities are classified as available-for-sale and are carried at fair value.
The following table sets forth the estimated fair value and gross unrealized losses associated with investment securities that were in an unrealized loss position as of December 31, 2014 and 2013, listed by length of time the securities were in an unrealized loss position.
All of the Company’s preferred stock holdings are perpetual preferred stocks. The Company evaluates perpetual preferred stocks with unrealized losses for “other-than-temporary” impairment similar to fixed maturity securities since they have debt-like characteristics such as periodic cash flows in the form of dividends and call features, are rated by rating agencies and are priced like other long-term callable fixed maturity securities. There was no evidence of any credit deterioration in the issuers of the preferred stocks and the Company does not intend to sell these securities before recovery, nor does it believe it will be required to sell these securities before recovery; therefore, it was determined that these securities were not “other-than-temporarily” impaired at December 31, 2014.
The amortized cost and estimated fair value of fixed maturity securities at December 31, 2014, 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.
The actual income tax expense for the years ended December 31, 2014, 2013 and 2012 differed from the “expected” income tax expense for those years (computed by applying the United States federal corporate tax rate of 35 percent to income before income tax expense) as follows:
Employers Mutual also offers postretirement benefit plans which provide certain health care and life insurance benefits for retired employees. Substantially all of its employees may become eligible for those benefits if they reach normal retirement age and have attained the required length of service while working for Employers Mutual. Through 2014, the health care postretirement plan required contributions from participants and contained certain cost sharing provisions such as coinsurance and deductibles. On December 2, 2013, Employers Mutual notified its employees and retirees that effective January 1, 2015, the health care plan would be replaced with a new Employers Mutual - funded Health Reimbursement Arrangement (HRA). Under the HRA, Employers Mutual will reimburse participants for amounts expended to enroll in publicly available health care plans and/or pay for qualifying out-of-pocket health care costs, up to a pre-determined maximum per participant. The obligations of the HRA are based on the total amount of reimbursements expected to be made by Employers Mutual over the lives of the participants, rather than the total amount of medical benefits expected to be paid over the participants’ lives. Therefore, the obligations of the HRA are not impacted by changes in the cost of health care. As a result of this change, the postretirement benefit plans' benefit obligation decreased by $96,704 (the Company's share was $26,937) as of December 31, 2013. The life insurance plan is noncontributory. The benefits provided under both plans are subject to change.
The expected long-term rates of return on plan assets were developed considering actual historical results, current and expected market conditions, plan asset mix and management’s investment strategy. Due to the planned conversion of the postretirement health care plan to an HRA effective January 1, 2015, an assumption for the health care cost trend rate is no longer necessary.
Presented below is a reconciliation of the assets measured at fair value using significant unobservable inputs (Level 3) for the years ended December 31, 2014 and 2013.
The following is a description of the fair value pricing techniques used for the asset classes of Employers Mutual’s qualified pension plan.
Employers Mutual plans to contribute approximately $7,000 to the pension plan in 2015. No contributions are expected to be made to the VEBA trust in 2015.
The Company participates in other benefit plans sponsored by Employers Mutual, including its 401(k) Plan, Board and Executive Non-Qualified Excess Plans and Defined Contribution Supplemental Executive Retirement Plan. The Company’s share of expenses for these plans amounted to $1,688, $1,457 and $1,823 in 2014, 2013 and 2012, respectively.
The Company has no stock-based compensation plans of its own; however, Employers Mutual has several stock plans which utilize the common stock of the Company. Employers Mutual can provide the common stock required under its plans by: 1) using shares of common stock that it currently owns; 2) purchasing common stock on the open market; or 3) directly purchasing common stock from the Company at the current fair value. Employers Mutual has historically purchased common stock from the Company for use in its stock plans and its non-employee director stock plans. Beginning with the second quarter 2014 purchase, Employers Mutual is also purchasing common stock from the Company to fulfill its obligations under its employee stock purchase plan (previously the shares needed for this were purchased on the open market).
Beginning in 2013, Employers Mutual's compensation committee began issuing restricted stock, rather than stock options. With the exception of death or permanent disability, any unvested shares of restricted stock are forfeited on termination of employment, including retirement. Restricted stock awards granted under the 2007 Plan generally have a vesting period of four years, with shares vesting in equal annual cumulative increments commencing on the first anniversary of the grant. Holders of unvested shares receive compensation income equal to the amount of any dividends declared.
The Company recognized compensation expense from these plans of $357 ($233 net of tax), $289 ($190 net of tax) and $240 ($174 net of tax) in 2014, 2013 and 2012, respectively.
Employers Mutual uses the average of the high and low trading prices of the Company's stock on the date of grant to determine the fair value of its restricted stock awards. Employers Mutual estimated the fair value of the 2012 option grant on the date of grant using the Black-Scholes-Merton option-pricing model with the following weighted-average assumptions:
The expected term of the options granted to individuals who were not eligible to retire as of the grant date was estimated using historical data that excluded certain option exercises that occurred prior to the normal vesting period due to the retirement of the option holders. The expected term used for options granted to individuals who were eligible to retire as of the grant date was three months, reflecting the fact that upon retirement all unvested options immediately become vested, and the option holder has 90 days to exercise his or her outstanding options.
At December 31, 2014, the Company’s portion of the unrecognized compensation cost associated with option awards issued under Employers Mutual’s stock plans that are not currently vested was $194, with a 1.56 year weighted-average period over which the compensation expense is expected to be recognized. At December 31, 2014, the Company’s portion of the unrecognized compensation cost associated with restricted stock awards issued under Employers Mutual’s stock plans that are not currently vested was $690, with a 2.76 year weighted-average period over which the compensation expense is expected to be recognized. A summary of non-vested restricted stock activity under Employers Mutual’s stock plans for 2014 and 2013 is as follows:
The 2003 Plan does not generally generate income tax deductions for the Company because only incentive stock options could be issued under the plan. The Company has recorded a deferred income tax benefit for a portion of the compensation expense associated with the March 2008 grant and for all subsequent grants (all made under the 2007 Plan) because non-qualified options and restricted stock awards were issued. The Company’s portion of the current income tax deduction realized from exercises of non-qualified stock options was $152, $165 and $2 in 2014, 2013 and 2012, respectively. These actual deductions are generally in excess of the deferred tax benefits recorded in conjunction with the compensation expense (referred to as excess tax benefits) and are reflected in the statement of cash flows as a financing cash inflow (outflow if less) with an offsetting cash flow from operating activities of $103, $96 and $(3) as the Company’s portion in 2014, 2013 and 2012, respectively. The income tax benefit that results from disqualifying dispositions of stock purchased through the exercise of incentive stock options is deemed immaterial.
Employers Mutual did not participate in this plan in 2014, 2013 or 2012. Activity under the plan was as follows:
On October 19, 2006, Employers Mutual entered into a stock appreciation rights (SAR) agreement with the Company’s Executive Vice President and Chief Operating Officer (Mr. Murray) at that time. Because the SAR agreement will be settled in cash, it is considered to be a liability-classified award under ASC Topic 718. As a result, the value of this agreement must be re-measured at fair value at each financial statement reporting date, subject to a minimum fair value stipulated in the SAR agreement. The full value of this agreement was expensed in 2006 because Mr. Murray was eligible for retirement and was entitled to keep the award at retirement, and as a result, the award did not have any subsequent service requirements. Subsequent changes in the fair value of this agreement are reflected as compensation expense, until the agreement is ultimately settled in 2016. Expenses allocated to the Company during 2014 associated with this award totaled $15. The Company did not recognize any compensation expense related to this award during either 2013 or 2012 because the fair value of the award did not exceed the floor amount in the agreement.
These accumulated other comprehensive income components are included in the computation of net periodic pension and postretirement benefit cost (income) (see Note 12, Employee Retirement Plans, for additional details).
The participants in the pooling agreement are subject to guaranty fund assessments by states in which they write business. Guaranty fund assessments are used by states to pay policyholder liabilities of insolvent insurers domiciled in those states. Many states allow assessments to be recovered through premium tax offsets. The Company has accrued estimated guaranty fund assessments of $931 and $894 as of December 31, 2014 and 2013, respectively. Premium tax offsets of $969 and $894, which are related to prior guarantee fund payments and current assessments, have been accrued as of December 31, 2014 and 2013, respectively. The guaranty fund assessments are expected to be paid over the next two years and the premium tax offsets are expected to be realized within ten years of the payments. The participants in the pooling agreement are also subject to second-injury fund assessments, which are designed to encourage employers to employ workers with pre-existing disabilities. The Company has accrued estimated second-injury fund assessments of $1,694 and $1,747 as of December 31, 2014 and 2013, 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.
Amounts include the reclassification of foreign currency exchange rate gains (losses) to other income in the consolidated financial statements. Prior to the fourth quarter of 2014, these amounts were reported as a component of other expenses.
In our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.