(a) Net Realized Investment Gains (Losses) in 2005, 2004, 2003, 2002 and 2001 include the effect of SFAS 133 adjustments of $0.4 million, $0.8 million, $0.8 million, $(0.2) million and $1.1 million, respectively.
(d) The Company adopted SFAS 123(R ) in 2005 which increased stock option expense $1.9 million and reduced net income (after tax) by $1.2 million, or $0.06 per share (diluted and basic). Prior year results were not restated.
Our residential property segment includes primarily manufactured housing and site-built dwelling insurance products. Approximately 45% of American Modern’s property and casualty and credit life gross written premium relates to physical damage insurance and related coverages on manufactured homes, generally written for a term of 12 months with many coverages similar to homeowner’s insurance policies. Our recreational casualty segment includes specialty insurance products such as motorcycle, watercraft, recreational vehicle, collector car and snowmobile. Our financial institutions segment includes specialty insurance products such as mortgage fire, collateral protection and debt cancellation, which are sold to financial service institutions or their customers. The all other insurance segment includes products such as credit life, long-haul truck physical damage, commercial, excess and surplus lines and also includes the results of our fee producing subsidiaries.
American Modern’s total property and casualty gross written premiums decreased 3.4% to $697.9 million in 2005 compared to $722.4 million in 2004. Manufactured housing premiums decreased to $331.5 million in 2005 compared to $334.1 million in 2004. Gross written premiums were pressured by the continued decline associated with several large manufactured housing lender accounts that are no longer making new manufactured housing loans. The top line was also adversely impacted by deliberate exposure management actions undertaken during the year. In order to reverse this trend, American Modern has continued to add to its sales force and has devoted significant energy to raising its brand and market awareness. We also continue to invest in our modernLINK technology in order to differentiate American Modern from its competitors. We believe these actions will allow us to grow our top line gross written premiums over the long term.
American Modern’s commissions and other policy acquisition costs decreased 1.3% in 2005 to $198.6 million from $201.2 million in 2004. This decrease is attributable to the decrease in net earned premium. However, the decrease was partially offset by an increase in performance-based commission expense as a result of the improved underwriting results achieved in 2005 compared to 2004. The fluctuations in performance-based commission expense
are attributable, in part, to American Modern’s “Pay for Performance” commission policy with agents representing the Company which reduces the up-front commission paid but rewards favorable underwriting and growth performance with a higher performance-based commission.
The Company’s operating and administrative expenses increased 3.5% to $112.3 million in 2005 compared to $108.5 million in 2004. This increase is due primarily to expenses related to modernLINK®, our proprietary information systems and web enablement initiative, and an increase in employee salaries and benefits. In addition, the Company adopted Statement of Financial Accounting Standards (“SFAS”) 123(R) in 2005 which resulted in the recognition of $1.9 million in stock option expense.
M/G Transport, Midland’s transportation subsidiary, contributed $4.9 million of income, before taxes, in 2005 compared to $1.7 million in 2004. The increased profitability was due partially to significantly improved freight rates during 2005, a trend that we expect to continue in 2006. In addition, M/G Transport focused its resources on shorter more profitable moves in 2005. This strategy considerably improved M/G Transport’s profitability, but hampered its top line revenues. In fact, M/G Transport’s revenues decreased slightly to $42.2 million in 2005 compared to $45.4 million in 2004.
The combined ratio for the residential property segment was 94.3% in 2004 compared to 97.3% in 2003. The results from this segment are driven primarily by the manufactured housing and site-built dwelling products. Although the manufactured housing industry continues to be depressed, American Modern’s gross written premium related to this product increased 4.3% to $334.1 million in 2004 from $320.2 million in 2003. This increase was primarily the result of rate increases combined with the strategic conversion of targeted books of business (where we obtain a book of business or future renewals from an agent). Site-built dwelling gross written premiums increased 7.2% to $88.4 million in 2004 compared to $82.5 million in 2003.
American Modern’s excess and surplus lines and credit life products were the primary drivers of the increase in gross written premiums in 2004 compared to 2003. A large percentage of credit life gross written premium is ceded to an insurance affiliate of the producing agent. The improvement in profitability in 2004 compared to 2003 is due primarily to the actions taken to address the run-off of our manufactured housing park and dealer commercial liability business which we exited in 2001. During 2003, the run-off of this previously exited business reduced pre-tax income by $12.1 million, or $0.44 per share (diluted). In 2004, the run-off of these discontinued lines increased pre-tax income by $2.9 million, or $0.10 per share (diluted).
Although net investment income is allocated to segments and product lines, the investment portfolio is generally managed as a whole and therefore is more meaningfully discussed in total. Net investment income increased to $37.2 million in 2004 from $33.3 million in 2003. This increase is due primarily to the increase in the size of the portfolio. The increase in portfolio size was due primarily to the investment of $24 million in proceeds related to the public stock offering, the investment of $24 million related to the issuance of junior subordinated debt securities and positive cash flow generated from operations. Reinvestment rates continue to be depressed due to the current low interest rate environment. The annualized pre-tax equivalent investment yield, on a cost basis, of the Company’s fixed income portfolio was 5.3% in 2004 compared to 5.5% in 2003.
During 2004 the company experienced favorable loss development, while it experienced unfavorable loss development in 2003. This was attributable to several factors. The company exited a commercial liability product line in 2001 related to manufactured housing park operators and dealers. Original loss reserve estimates in 2001 and 2002 related to this line were not adequate. Loss reserve estimates were increased in 2003 to account for this deficiency. Subsequent settlement of these reserves has been for amounts below the revised loss reserves, resulting in a redundancy in 2004. Another factor that contributed to the favorable development was an overestimate of the reserves related to the motorcycle line of business, the excess and surplus lines business and the liability component of our other personal lines products. The liability components associated with these lines are inherently less predictable than the company’s traditional property coverages. The company entered the motorcycle line in 2000 and the excess and surplus lines in 2002. The excess and surplus line has continued to grow at a rapid pace while the motorcycle line contracted in 2004.
No shares were repurchased in the open market under the Company’s share repurchase program during 2005 and a total of 586,000 shares remain authorized for repurchase under terms of this authority. On April 29, 2004, the Company’s Board of Directors approved a two-year extension to the share repurchase program that will run through the date of the Board’s second quarterly meeting in 2006. The resolution does not require the repurchase of shares, but rather gives management discretion to make purchases based on market conditions and the Company’s capital requirements.
We paid dividends to our shareholders of $4.2 million during 2005, $3.7 million in 2004 and $3.3 million in 2003.
We expect that our existing cash and other liquid investments, coupled with future operating cash flows and our short-term borrowing capacity, will meet our operating cash requirements for the next 12 months.
Midland has a commercial paper program under which qualified purchasers may invest in the short-term unsecured notes of Midland. As of December 31, 2005, we had $6.0 million of commercial paper debt outstanding, $5.1 million of which represented notes held either directly or indirectly by our executive officers and directors. The effective annual yield paid to all participants in this program was 4.3% as of December 31, 2005, a rate that is considered to be competitive with the market rates offered for similar instruments. As of December 31, 2005, Midland also had $83.0 million of conventional short-term credit lines available at costs not exceeding prime borrowing rates, of which $14.0 million was outstanding. These lines of credit contain minimal covenants and are typically drawn and repaid over periods ranging from two weeks to three months. We also have a mortgage obligation related to the financing of our corporate headquarters building. As of December 31, 2005, the outstanding balance of this mortgage was $13.9 million. This mortgage obligation includes normal and customary debt covenants for instruments of this type. Monthly interest payments are required until maturity in December 2007. The effective interest rate on this obligation is based on LIBOR plus 1% and was 5.36% at December 31, 2005.
The market value of Midland’s consolidated investment portfolio (comprised primarily of the investment holdings of American Modern) decreased 2.5% to $947.1 million at December 31, 2005 from $971.4 million at December 31, 2004. This decrease was due primarily to the $21.4 million decrease in unrealized appreciation in the market value of the securities held at December 31, 2005 compared to year end 2004. The decrease in the unrealized appreciation was due to a $4.5 million decrease in unrealized appreciation related to the equity portfolio combined with a $16.9 million decrease in unrealized appreciation pertaining to the fixed income portfolio. Midland’s largest equity holding, 2.5 million shares of U.S. Bancorp, decreased to $73.5 million as of December 31, 2005 from $77.1 million as of December 31, 2004.
Securities with unrealized gains and losses by category (equity and debt) and by time frame are summarized in the chart below (amounts in 000’s):
Accounts receivable is primarily comprised of premium due from both policyholders and agents. In the case of receivables due directly from policyholders, policies are cancelable in the event of non-payment and thus offer minimal credit exposure. Approximately 63% of American Modern’s accounts receivables relate to premium due directly from policyholders as of December 31, 2005. In the case of receivables due from agents, American Modern has extended payment terms that are customary and normal in the insurance industry. Management monitors its credit exposure with its agents and related concentrations on a regular basis. However, as collectibility of such receivables is dependent upon the financial stability of the agent, American Modern cannot assure collections in full. Where management believes appropriate, American Modern has provided a reserve for such exposures. Accounts receivable increased $23.1 million to $137.1 million at December 31, 2005 compared to $114.0 million at year end 2004. The increase is due, in part, to the increase in the use of installment billing in 2005.
The increase in reinsurance recoverables of $45.0 million at December 31, 2005 compared to 2004 is attributable primarily to increased recoverables from catastrophe reinsurers related to hurricanes Katrina, Rita and Wilma.
The increase of $21.7 million in insurance loss reserves was due to the remaining gross reserves related to hurricanes Katrina, Rita and Wilma. The following table provides additional detail surrounding the Company’s insurance policy loss reserves at December 31, 2005 and 2004 (amounts in 000’s):
The transportation subsidiaries entered into a fifteen-year lease in 1999 for transportation equipment. Aggregate rental payments under this operating lease over the next ten years will approximate $5.2 million.
In 2003, M/G Transport adopted the provisions of FASB Interpretation No. 46 (“FIN” 46), “Consolidation of Variable Interest Entities”, and capitalized an operating lease related to certain transportation equipment. The recorded asset value was subsequently determined to be in excess of its fair market value and impairment charges of $0.8 million (pre-tax) and $0.5 million (pre-tax) were recorded in 2004 and 2003, respectively. Later in 2004, the Company sold the transportation equipment for $1.7 million and recognized a pre-tax gain of $0.2 million. The Company used the proceeds from this sale to eliminate the debt related to the equipment.
The differences between our net income and comprehensive income are changes in unrealized gains on marketable securities, changes in the fair value of the interest rate swap agreement and additional minimum liability requirements related to our defined benefit pension
Net unrealized investment gains in equity securities (net of income tax effects) decreased $2.9 million in 2005 and increased $2.7 million in 2004 and $25.5 million in 2003. For fixed income securities, net unrealized gains decreased $11.0 million in 2005, $1.7 million in 2004 and $0.3 million in 2003.
Changes in net unrealized gains on marketable securities result from both market conditions and realized gains recognized in a reporting period. The interest rate swap agreement expired during 2005. While the interest rate swap agreement was in place, its after-tax fair value varied according to the current interest rate environment relative to the fixed rate of the swap agreement. Changes in the additional minimum pension liability are actuarially determined based on the funded status of the plans and current actuarial assumptions.
We believe the following critical accounting policies require significant judgments and estimates in the preparation of our consolidated financial statements.
American Modern’s reserve for insurance losses is based on past experience of settling known claims as well as estimating those not yet reported. While management believes the amounts are fairly stated, the ultimate liability, once fully developed, may be more than or less than that provided. Management and its actuaries, both internal and external, regularly review these liabilities and adjustments are made as necessary in the current period. Management does not foresee any significant change in the manner in which it records its reserve for insurance losses.
While management believes the amounts are fairly stated, the ultimate liability, once fully developed, may be more than or less than the recorded amount. Management believes that the likelihood that actual loss development patterns will differ significantly from past experience is low given the short-tail, property oriented nature of the Company’s business. However, if the ultimate pay outs would significantly exceed the expected amounts, the Company has several potential options to utilize in order to satisfy the additional obligations. For example, the Company could liquidate a portion of its investment portfolio or draw on conventional short-term credit lines available, at costs not exceeding prime rates. The Company believes either of these options would be sufficient to meet any increases in required loss payments.
near term prospects for improvement of the issuer and/or its industry to include relevant industry conditions and trends
It is our intent, and thus the intent of our investment managers, to hold securities that have an unrealized gain or loss. For the securities with an unrealized loss, which in our judgment we believe to be temporary, it is our intent to hold the security for a period of time that will allow the security to recover in value. However, if the investment managers believe returns would be enhanced by selling the security and reinvesting the proceeds, the managers may do so, in which case the unrealized gain or loss will be recognized as a realized gain or loss. As part of our comprehensive quarterly review for other than temporary impairment, the investment managers identify any securities in which they have the intent to sell in the near term. In the case where investment managers have indicated their intent to sell a security in the near term and there is an unrealized loss, we record an other-than-temporary impairment at the balance sheet date, if such date is prior to the sale of the security. At December 31, 2005, we had no securities with an unrealized loss for which a decision was made to sell in the near term.
For the years ended December 31, 2005 and 2004, we incurred no losses related to other-than-temporary impairments. For the year ended December 31, 2003, we incurred approximately $1.9 million in other-than-temporary impairment losses. Impairment charges are included in the consolidated financial statements in “net realized investment gains (losses).”
Midland maintains defined benefit pension plans for a limited number of active participants. The defined benefit pension plans are not open to employees hired after March 31, 2000. The pension expense is calculated based upon a number of actuarial assumptions, including an expected long-term rate of return and a discount rate. In determining our expected
In May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Correction,” which replaces Accounting Principles Board (“APB”) Opinion No. 20, Accounting Changes, and FASB Statement No. 3, Reporting Accounting Changes in Interim Financial Statements. SFAS No. 154 requires retrospective application to prior periods’ financial statements for changes in accounting principle, unless determination of either the period specific effects or the cumulative effect of the change is impracticable or otherwise promulgated. SFAS No. 154 is effective for fiscal years beginning after December 15, 2005. SFAS No. 154, upon adoption, is not expected to have a material effect on the Company’s Consolidated Financial Position or Results of Operations.
In November 2005, the Financial Accounting Standards Board (“FASB”) issued FSP FAS 115-1, which nullifies the guidance in paragraphs 10-18 of EITF Issue 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” and references existing other than temporary impairment guidance. FSP FAS 115-1 clarifies that an investor should recognize an impairment loss no later than when the impairment is deemed other-than-temporary, even if a decision to sell the security has not been made, and also provides guidance on the subsequent accounting for an impaired debt security. FSP FAS 115-1 is effective for reporting periods beginning after December 15, 2005. The adoption of FSP FAS 115-1 is not expected to have a material impact on the Company’s Consolidated Financial Position or Results of Operations.
We do not consider the impact of the change in prices due to inflation to be material in the analysis of our overall operations.
We have audited the accompanying consolidated balance sheets of The Midland Company and subsidiaries (the “Company”) as of December 31, 2005 and 2004, and the related consolidated statements of income, changes in shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2005. Our audits also included the financial statement schedules listed in the Index at Item 15(a)(2). These financial statements and schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of The Midland Company and subsidiaries at December 31, 2005 and 2004, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2005, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein.
As discussed in Note 1, the Company adopted Statement of Financial Accounting Standards No. 123 (revised 2004), “Share Based Payment,” effective January 1, 2005.
In 2003, an obligation of $2,649 was incurred when the Company capitalized a lease related to a certain piece of transportation
equipment upon adoption of FASB Interpretation No. 46. The asset was sold in 2004.
Treasury stock issued under the Company’s performance stock award plan amounted to $1,155 for 2005.
The Midland Company (the “Company” or “Midland”) operates in two industries-insurance and transportation with the most significant business activities being in insurance. Midland’s insurance operations are conducted through its wholly-owned subsidiary, American Modern Insurance Group, Inc. (“American Modern”). M/G Transport Services, Inc. and MGT Services, Inc. (collectively “M/G Transport”) operates a fleet of dry cargo barges for the movement of dry bulk commodities such as petroleum coke, ores, barite, sugar and other cargos primarily on the lower Mississippi River and its tributaries.
Insurance Loss Reserves - Unpaid insurance losses and loss adjustment expenses include an amount determined from reports on individual cases and an amount, based on past experience and other assumptions, for losses incurred but not reported. Such liabilities are necessarily based on estimates and, while management believes that the amounts are fairly stated, the ultimate liability may be in excess of or less than the amounts provided. The methods of making such estimates and for establishing the resulting liabilities are continually reviewed and any adjustments resulting therefrom are included in earnings currently. Insurance loss reserves also include an amount for claim drafts issued but not yet paid. In addition, insurance loss reserves are presented net of amounts recoverable from salvage and subrogation and include amounts recoverable from reinsurance for which receivables are recognized.
Transportation Revenues - Revenues for river transportation activities are recognized when earned. If freight services are in process at the end of a reporting period, an allocation of revenue between reporting periods is made based on relative transit time in each reporting period with expenses recognized as incurred.
In October 2005, the American Institute of Certified Public Accountants issued Statement of Position (“SOP”) 05-1. SOP 05-1 provides accounting guidance for deferred policy acquisition costs on internal replacements of insurance and investment contracts other than those specifically described in SFAS No. 97, “Accounting and Reporting by Insurance Enterprises for
Included in Net Realized Investment Gains (Losses) for 2005, 2004 and 2003 is the change in the fair value of derivative features of (amounts in 000’s) $392, $764 and $799 respectively.
The cost or amortized cost and approximate fair value of debt securities held at December 31, 2005, summarized by contractual maturities, are shown below. Actual maturities may differ from contractual maturities when there exists a right to call or prepay obligations with or without call or prepayment penalties (amounts in 000’s).
The Company’s fixed income portfolio primarily consists of high quality investment grade securities and has an “AA” Standard & Poor’s average quality rating at December 31, 2005. The Company performs quarterly comprehensive reviews of individual fixed income and equity portfolio holdings that have a market value less than their respective carrying value. The Company, with the assistance of its external professional money managers, applies both quantitative and qualitative criteria in its evaluation of possible other-than-temporary impairment, including facts specific to each individual investment, including, but not limited to, the length of time the fair value has been below carrying value, the extent of the decline, the Company’s intent to hold or sell the security, the expectation for each security’s performance as well as prospects for recovery, the credit worthiness and related liquidity of the issuer and the issuer’s business sector.
The following table shows the Company’s investments’ gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at December 31, 2005 and 2004 (amounts in 000’s):
At December 31, 2005 and 2004, property, plant and equipment stated at original cost consist of the following (amounts in 000’s):
Total rent expense related to the rental of equipment included in the accompanying Consolidated Statements of Income is (amounts in 000’s) $3,808 in 2005, $3,756 in 2004 and $4,889 in 2003. Future rentals under non-cancelable operating leases are approximately (amounts in 000’s): $1,204 - 2006; $935 - 2007; $590 - 2008; $566 - 2009; $635 in 2010 and $2,379 - thereafter.
As of December 31, 2005 and 2004, the unamortized balance of modernLINK’s software development costs was $20.1 million and $9.9 million, respectively.
Acquisition costs incurred and capitalized during 2005, 2004 and 2003 amounted to $196.5 million, $203.7 million and $169.1million, respectively. Commissions and other policy acquisition costs, including amortization of deferred acquisition costs, was $198.6 million, $201.2 million and $177.6 million for 2005, 2004 and 2003, respectively.
The Company had conventional lines of credit with commercial banks of $83 million and $79 million with $14 million and $29 million in use under these agreements at December 31, 2005 and 2004, respectively. Borrowings under these lines of credit constitute senior debt. Total commercial paper debt outstanding at December 31, 2005 and 2004 was $6.0 million and $4.2 million, respectively.
The aforementioned notes payable, together with outstanding commercial paper, had weighted average interest rates of 4.90% and 2.80% at December 31, 2005 and 2004, respectively.
Equipment and real estate obligations are collateralized by transportation equipment and real estate with a net book value of $41.2 million at December 31, 2005.
Significant components of the Company’s net deferred federal income tax liability are summarized as follows (amounts in 000’s):
The amounts of recoveries pertaining to property and casualty reinsurance contracts that were deducted from losses incurred during 2005, 2004 and 2003 were (amounts in 000’s): $189,407, $38,295 and $23,151, respectively.
In 2005 and 2004 incurred losses related to prior years benefited from claims settling in 2005 and in 2004 for less than the case base reserve amounts that were estimated at the end of the previous respective years. During 2003, the company strengthened loss reserves, as losses from years prior to 2003 developed unfavorably, particularly in the exited commercial liability lines of business.
Loss reserves, net of reinsurance, for Life and Other totaled $6.0 million, $6.9 million and $6.8 million at December 31, 2005, 2004 and 2003 respectively.
At December 31, 2005 and 2004, the Company’s additional minimum pension liabilities were $6.0 million and $3.6 million, respectively. Related to these actually determined minimum pension liabilities, comprehensive income was reduced by $1.6 million and $2.0 million, net of deferred federal income taxes, at December 31, 2005 and 2004, respectively.
At December 31, 2005, options exercisable have exercise prices between $6.32 and $33.21 and an average contractual life of approximately 5.4 years.
At December 31, 2005, 1,432,000 common shares are authorized for future option award or stock grants.
During the fourth quarter of 2005, the Company elected to early adopt SFAS 123 (Revised 2004), “Share-Based Payment” (“SFAS 123(R)”) under the modified retrospective approach, restating only prior interim periods in fiscal 2005. As a result, the Company recognized $1.9 million of expense in 2005 related to its stock option program.
The Company has 40,000,000 shares of common stock authorized for issuance without par value (stated value of $.042 a share). The Company also has 1,000,000 shares of preferred stock authorized, without par value, none of which have been issued.
In January 2001, the Company’s Board of Directors authorized the repurchase of up to 1,000,000 shares of the Company’s common stock and 414,000 of these shares have been repurchased as of December 31, 2005. No shares were repurchased in 2005 or 2004.
The change in accumulated other comprehensive income is due to changes related to the unrealized gains and losses on investments, the fair value of interest rate swaps and additional minimum pension liability as follows (amounts in 000’s):
Net income as reported by the Company’s insurance subsidiaries, determined in accordance with statutory accounting practices, which differ in certain respects from accounting principles generally accepted in the United States of America, for the Company’s insurance subsidiaries was (amounts in 000’s): $68,634, $57,677 and $34,518 for 2005, 2004 and 2003, respectively. Statutory surplus as reported by the Company’s insurance subsidiaries, was (amounts in 000’s): $394,314 and $355,518 at December 31, 2005 and 2004, respectively.
The Company has a commercial paper program under which qualified purchasers may invest in the short-term unsecured notes of Midland. Many of the investors in this program are executive officers and directors of the Company. Total commercial paper debt outstanding at December 31, 2005 and 2004 was $6.0 million and $4.2 million, respectively, of which $5.1 million and $3.5 million at those respective dates represented notes held either directly or indirectly by the executive officers and directors of the Company. The effective annual yield paid to all participants in this program was 4.3% as of December 31, 2005, a rate that is considered to be competitive with the market rate for similar instruments.
The Company writes insurance throughout the United States with larger concentrations in the southern and southeastern states. Transportation includes barge chartering and freight brokerage operations primarily on the lower Mississippi River and its tributaries.
The amounts shown for residential property, recreational casualty, financial institutions, all other insurance and unallocated insurance comprise the consolidated amounts for Midland’s insurance operations subsidiary, American Modern Insurance Group, Inc. Intersegment revenues were not significant for 2005, 2004 or 2003. During 2004 the Midland parent company purchased 492,634 shares of U.S. Bancorp common stock from American Modern Insurance Group, Inc. The effects of this transaction were eliminated from consolidated net realized investment gains, income before taxes and income tax expense.