Consolidated Statements of Shareholders’ Equity for the Years Ended December 31, 2010 and 2009
We have audited the accompanying consolidated balance sheets of Penn Millers Holding Corporation and subsidiary (the Company) as of December 31, 2010 and 2009, and the related consolidated statements of operations, shareholders’ equity, and cash flows for the years then ended. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
The Company owned Eastern Insurance Group (EIG), an insurance agency, and Penn Software & Technology Services, Inc. (PSTS), which provided both hardware and computer programming services to its clients. The Company sold substantially all of the assets of EIG and PSTS in 2009 and 2008, respectively (see note 17). The financial results of each of these subsidiaries have been presented as discontinued operations during the year ended December 31, 2009. The Company ceased all operations of EIG in 2009 and PSTS in 2008.
The accompanying consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles (GAAP) and include the accounts and operations of the Company and its subsidiary. All material intercompany balances and accounts have been eliminated in consolidation.
The preparation of consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the consolidated financial statements. These reported amounts include the financial statement recognition of loss reserves, contingent liabilities, tax valuation allowances, valuation of deferred policy acquisition costs, valuation of defined benefit pension obligations and valuation of investments, including other-than-temporary impairment of investments. These reported amounts also include the disclosure of contingent assets and liabilities. Management’s estimates and assumptions also affect the reported amounts of revenues and expenses, during the reporting period. Actual results could differ from these estimates.
Additionally, one producer, Arthur J. Gallagher Risk Management Services, which writes business for the Company through nine of its offices, accounted for 13% of the Company’s direct premium writings for 2010. Only one other producer accounted for more than 5% of the Company’s 2010 direct premium writings.
Realized gains and losses on sale of investments are recognized in net income on the specific identification basis as of the trade date. Realized losses also include losses for fair value declines that are considered to be other-than-temporary. Changes in unrealized gains or losses on investments carried at fair value, net of applicable
income taxes, are reflected directly in shareholders’ equity as a component of comprehensive income (loss) and, accordingly, have no effect on net income.
On April 1, 2009, the Financial Accounting Standards Board (FASB) issued new guidance on the recognition and presentation of other-than-temporary impairments. This new guidance amends the previously used methodology for determining whether an other-than-temporary impairment exists for fixed maturity securities. Per the Company’s current policy, a fixed maturity security is other-than-temporarily impaired if the present value of the cash flows expected to be collected is less than the amortized cost of the security or where the security’s fair value is below cost and the Company intends to sell or more likely than not will be required to sell the security before recovery of its value. If the fixed maturity security meets either of these two criteria, the other-than-temporary impairment recognized in earnings is equal to the entire difference between the security’s amortized cost basis and its estimated fair value at the impairment measurement date. If the Company does not intend to sell, or more likely than not will not be required to sell, a fixed maturity security whose fair value has declined below its cost, the amount of the decline below cost due to credit-related reasons is charged to earnings and the remaining difference is included in comprehensive income.
The fair value of investments is reported in note 3. The fair value of other financial instruments, principally receivables, accounts payable and accrued expenses approximates their December 31, 2010 and 2009 carrying values.
Policy acquisition costs, such as commissions, premium taxes, and certain other underwriting expenses that vary with, and are primarily related to, the production of new and renewal business, have been deferred and are amortized over the effective period of the related insurance policies. The method followed in computing deferred policy acquisition costs limits the amount of such deferred costs to their estimated realizable value, which gives effect to the premium to be earned, related investment income, losses and loss adjustment expenses, and certain other costs expected to be incurred as the premium is earned. Future changes in estimates, the most significant of which is expected losses and loss adjustment expenses, may require adjustments to deferred policy acquisition
The costs of property and equipment are depreciated using the straight-line method over the estimated useful lives of the assets. Maintenance, repairs, and minor renewals are charged to expense as incurred, while expenditures that substantially increase the useful life of the assets are capitalized. Fixed assets are depreciated over three to seven years. Property is depreciated over useful lives generally ranging from five to forty years. The Company continually monitors the reasonableness of the estimated useful lives and adjusts them as necessary.
The Company tests for impairment of property, plant, and equipment whenever events or changes in circumstances indicate that the carrying amount of the assets may not be recoverable. As of December 31, 2010, an impairment is not considered necessary.
Discontinued operations represent components of the Company that have been disposed of. The results of operations of reporting units classified as discontinued operations are done so for all periods presented.
The Company’s estimated liability for asbestos and environmental claims is $2,363 and $2,397 at December 31, 2010 and 2009, respectively, a substantial portion of which results from the Company’s participation in assumed reinsurance pools. The Company estimates this liability based on its pro rata share of asbestos and environmental case reserves reported by the pools and an additional estimate of incurred but not reported losses and loss adjustment expenses based on actuarial analysis of the historical development patterns. The estimation of the
ultimate liability for these claims is difficult due to outstanding 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 significantly greater than normal variation and uncertainty.
The Company records annual amounts relating to its defined benefit pension plan and nonqualified Supplemental Executive Retirement Plan (SERP) based on calculations that include various actuarial assumptions, such as discount rates, mortality and rates of return. These estimates are highly susceptible to change from period to period based on the performance of plan assets, demographic changes, and market conditions. The Company reviews its actuarial assumptions on an annual basis and makes modifications to the assumptions based on current rates and trends. The Company believes that the assumptions used in recording its defined benefit pension plan and SERP obligations are reasonable based on its experience, market conditions, and input from its actuaries and investment advisors.
The Company recognizes compensation expense related to its ESOP equal to the product of the number of shares earned, or committed to be released during the period, and the average price of the Company’s common stock during the period. The estimated fair value of unearned ESOP shares is calculated based on the average price of the Company’s common stock for the period. For purposes of calculating earnings per share, the Company includes the weighted average of ESOP shares committed to be released for the period.
Insurance premiums on property and casualty insurance contracts are recognized in proportion to the underlying risk insured and are earned ratably over the duration of the policies. The reserve for unearned premiums on these contracts represents the portion of premiums written relating to the unexpired terms of coverage. The Company estimates earned but unbilled (EBUB) audit premiums and records them as an adjustment to earned premiums. The estimation of EBUB is based on a quantitative analysis of the Company’s historical audit experience.
In January 2010, the Financial Accounting Standards Board (FASB) issued guidance to improve the disclosures related to fair value measurements. The new guidance requires expanded fair value disclosures, including the reasons for significant transfers between Level 1 and Level 2 and the amount of significant transfers into each level disclosed separately from transfers out of each level. For Level 3 fair value measurements,
In July 2010, the FASB issued Accounting Standards Update (ASU) 2010-20, Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses, which requires significant new disclosures about the allowance for credit losses and the credit quality of financing receivables. The requirements are intended to enhance transparency regarding credit losses and the credit quality of loan and lease receivables. Under this statement, allowance for credit losses and fair value are to be disclosed by portfolio segment, while credit quality information, impaired financing receivables and nonaccrual status are to be presented by class of financing receivable. The disclosures are to be presented at the level of disaggregation that management uses when assessing and monitoring the portfolio’s risk and performance. This ASU is effective for interim and annual reporting periods after December 15, 2010. Excluding certain agency receivables, which are immaterial, all of the Company’s financing receivables have maturity dates of less than one year. The adoption of this ASU did not have an impact on the Company’s financial position and results of operations.
The fair value of a financial asset or financial liability is the amount at which the asset or liability could be bought or sold in a current transaction between willing parties, that is, other than in a forced or liquidated sale. In accordance with the guidance set forth by ASC 820, the Company’s financial assets and financial liabilities
The table below presents the balances of assets and liabilities measured at fair value on a recurring basis as of December 31, 2010 and December 31, 2009:
The Company uses quoted values and other data provided by a nationally recognized independent pricing service in its process for determining fair values of its investments. The pricing service provides the Company one quote per instrument. Level 1 securities consist of U.S. Treasury fixed maturity securities and publicly traded mutual funds. Level 2 securities are comprised of available for sale fixed maturity securities whose fair value was determined using observable market inputs. For fixed maturity securities that have quoted prices in active markets, market quotations are provided. Fair values for securities for which quoted market prices were unavailable were estimated based upon reference to observable inputs such as benchmark interest rates, market comparables, and other relevant inputs. Investments valued using these inputs include obligations of U.S. government agencies, obligations of states and political subdivisions, commercial and residential mortgage-backed securities, and corporate securities. Inputs into the fair value application that are utilized by asset class include but are not limited to:
Corporate securities: overall credit quality; the establishment of a risk adjusted credit spread over the applicable risk free yield curve for discounted cash flow valuations; assessments of the level of industry economic sensitivity; company financial policies; indenture restrictive covenants; and/or security and collateral.
The amortized cost and fair value of investments in fixed maturity and equity securities, which are all available for sale, at December 31, 2010 and December 31, 2009, are as follows:
At December 31, 2010 and December 31, 2009, investments with a fair value of $4,348 and $4,358, respectively, were on deposit with regulatory authorities, as required by law.
Realized gross gains from investments and the change in difference between fair value and cost of investments, before applicable income taxes, are as follows:
The fair value and unrealized losses for securities temporarily impaired as of December 31, 2010 and December 31, 2009 are as follows:
These fixed maturity and equity securities are classified as available for sale because the Company will, from time to time, sell securities that are not impaired, consistent with its investment goals and policies. Fair values of interest rate sensitive instruments may be affected by increases and decreases in prevailing interest rates which generally translate, respectively, into decreases and increases in fair values of fixed maturity investments. The fair values of interest rate sensitive instruments also may be affected by the credit worthiness of the issuer, prepayment options, relative values of other investments, the liquidity of the instrument, and other general market conditions. There are $4,092 in fixed maturity securities, at fair value, that at December 31, 2010, had been below cost for 12 months or longer. The $58 of unrealized losses on such securities relates to securities which carry an investment grade debt rating and have declined in fair value roughly in line with overall market conditions. The Company has evaluated each fixed maturity security and taken into account the severity and duration of the impairment, the current rating on the bond, and the outlook for the issuer according to independent analysts. The Company has found that the declines in fair value of these assets are most likely attributable to the current interest rate environment.
A portion of the Company’s investment portfolio is in a high-yield bond fund that invests primarily in U.S. debt securities. This is a publicly traded mutual fund in which the Company has an ownership stake in the overall assets of the fund, which is stated as a number of shares, and the Company is not a creditor in the underlying debt securities. Therefore, the mutual fund is classified as an equity security.
See note 10 for additional information related to the allocation of tax between continuing operations and accumulated other comprehensive income.
Changes in deferred policy acquisition costs for the years ended December 31, 2010 and 2009 are as follows:
Property and equipment consisted of land and buildings with a cost of $5,784 and $5,746 and equipment, capitalized software costs, and other items with a cost of $9,317 and $9,177 at December 31, 2010 and 2009,
Rental expense under leases for continuing operations amounted to $100 and $100 for 2010 and 2009, respectively.
On August 1, 2009, upon approval by the board of directors, the Company’s administrator amended the defined benefit pension plan, whereby all participants’ accrued benefits under the plan were frozen as of October 31, 2009. The Company recognized a curtailment benefit of $1,659 for the year ended December 31, 2009, which has been reflected in accumulated other comprehensive income in equity. Due to a decline in interest rates, this benefit was partially offset by an actuarial loss of $717.
On May 12, 2010, upon approval by the Board of Directors, the Company terminated the SERP for four of the five participants. The one remaining participant is a retired employee in pay status. The SERP benefit obligation was re-measured on that date and the Company recorded a net curtailment loss of $68 and a settlement gain of $747 which were classified as underwriting and administrative expenses in the consolidated statements of operations. The net curtailment loss of $68 was a result of the recognition of $472 of prior unrecognized service costs which was net of a $404 reduction of the projected benefit obligation to the accumulated benefit obligation. The settlement gain of $747 was the result of a further reduction of the accumulated benefit obligation to zero for the four former participants. On the re-measurement date, the weighted average discount rate was 5.41% compared to 5.67% at December 31, 2009. The accumulated benefit obligation for the one remaining participant in pay status at December 31, 2010 is $627.
The accumulated benefit obligation for the qualified defined benefit pension plan was $8,001 and $7,380 at December 31, 2010 and 2009, respectively.
Weighted average assumptions used to determine benefit obligations at December 31, 2010 and 2009 are as follows:
Pension plan assets are invested for the exclusive benefit of the plan participants and beneficiaries and are intended, over time, to satisfy the benefit obligations under the plan. The Company maintains an investment policy for the pension plan, which is reviewed at least annually. The overall investment strategy is to maintain appropriate liquidity to meet the cash requirements of the short-term plan obligations and to maximize the plan’s return while adhering to the policy’s objectives and risk guidelines, as well as the regulations set forth by various government entities. The policy sets forth asset allocation guidelines that emphasize U.S. investments with strong credit quality and restricts traditionally risky investments.
The current target allocation for plan assets is 60% for equity securities and 40% for fixed income securities. Equity securities include investments in domestic large and small cap index funds, as well as an international developed markets index fund. The target asset allocation within equities is 70% domestic large cap, 15% domestic small cap, and 15% international developed markets. Fixed income securities are in an investment grade long term bond index fund. Investment asset allocation is measured and monitored on an ongoing basis.
To develop the expected long-term rate of return on assets assumption, the Company considered the historical returns and the future expectations for returns for each asset class, as well as the target asset allocation of the pension plan portfolio. This resulted in the selection of the 7.5% long-term rate of return on assets assumption.
For a discussion of the methods employed by the Company to measure the fair value of invested assets, see note 3. The following discussion of fair value measurements apply exclusively to the Company’s pension plan assets.
This category seeks to track the performance of a benchmark index that measures the investment return of stocks issued by companies located in the major markets of Europe and the Pacific region. It follows a passively managed, full replication approach.
The Company has a defined contribution benefit plan sponsored by PMIC covering all employees who have attained age 21. Eligible employees may contribute up to 30% of their salary to the plan, subject to statutory limits. The Company matches 50% of employee contributions up to 3% of employee compensation. Amounts charged to operations were $201 and $175 for 2010 and 2009, respectively.
As of December 31, 2010, the estimated fair value of unearned ESOP shares was $6,311.
On May 12, 2010, 141,122 shares of restricted stock were granted to executives of the Company. The restricted stock will be issued from treasury shares upon vesting. The restricted stock had a grant date fair value of $14.83 per share, which was the Company’s closing stock price on that date. The restricted stock vests 25% in the first year and 15% in each of the five years thereafter, based on the satisfaction of service conditions.
The total compensation cost recognized in the statements of operations and classified as underwriting and administrative expenses for all stock-based compensation awards, excluding the Company’s ESOP, was $385 for the year ended December 31, 2010. The related tax benefit recognized was $110 for the same period. The total compensation cost recognized in the statements of operations and classified as underwriting and administrative expenses for the Company’s ESOP was $703 and $92 for the years ended December 31, 2010 and 2009, respectively. The related tax benefit recognized was $184 and $31 for the same periods.
The total unrecognized compensation cost related to all nonvested Plan awards at December 31, 2010 was $2,137, which is expected to be recognized in future periods over a weighted average period of 4.9 years.
No equity awards were exercised or forfeited during the year ended December 31, 2010. No additional awards were granted during the year ended December 31, 2010.
Components of the provision for income tax expense (benefit) from continuing operations for the years ended December 31, 2010 and 2009 are as follows:
The Company’s net payment (refunds) for income taxes in 2010 and 2009 were $969 and $(907), respectively.
A reconciliation of the expected and actual federal income tax expense (benefit) from continuing operations for the years ended December 31, 2010 and 2009 is as follows:
At December 31, 2010 and 2009, the Company had available $1,128 and $3,503, respectively, of federal capital loss carryforwards. The capital loss carryforwards have a five year carryforward and will completely expire in 2013. In addition, at December 31, 2010, the Company had available $2,252 of federal (net operating loss NOL) carryforwards. The federal NOL carryforwards have a twenty year carryforward and will completely expire in 2030.
Deferred income taxes arise from the recognition of temporary differences between financial statement carrying amounts and the tax bases of our assets and liabilities. A valuation allowance is provided when it is more likely than not that some portion of the deferred tax asset will not be realized. The Company must assess the likelihood that any recorded deferred tax assets will be recovered against future taxable income. The Company considers many factors when assessing the likelihood of future realization of deferred tax assets, including recent cumulative earnings experience by taxing jurisdiction, expectations of future taxable income or loss, the carry-forward periods available to us for tax reporting purposes, and other relevant factors. To the extent the Company believes that recovery is not more likely than not, a valuation allowance must be established.
Although the Company’s current financial forecasts indicate that taxable income will be generated in the future, those forecasts were not considered sufficient positive evidence to overcome the observable negative evidence associated with its three year cumulative loss position. Accordingly, the Company recorded a full valuation allowance of $3,468 on its federal net deferred tax assets for the year ended December 31, 2010.
As of December 31, 2010, the Company had no material unrecognized tax benefits or accrued interest and penalties. The Company’s policy is to account for interest as a component of interest expense and penalties as a component of other expense. Federal tax years 2007 through 2010 were open for examination as of December 31, 2010.
Reinsurance is ceded by the Company on a pro rata and excess of loss basis, with the Company’s retention generally at $500 per occurrence in 2010 and 2009. The Company purchased catastrophe excess-of-loss reinsurance with a retention of $2,000 per event in 2009. Effective January 1, 2010, the Company increased its retention to $3,000 per event.
The Company continues to maintain a whole account, accident year aggregate excess of loss (aggregate stop loss) contract. This contract covers the 2008 and 2009 accident years and provides reinsurance coverage for loss and allocated loss adjustment expense (ALAE) from all lines of business, in excess of a 72% loss and ALAE ratio. The reinsurance coverage has a limit of 20% of subject net earned premiums. As of December 31, 2010 and 2009, the Company has not ceded any losses under the aggregate stop loss contract. Effective January 1, 2010, the Company has not entered into a new stop loss contract.
The Company recognized favorable development in the provision for insured events of prior years of $2,086 in 2010 and unfavorable development of $1,555 in 2009. Increases or decreases of this nature occur as the result of claim settlements during the current year, and as additional information is received regarding individual claims, causing changes from the original estimates of the cost of these claims. Recent loss development trends are also taken into account in evaluating the overall adequacy of unpaid losses and loss adjustment expenses.
development in the fire and allied lines of business due to updated information on previously reported large property claims. In the commercial business segment, the Company experienced net favorable prior year reserve development of $26. Favorable loss emergence, relative to expectations, in the commercial multi-peril line and favorable claims settlements in the fire and allied lines were offset by unfavorable development in the commercial auto liability line and other liability lines.
The net unfavorable development for 2009 of $1,555 is due to the $4,292 stop loss reversal on ceded losses that impacted all lines of business. Excluding the impact of the stop loss reversal, the net favorable development of $2,737 was primarily attributable to: favorable loss development of approximately $1,659 in the fire and allied, resulting from favorable settlements on prior years’ claims; favorable loss development of approximately $1,812 in the commercial multi-peril lines attributable to lower level emergence of incurred losses, relative to expectations, for the 2007 and 2008 accident years; and unfavorable development of approximately $1,501 in the Company’s workers’ compensation line due to a higher level of incurred loss emergence relative to expectations for the 2008 and 2007 accident years.
Total retirement and severance expense of $118 and $363 was unpaid as of December 31, 2010 and 2009, respectively.
The Company records its estimated future payment related to guaranty fund assessments and its estimated ultimate exposure related to other insurance-related assessments. Estimates are based on historical assessment and payment patterns, the Company’s historical premium volume, and known industry developments that affect these assessments, such as insurance company insolvencies and industry loss and pricing trends. The Company’s net accrued liability for guaranty fund and other insurance related assessments is $1,348 and $1,397 at December 31, 2010 and 2009, respectively. The accrual is expected to be paid as assessments are made over the next several years.
In July 2008, the Company completed the sale of PSTS. As of December 31, 2009, results of operations from PSTS consisted of $50 in income before tax expense of $17.
(c) The activity of the Corporation’s common stock was as follows:
(d) As of December 31, 2010, 271,562 shares remain to be purchased under the share repurchase plans approved by the Board of Directors. The authorization has no expiration date.
Basic earnings per common share is computed by dividing net (loss) income by the weighted-average number of shares of common stock outstanding during the period. Diluted earnings per common share is computed by dividing net (loss) income by the weighted-average number of shares of common stock outstanding during the
As described in note 1, the Offering resulted in the issuance of common shares of the Company on October 16, 2009. The following table sets forth the computation of basic and diluted earnings per common share for the years ended December 31, 2010 and 2009: