Our headquarters are located in a four story, 110,000 square foot building that we own in Blue Bell, Pennsylvania. We lease approximately 27,000 square feet in Philadelphia, Pennsylvania. We also lease approximately 63,000 square feet of office space in Yardley, Pennsylvania, which previously housed our excess and surplus lines business and now is subleased to an unaffiliated third party.
Results for 2003 were impacted by $49 million from the recording of a valuation allowance on the Company’s deferred tax asset. Results for 2002 were impacted by $43 million pre-tax ($28 million after-tax) for costs associated with the exit from and run off of Caliber One, our former excess and surplus lines business. Results for 2001 were impacted by $30 million pre-tax ($20 million after-tax) for World Trade Center losses.
The expense ratio equals the sum of acquisition and insurance-related operating expenses divided by net premiums earned. Acquisition and insurance-related expenses for The PMA Insurance Group were $108.7 million, $129.7 million, $142.7 million, $108.6 million and $92.3 million for 2005, 2004, 2003, 2002 and 2001, respectively.
The combined ratio computed on a GAAP basis is equal to losses and loss adjustment expenses plus acquisition and operating expenses and policyholders' dividends (where applicable), all divided by net premiums earned.
The following is a discussion of the financial condition of PMA Capital Corporation and its consolidated subsidiaries (“PMA Capital” or the “Company” which also may be referred to as “we” or “us”) as of December 31, 2005, compared with December 31, 2004, and the results of operations of PMA Capital for 2005 and 2004, compared with the immediately preceding year. The balance sheet information presented below is as of December 31 for each respective year. The statement of operations information is for the year ended December 31 for each respective year.
This discussion and analysis should be read in conjunction with our audited Consolidated Financial Statements and Notes thereto presented in Item 8 of this Form 10-K (“Consolidated Financial Statements”). You should also read our discussion of Critical Accounting Estimates beginning on page 55 for an explanation of those accounting estimates that we believe are most important to the portrayal of our financial condition and results of operations and that require our most difficult, subjective and complex judgments.
This Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) contains forward-looking statements, which involve inherent risks and uncertainties. Statements that are not historical facts, including statements about our beliefs and expectations, and containing words such as “believe,” “estimate,” “anticipate,” “expect” or similar words are forward-looking statements. These statements are based upon current estimates, assumptions and projections. Actual results may differ materially from those projected in such forward-looking statements, and therefore, you should not place undue reliance on them. See “Cautionary Statements” on page 62 for a list of factors that could cause our actual results to differ materially from those contained in any forward-looking statement. Also, see “Item 1A - Risk Factors” for a further discussion of risks that could materially affect our business.
We are a property and casualty insurance holding company, which offers through our subsidiaries workers’ compensation and to a lesser extent, other standard lines of commercial insurance, primarily in the eastern part of the United States. These products are written through The PMA Insurance Group business segment. Our Run-off Operations include our prior reinsurance and excess and surplus lines operations.
In 2005, we saw an increase in new business at The PMA Insurance Group, with $108.5 million of new business in 2005, up from $46.4 million for 2004. Our renewal retention rate improved throughout 2005, ending the year at 76% for workers’ compensation business, up from 62% in 2004. The improving retention rates and new business opportunities resulted in a 3% increase in our direct written premiums for 2005 compared to 2004.
As of December 31, 2005, our total outstanding debt had decreased to $196.2 million, compared to $210.8 million at December 31, 2004, primarily due to the open market purchases of $25.7 million principal amount of our 6.50% Senior Secured Convertible Debt due 2022 (“6.50% Convertible Debt”), which was partially offset by the issuance of $10.0 million of Floating Rate Surplus Notes due 2035 (“Surplus Notes”) by one of our insurance subsidiaries. We financed the purchases of 6.50% Convertible Debt through the issuance of the Surplus Notes at The PMA Insurance Group, and also directly purchased a portion of these bonds at our Run-off Operations.
principal amount. We expect to be able to receive capital distributions from our principal operating subsidiaries sufficient to repurchase this debt on the put date of June 30, 2009.
PMACIC, our reinsurance subsidiary which is in run-off, owned the primary insurance subsidiaries that comprise The PMA Insurance Group, or the Pooled Companies, until June 2004. In its Order approving the transfer of the Pooled Companies from PMACIC to PMA Capital, the Pennsylvania Insurance Department prohibited PMACIC from any declaration or payment of dividends, return of capital or any other types of distributions in 2004 and 2005 to PMA Capital. In 2006, PMACIC may declare and pay ordinary dividends or returns of capital without the prior approval of the Pennsylvania Insurance Department if, immediately after giving effect to the dividend or return of capital, PMACIC’s risk-based capital equals or exceeds 225% of Authorized Control Level Capital as defined by the National Association of Insurance Commissioners. PMACIC is permitted to request an “extraordinary” dividend, as defined under Pennsylvania law, in 2006 subject to the same risk-based capital requirements. Such “extraordinary” dividend must be approved by the Pennsylvania Insurance Department prior to payment. In 2007 and beyond, PMACIC may make dividend payments, as long as such dividends are not considered “extraordinary.” At December 31, 2005, PMACIC’s risk-based capital is 547% of Authorized Control Level Capital.
The PMA Insurance Group earns revenue and generates cash primarily by writing insurance policies and collecting insurance premiums. The PMA Insurance Group also earns other revenues by providing risk control and claims adjusting services to customers. As time normally elapses between the receipt of premiums and the payment of claims and certain related expenses, we are able to invest the available premiums and earn investment income. The types of expenses that we incur are:
The net loss for 2003 reflects a third quarter after-tax charge of $97.5 million ($150 million pre-tax), to increase loss reserves for our reinsurance business. On November 6, 2003, we announced our decision to exit the reinsurance business. Additionally, we established a valuation allowance of $49 million on our deferred tax asset in 2003.
Included in 2005 and 2004 results were after-tax net realized investment gains of $1.4 million and $4.2 million, primarily reflecting sales reducing our per issuer exposure and general duration management trades. These after-tax net realized gains for 2005 and 2004 were reduced by $2.4 million and $2.5 million, respectively, due to increases in the fair value of the derivative component of our 6.50% Convertible Debt. After-tax net realized gains were $9.0 million in 2003. Net realized investment gains in 2003 were primarily attributable to sales intended to change the duration of our investment portfolio in order to better match our cash flows with our liability payouts.
We provide combined ratios and operating ratios for The PMA Insurance Group on page 37. The “combined ratio” is a measure of property and casualty underwriting performance. The combined ratio computed using GAAP-basis numbers is equal to losses and LAE, plus acquisition expenses, insurance-related operating expenses and policyholders’ dividends, where applicable, all divided by net premiums earned. A combined ratio of less than 100% reflects an underwriting profit. Because time normally elapses between the receipt of premiums and the payment of claims and certain related expenses, we invest the available premiums. Underwriting results do not include investment income from these funds. Given the long-tail nature of our liabilities, we believe that the operating ratios are also important in evaluating our business. The operating ratio is the combined ratio less the net investment income ratio, which is net investment income divided by net premiums earned.
Summarized financial results of The PMA Insurance Group are as follows:
Direct workers’ compensation and integrated disability premiums written were $347.7 million in 2005, compared to $341.2 million in 2004. In 2004, direct workers’ compensation and integrated disability premiums written decreased 38%, compared to 2003, primarily reflecting the impact of the B++ A.M. Best financial strength rating between November 2003 and November 2004. This rating constrained our ability to write new business and to retain existing business in 2004. In addition, direct workers’ compensation premiums written for 2003 contained $35 million of retrospectively rated premiums recorded in the fourth quarter under loss sensitive policies that were attributable to higher than expected losses for accident years 2001 and 2002. See “Losses and Expenses” beginning on page 39 for additional information. Our renewal retention rate on existing workers’ compensation accounts was 76% for 2005 compared to 62% for 2004 and 84% for 2003. New workers’ compensation and integrated disability business was $92.7 million in 2005, compared to $42.1 million for 2004 and $133.3 million for 2003, respectively. We obtained price increases of approximately 4% in 2005, 6% in 2004, and 10% in 2003 on workers’ compensation business.
For workers’ compensation coverages, the premium charged on fixed-cost policies is primarily based upon the manual rates filed with state insurance departments. Workers’ compensation manual rates for The PMA Insurance Group’s business in its principal marketing territories increased on average 2% in 2005, 4% in 2004 and 8% in 2003. These increases in manual rates generally reflect the effects of higher average medical and indemnity costs in recent years. Manual rate changes directly affect the prices that The PMA Insurance Group can charge for its rate sensitive workers’ compensation products, which comprised 57% of workers’ compensation premiums written in 2005.
Premiums assumed decreased $12.3 million in 2005 and increased $10.0 million in 2004, due primarily to fluctuations in our direct premiums written, compared to the immediately preceding years. Assumed premiums primarily relate to involuntary residual market business assigned to us. Companies that write premiums in certain states generally must share in the risk of insuring entities that cannot obtain insurance in the voluntary market. Typically, an insurer’s share of this residual market business is assigned on a lag based on its market share in terms of direct premiums in the voluntary market. These assignments are accomplished either by direct assignment or by assumption from pools of residual market business.
Net premiums written and earned decreased by 1% and 19%, respectively, in 2005, compared to 2004 and decreased 37% and 22%, respectively, in 2004, compared to 2003. Generally, trends in net premiums earned follow patterns similar to net premiums written adjusted for the customary lag related to the timing of premium writings within the year. In periods of decreasing premium writings, the decrease in net premiums written will typically be greater than the decrease in premiums earned, as was the case in 2004. However, the decrease in net premiums earned in 2005, compared to 2004 is greater than the decrease in net premiums written, reflecting the combined effect of lower net premiums written in compared to 2003 and lower net premiums written in the first half of 2005 compared to the corresponding period of 2004. Direct premiums are earned principally on a pro rata basis over the terms of the policies. However, with respect to policies that provide for premium adjustments, such as experience-rated or exposure-based adjustments, such premium adjustment may be made subsequent to the end of the policy’s coverage period and will be recorded as earned premium in the period in which the adjustment is made. We made such an adjustment in 2003 as described above.
The operating expense ratio equals insurance-related operating expenses divided by net premiums earned. Insurance-related operating expenses were $37.4 million, $43.7 million and $52.2 million for 2005, 2004 and 2003, respectively.
The loss and LAE ratio improved 2.3 points in 2005, compared to 2004. The improved loss and LAE ratio primarily reflects a lower current accident year loss and LAE ratio in 2005, compared to 2004. Price increases and payroll inflation have slightly outpaced an increase in overall loss trends in workers' compensation. We estimate our medical cost inflation, which is a significant component of loss costs, for 2005 to be 9%, compared to our 2004 estimate of 11%. The medical cost inflation rate has declined mainly due to our network and managed care initiatives throughout which has benefited our current year loss ratio. We do not expect the rate of decline in medical cost inflation to be as significant in 2006. The 2005 loss ratio has also benefited from a change in the geographic mix of our business.
As part of the year end closing process, in the fourth quarter of 2003, our internal actuaries completed a comprehensive year-end actuarial analysis of loss reserves. Based on the actuarial work performed, we noticed higher than expected claims severity in our workers' compensation business written for accident years 2001 and 2002, primarily from loss-sensitive and participating workers' compensation business. As a result, The PMA Insurance Group increased loss reserves for prior years by $50 million. An independent actuarial firm also conducted a comprehensive review of The PMA Insurance Group’s loss reserves as of December 31, 2003 and concluded that such carried loss reserves were reasonable as of December 31, 2003. Under The PMA Insurance Group's loss-sensitive rating plans we adjust the amount of the insured's premiums after the policy period expires based, to a large extent, upon the insured's actual losses incurred during the policy period. Under policies that are subject to dividend plans, the ultimate amount of the dividend that the insured may receive is also based, to a large extent, upon loss experience during the policy period. Accordingly, offsetting the effects of this unfavorable prior year loss development were premium adjustments of $35 million under loss-sensitive plans and reduced policyholder dividends of $8 million, resulting in a net fourth quarter pre-tax charge of $7 million. This
unfavorable prior year loss development and resulting premium and policyholders' dividend adjustments in 2003 increased the loss and LAE ratio by approximately 4 points and decreased the total expense ratio and policyholder's dividend ratio each by approximately 1.5 points. The total impact to the combined ratio was approximately 1 point.
Losses and LAE incurred decreased significantly for 2005 and 2004, compared to 2003. This is primarily due to the effects of lower net premiums earned in these years compared to 2003, and the adverse prior year loss development recorded in 2003. Losses incurred in 2005 included a first quarter charge of $30 million for adverse prior year loss development. In the first quarter of 2005, our actuaries identified higher than expected claim frequency and severity on policies covering contractors’ liability for construction defects from accident years 1998 to 2001 written by our former excess and surplus lines operation and an increase in reported losses and continued volatility in pro rata professional liability reinsurance business written from accident years 1997 to 2001.
During 2003, the Run-off Operations increased its net loss reserves for prior accident years for reinsurance business by $169.1 million, including $150 million during the third quarter. The third quarter 2003 reserve charge related to higher than expected underwriting losses, primarily from casualty business written in accident years 1997 through 2000. Approximately 75% of the charge was related to general liability business written from 1997 to 2000 with substantially all of the remainder of the charge from the commercial automobile line written during those same years. During the third quarter, our actuaries conducted their periodic comprehensive reserve review. Based on the actuarial work performed, which included analyzing recent trends in the levels of the reported and paid claims, an updated selection of actuarially determined loss reserve estimates was developed by accident year for each major line of reinsurance business written. The information derived during this review indicated that a large portion of the change in expected loss development was due to increasing loss trends emerging in calendar year 2003 for prior accident years. This increase in 2003 loss trends caused us to determine that the reserve levels, primarily for accident years 1997 to 2000, needed to be increased by $150 million. An independent actuarial firm also conducted a comprehensive review of our Traditional-Treaty, Specialty-Treaty and Facultative reinsurance loss reserves, and concluded that those carried loss reserves were reasonable at September 30, 2003.
Operating expenses for 2005 and 2004 were significantly lower compared to the immediately preceding years due primarily to our exit from the reinsurance business. Operating expenses for 2003 include exit costs of $2.6 million, mainly employee termination benefits, as a result of the decision to exit from this business. Approximately 100 employees have been terminated in accordance with this exit plan and 38 positions, primarily claims and financial personnel, remain. We have established an employee retention arrangement for these remaining employees. Under this arrangement, expenses of $1.4 million and $1.7 million were recorded in 2005 and 2004, respectively, which included retention bonuses and severance. We expect to incur an additional $1 million of these expenses in 2006.
Operating expenses for 2004 were reduced by $2.5 million from a gain on the sale of our interest in Cathedral Capital PLC, a Lloyd’s of London managing general agency.
Net investment income was $16.3 million, $24.7 million and $34.4 million in 2005, 2004 and 2003, respectively. The lower net investment income in 2005, compared to 2004, reflects an average invested asset base that decreased by approximately 41% offset by higher yields of approximately 31 basis points and lower net interest credited of $4.0 million on funds held. The lower net investment income in 2004, compared to 2003, reflects lower yields of
The Corporate and Other segment primarily includes corporate expenses, including debt service. This segment recorded pre-tax operating losses of $24.2 million, $21.2 million and $22.7 million in 2005, 2004 and 2003, respectively. The primary reason for the increased loss in 2005 was a $3.5 million increase in interest expense. This increase was due to a higher average amount of debt outstanding and a higher average interest rate on our convertible debt. Although the Company purchased $25.7 million par of its 6.50% Convertible Debt during the third and fourth quarters of 2005, the Corporate and Other segment will not benefit from the reduced level of consolidated interest expense because the bonds were purchased and held by its operating companies. For segment reporting purposes, the Company allocates interest income for the bonds owned by its operating companies and reduces its investment income in Corporate and Other.
The following table represents the reserve levels(1) as of December 31, 2005 for each of the Company’s business segments and significant lines of business within those segments:
Unpaid losses and loss adjustment expenses for certain intercompany arrangements which eliminate in consolidation, are excluded from unpaid losses and loss adjustment expenses in this table.
Additionally, reinsurers are dependent on their ceding companies for reporting information regarding incurred losses. The nature and extent of information provided to reinsurers may vary depending on the ceding company as well as the type of reinsurance purchased by the ceding company. Ceding companies may also independently adjust their reserves over time as they receive additional data on claims and go through their own actuarial process for evaluating reserves. For casualty lines of reinsurance, significant periods of time may elapse from the period that a loss is incurred and reported by the ceding company’s insured, the investigation and recognition of such loss by the ceding insurer, and the reporting of the loss and evaluation of coverage by a reinsurer. As all of the Company’s reinsurance business was produced through independent brokers, an additional lag occurs because the ceding companies report their experience to the placing broker, who then reports such information to the reinsurer. Because of these time lags, and because of the variability in reserving and reporting by ceding companies, reported claims for reinsurers become known more slowly than for primary insurers and are subject to more unforeseen development and uncertainty.
Management believes that its unpaid losses and LAE are fairly stated at December 31, 2005. However, estimating the ultimate claims liability is necessarily a complex and judgmental process inasmuch as the amounts are based on management’s informed estimates, assumptions and judgments using data currently available. As additional experience and data become available regarding claims payment and reporting patterns, legal and legislative developments, judicial theories of liability, the impact of regulatory trends on benefit levels for both medical and indemnity payments, changes in social attitudes and economic conditions, the estimates are revised accordingly. If our ultimate losses, net of reinsurance, prove to differ substantially from the amounts recorded at December 31, 2005, the related adjustments could have a material adverse effect on our financial condition, results of operations and liquidity. See the discussion under Losses and Expenses beginning on page 39, and Run-off Operations beginning on page for additional information regarding increases in loss reserves for prior years.
At December 31, 2005, 2004 and 2003, our gross reserves for asbestos-related losses were $26.9 million, $27.9 million and $37.8 million, respectively ($13.2 million, $14.0 million and $17.8 million, net of reinsurance, respectively). At December 31, 2005, 2004 and 2003, our gross reserves for environmental-related losses were $15.3 million, $16.1 million and $14.2 million, respectively ($5.0 million, $6.4 million and $8.8 million, net of reinsurance, respectively).
Under our reinsurance and retrocessional coverages in place during 2005, 2004 and 2003, we ceded premiums totaling $48.9 million, $78.9 million and $228.6 million, and we ceded losses and LAE of $70.6 million, $99.8 million and $243.1 million to reinsurers and retrocessionaires.
At December 31, 2005 and 2004, we had amounts receivable from our reinsurers and retrocessionaires totaling $1,094.7 million and $1,142.6 million, respectively. As of December 31, 2005 and 2004, $54.8 million and $58.7 million, or 5% for each year, of these amounts were due to us on losses we have already paid. The remainder of the reinsurance receivables related to unpaid claims.
At December 31, 2005, we had reinsurance receivables due from the following unaffiliated reinsurers in excess of 5% of our shareholders’ equity:
Includes Trabaja Reinsurance Company ($220.1 million) and London Life & General Reinsurance Company ($12.6 million).
Includes GE Reinsurance Corporation ($19.0 million) and Employers Reinsurance Corporation ($2.1 million).
The timing of payments and the collectibility of reinsurance receivables have not had a material adverse effect on our liquidity.
In February 2006, A.M. Best downgraded the rating of PXRE Reinsurance Company (“PXRE”) to “B+” from “A-” and issued a negative outlook. Our collateral from PXRE is in the form of an investment portfolio that is held in trust for our benefit, and we believe that the investment securities, together with the interest earned on the portfolio will be sufficient to pay all billings that we submit.
At December 31, 2005, our reinsurance and retrocessional protection for major lines of business that we write was as follows:
Effective January 1, 2006, the retention was reduced to $500,000 and the limit was increased to $49.5 million.
Certain portions of The PMA Insurance Group’s workers’ compensation reinsurance include coverage for terrorist acts. In 2005, the Company's per occurrence reinsurance coverage for $5 million excess of $1 million included coverage for terrorist acts, except for certified nuclear, biological and chemical events. Effective January 1, 2006, coverage for terrorist acts was added to the Company's existing per occurrence reinsurance to cover one half of losses between $6 million and $10 million, all losses between $10 million and $50 million, and one half of losses above $50 million to $70 million, subject to the Company’s TRIEA retention, except for nuclear, biological and chemical events. For nuclear, biological and chemical events, the Company added coverage for one half of the losses for $24 million excess of its $2 million retention.
method. Accordingly, the Company has a deferred gain on retroactive reinsurance of $27.2 million at December 31, 2005, which is included in accounts payable, accrued expenses and other liabilities on the Balance Sheet. Amortization of the deferred gain in 2005 reduced net loss and loss adjustment expenses by $2.8 million. At December 31, 2005, the Run-off Operations had $75 million of available coverage under this agreement for future adverse loss development.
Any future cession of losses may require the Company to cede additional premiums of up to $28.3 million on a pro rata basis, at the following contractually determined levels:
Operating cash flows declined significantly in 2005 and 2004, compared to 2003, primarily due to the run-off of our reinsurance business, including the commutation and novation of certain reinsurance and retrocessional contracts of the Run-off Operations and the 2004 purchase of a reinsurance agreement covering potential adverse development at the Run-off Operations. See Notes 4 and 5 to the Consolidated Financial Statements for additional information regarding commutations and novations by the Run-off Operations and the reinsurance agreement covering potential adverse loss development, respectively. To a lesser extent, the impact of The PMA Insurance Group’s B++ financial strength rating between November 2003 and November 2004 also negatively impacted operating cash flows for 2004.
We have $73.4 million of 6.50% Convertible Debt outstanding as of December 31, 2005. Holders, at their option, may require us to repurchase all or a portion of this debt on June 30, 2009 at 114% of the principal amount. We expect to be able to receive capital distributions from our principal operating subsidiaries sufficient to repurchase this debt on the put date of June 30, 2009.
PMACIC, our reinsurance subsidiary which is currently in run-off, had statutory surplus of $204.9 million as of December 31, 2005. However, in its Order approving the transfer of the Pooled Companies from PMACIC to PMA Capital Corporation, the Pennsylvania Insurance Department prohibited PMACIC from any declaration or payment of dividends, return of capital or other types of distributions in and 2005 to PMA Capital Corporation. In 2006, PMACIC may declare and pay ordinary dividends or return capital without the prior approval of the Pennsylvania Insurance Department if, immediately after giving effect to the dividend or return of capital, PMACIC’s risk-based capital equals or exceeds 225% of Authorized Control Level Capital, as defined by the National Association of Insurance Commissioners. PMACIC is permitted to request an “extraordinary” dividend, as defined under Pennsylvania law, in 2006 subject to the same risk-based capital requirements. Such “extraordinary” dividend must be approved by the Pennsylvania Insurance Department prior to payment. In 2007 and beyond, PMACIC may make dividend payments, as long as such dividends are not considered “extraordinary.” As of December 31, 2005, the statutory surplus of PMACIC was $204.9 million, which included $11.4 million of unassigned surplus, and its risk based capital ratio was 547% of Authorized Control Level Capital.
The Pooled Companies are not subject to the Pennsylvania Insurance Department’s Order and paid $7.0 million and $12.1 million in dividends in 2005 and 2004 respectively. In considering its future dividend policy, the Pooled Companies will consider, among other things, the impact of paying dividends on its financial strength ratings. The Pooled Companies had statutory surplus of $315.1 million as of December 31, 2005, including $10.0 million
Our unpaid losses and LAE do not have contractual maturity dates and the exact timing of payments cannot be predicted with certainty. However, based on historical payment patterns, we have included an estimate, gross of discount of $203.6 million, of when we expect our unpaid losses and LAE (without the benefit of reinsurance recoveries) to be paid. We maintain an investment portfolio with varying maturities that we believe will provide adequate cash for the payment of claims.
As of December 31, 2005, our total outstanding debt was $196.2 million, compared to $210.8 million at December 31, 2004. The decrease is primarily due to the open market purchase of $25.7 million principal amount of our 6.50% Convertible Debt, partially offset by the issuance of $10.0 million of Surplus Notes by one of our insurance subsidiaries. The debt purchases were financed through proceeds from the Surplus Notes, and the direct purchase of a portion of these bonds at the Run-off Operations. We paid $27.9 million for these bond purchases, exclusive of accrued interest. We also retired $270,000 of our 4.25% Senior Convertible Debt due 2022 in 2005. This purchase and retirement activity has lowered our level of debt and increased its duration, which we believe provides us with a stronger, more flexible capital base.
The 6.50% Convertible Debt is secured equally and ratably with our $57.5 million 8.50% Monthly Income Senior Notes due 2018 (“Senior Notes”) by a first lien on 20% of the capital stock of our principal operating subsidiaries. This lien is released if the 6.50% Convertible Debt is no longer outstanding. However, execution of any lien by the holders of the 6.50% Convertible Debt is subject to the approval by the Pennsylvania Insurance Department. The 6.50% Convertible Debt is convertible at the rate of 61.0948 shares per $1,000 principal amount, equivalent to a conversion price of $16.368 per share of Class A Common stock for $68.4 million principal amount and 62.9287 shares per $1,000 principal amount, equivalent to a conversion price of $15.891 per share for $5.0 million principal amount. The indenture governing the 6.50% Convertible Debt contains restrictive covenants with respect to limitations on our ability to incur indebtedness, enter into transactions with affiliates or engage in a merger or sale of all or substantially all of the Company’s assets.
In December 2005, we entered into interest rate swaps that we have designated as cash flow hedges to manage interest costs and cash flows associated with the variable interest rates associated with a portion of our junior subordinated debt and Surplus Notes. There was no consideration paid or received for these swaps. The swaps will effectively convert $20.0 million of the junior subordinated debt and $10.0 million of Surplus Notes to fixed rate debt with interest rates of 9.17% and 9.56%, respectively.
During 2005, 2004 and 2003, we incurred $16.1 million, $12.4 million and $9.9 million of interest expense, and paid interest of $13.9 million, $11.6 million and $8.4 million in each respective year. The increase in interest expense and interest paid is due to a higher average amount of debt outstanding in 2005 and 2004 and higher interest rates on our debt, compared to the immediately preceding years.
We did not make a contribution to our qualified pension plan in 2005 or 2004. Our accumulated benefit obligation was greater than the fair value of plan assets by approximately $17 million and $8 million at December 31, 2005 and December 31, 2004, respectively, largely due to reductions in the discount rate used to measure the benefit obligation. As a result, we increased our additional minimum pension liability by $5.1 million and reduced accumulated other comprehensive income by $3.3 million, after-tax in 2005. In 2004, we increased the additional minimum pension liability by $1.2 million and reduced accumulated other comprehensive income by $806,000 after-tax. In 2005 and 2004, we were not required to make any contribution to the pension plan under the minimum funding requirements of the Employee Retirement Income Security Act (“ERISA”) of 1974. Our plan assets are
Under the terms of the sale of one of our insurance subsidiaries, PMA Insurance Cayman, Ltd. (renamed Trabaja Reinsurance Company), to London Life and Casualty Reinsurance Corporation in 1998, we have agreed to indemnify the buyer, up to a maximum of $15.0 million if the actual claim payments in the aggregate exceed the estimated payments upon which the loss reserves of the former subsidiary were established. If the actual claim payments in the aggregate are less than the estimated payments upon which the loss reserves have been established, we will participate in such favorable loss reserve development. Trabaja Reinsurance Company is our largest reinsurer. As of December 31, 2005, we are not aware of any significant changes from our original estimate. See Note 5 to the Consolidated Financial Statements for additional information.
Our investment objectives are to (i) seek competitive after-tax income and total returns, (ii) maintain high investment grade asset quality and high marketability, (iii) maintain maturity distribution commensurate with our business objectives, (iv) provide portfolio flexibility for changing business and investment climates and (v) provide liquidity to meet operating objectives. Our investment strategy includes setting guidelines for asset quality standards, allocating assets among investment types and issuers, and other relevant criteria for our portfolio. In addition, invested asset cash flows, which includes both current interest income received and investment maturities, are structured to consider projected liability cash flows of loss reserve payouts using actuarial models. Property and casualty claim demands are somewhat unpredictable in nature and require liquidity from the underlying invested assets, which are structured to emphasize current investment income while maintaining appropriate portfolio quality and diversity. Liquidity requirements are met primarily through operating cash flows and maintaining a portfolio whose maturities consider expected cash flow requirements.
Our investment portfolio includes only fixed maturities, short-term investments and cash. The portfolio is diversified and does not contain any significant concentrations in single issuers other than U.S. Treasury and agency obligations. Our largest exposure to a single corporate issuer is $14.8 million, or 1% of total invested assets. In addition, we do not have a significant concentration of our investments in any single industry segment other than finance companies, which comprise 11% of invested assets at December 31, 2005. Included in this industry segment are diverse financial institutions, including the financing subsidiaries of automotive manufacturers. Substantially all of our investments are dollar denominated as of December 31, 2005.
At December 31, our fixed maturities had an overall average credit quality of AA+, broken down as follows:
Gross investment income less investment expenses and before interest credited on funds held treaties. Excludes net realized investment gains and losses and amounts related to securities lending activities.
At December 31, 2005, of the 139 securities that have been in an unrealized loss position for more than 12 months, 138 securities have an unrealized loss of less than $1 million each and less than 20% of each security's amortized cost. These 138 securities have a total fair value of 97% of the amortized cost basis at December 31, 2005, and the average unrealized loss per security is approximately $35,000. There is only one security out of the 139 with an unrealized loss in excess of $1 million at December 31, 2005, and it has a fair value of $15.9 million and a par value and cost of $20.0 million. The security, which matures in 2011, is a structured security backed by a U.S. Treasury Strip, and is rated AAA. We have both the ability and intent to hold this security until it matures.
We had pre-tax net realized investment gains of $2.1 million in 2005, compared to $6.5 million in 2004 and $13.8 million in 2003. During 2005, there were gross realized investment gains and losses of $9.8 million and $4.6 million, respectively, on our invested asset portfolio. Also included in 2005 net realized investment gains were realized losses of $3.7 million related to the increase in the fair value of the derivative component of our 6.50% Convertible Debt and $0.6 million of foreign exchange gains. Gross realized investment losses in 2005 reflected sales reducing our per issuer exposure and general duration management trades and impairment losses of $1.0 million on fixed income securities.
In March 2004, the Emerging Issues Task Force (“EITF”) reached a consensus regarding EITF 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.” The consensus provides guidance for evaluating whether an investment is other-than-temporarily impaired. The Company has applied the disclosure provisions of EITF 03-1 to its Consolidated Financial Statements. In September 2004, the Financial Accounting Standards Board (“FASB”) issued Staff Position (“FSP”) EITF 03-1-1, which delayed the effective date of the application of the recognition and measurement provisions of EITF 03-1. In the third quarter of 2005, the FASB decided not to provide additional guidance on the meaning of other-than-temporary impairment and directed its staff to finalize proposed FASB Staff Position (FSP) EITF 03-1-a, “Implementation Guidance for the Application of Paragraph 16 of EITF Issue No. 03-1.” The final FSP, retitled as FSP FAS 115-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” was finalized in the fourth quarter of 2005 and will be subject to adoption for reporting periods beginning after December 15, 2005. The Company does not believe that the adoption of this guidance will have a material impact on its financial condition or results of operations.
In December 2004, the FASB revised Statement of Financial Accounting Standards (“SFAS”) No. 123, “Share-Based Payment,” to require the recognition of expenses relating to share-based payment transactions, including employee stock options, based on the fair value of the equity instruments issued. The Company is required to adopt the revised SFAS No. 123 in the first quarter of 2006. Effective in the first quarter of 2006, the Company will recognize an expense over the required service period for any stock options granted, modified, cancelled, or repurchased after that date and for the portion of grants for which the requisite service has not yet been rendered,
based on the grant-date fair value of those awards. See Note 2-J for the effect on net income (loss) if the fair value based method had been applied.
Our actuaries utilize a variety of actuarial techniques based on various assumptions to derive reserve estimates on subsets of the business within segments. The techniques and assumptions vary depending upon the characteristics particular to the business within a segment. For each of our business segments, our actuaries periodically perform detailed studies of historical data on incurred claims, reported claims and paid claims for each major line of business and by accident year and also analyze data for the current accident year. The actuarial techniques typically used by our actuaries are as follows:
Within the workers’ compensation line of business, we review medical and indemnity costs separately. We undertake this review because we believe that the medical cost component of workers’ compensation claims has a different development pattern than the indemnity payments, and also because we believe that certain assumptions within the medical cost component, such as the rate of medical cost inflation, can lead to more volatility as compared to the indemnity component. At December 31, 2005, our medical loss reserves were approximately 46% of the workers’ compensation loss reserves, with the balance being indemnity costs. We also review the workers’ compensation line of business by state for some of our larger states. We undertake this review because workers’ compensation benefits vary by state and this can cause loss development patterns to vary by state.
It is important to understand that the process of estimating our ultimate claims liability is necessarily a complex and judgmental process inasmuch as the amounts are based on management’s informed estimates, assumptions and judgments using data currently available. The assumptions we utilize in developing a range of loss reserves are based on the premise that past experience, adjusted for the effects of current developments and anticipated trends, are an appropriate basis for establishing our reserve ranges. As more current and additional experience and data become available regarding the existence and the dollar amounts of claims, claims payment and reporting patterns, legal and legislative developments, judicial theories of liability, the impact of regulatory trends on benefit levels for both medical and indemnity payments, and changes in social attitudes and economic conditions, we revise our actuarially determined range of estimates accordingly. Because of the aforementioned factors, actual results can differ from our current estimates in both The PMA Insurance Group and in our Run-off Operations. While all of these factors affect the reserving process and results, we believe that the major factors that can cause actual results to vary from our estimates for The PMA Insurance Group are a change in frequency of reported claims, a change in the severity of claims reported to us, and in particular for workers’ compensation, a change in the rate of medical cost inflation.
the claims being reported to us, which, in turn, would affect our estimate of the frequency and severity of claims for the Run-off Operations. The long-tail nature of a significant portion of this business (in many cases, significant periods of time, ranging up to several years or more, may elapse between the occurrence of an insured loss, the reporting of the loss to us and our payment of that loss) is also a major factor that could impact reserve development.
The following table represents the reserve levels (1) as of December 31, 2005 for each of our business segments:
Unpaid losses and loss adjustment expenses for certain intercompany arrangements which eliminate in consolidation are excluded from unpaid losses and loss adjustment expenses in this table.
The components of our (favorable) unfavorable development of reserves for losses and LAE for prior accident years by accident year, excluding accretion of discount, are as follows:
The PMA Insurance Group recorded favorable prior year loss development of $2.0 million and $2.1 million in 2005 and 2004, respectively, primarily reflecting better than expected loss experience from rent-a-captive workers’ compensation business. Dividends to policyholders offset this favorable development. Rent-a-captives are used by customers as an alternative method to manage their loss exposure without establishing and capitalizing their own captive insurance company.
During 2003, the Run-off Operations increased its net loss reserves for prior accident years for reinsurance business by $169.1 million, including $150 million during the third quarter. The third quarter 2003 reserve charge related to higher than expected underwriting losses, primarily from casualty business written in accident years 1997 through 2000. Approximately 75% of the charge was related to general liability business written from 1997 to 2000 with substantially all of the remainder of the charge from the commercial automobile line written during those same years. During the third quarter, the Company’s actuaries conducted their periodic comprehensive reserve review. Based on the actuarial work performed, which included analyzing recent trends in the levels of the reported and paid claims, an updated selection of actuarially determined loss reserve estimates was developed by accident year for each major line of reinsurance business written. The information derived during this review indicated that a large portion of the
change in expected loss development was due to increasing loss trends emerging in calendar year 2003 for prior accident years. This increase in 2003 loss trends caused management to determine that the reserve levels, primarily for accident years 1997 to 2000, needed to be increased by $150 million. An independent actuarial firm also conducted a comprehensive review of the Company’s Traditional-Treaty, Specialty-Treaty and Facultative reinsurance loss reserves, and concluded that those carried loss reserves were reasonable at September 30, 2003.
All investments in our portfolio are carried at fair value. For 99% of our investments, we determine the fair value using prices obtained in the public markets, both primary and secondary markets. These market prices reflect publicly reported values of recent purchase and sale transactions for each specific, individual security. Therefore, we believe that the reported fair values for our investments at December 31, 2005 reflect the value that we could realize if we sold these investments in the open market at that time.
We follow the customary insurance industry practice of reinsuring with other insurance and reinsurance companies a portion of the risks under the policies written by our insurance and reinsurance subsidiaries. Our reinsurance receivables total $1,094.7 million at December 31, 2005. We have estimated that $9.6 million of our total reinsurance receivables will be uncollectible, and we have provided a valuation allowance for that amount.
Although the contractual obligation of individual reinsurers to pay their reinsurance obligations is determinable from specific contract provisions, the collectibility of such amounts requires significant estimation by management. Many years may pass between the occurrence of a claim, when it is reported to us and when we ultimately settle and pay the claim. As a result, it can be several years before a reinsurer has to actually remit amounts to us. Over this period of time, economic conditions and operational performance of a particular reinsurer may impact their ability to meet these obligations and while they may still acknowledge their contractual obligation to do so, they may not have the financial resources to fully meet their obligation to us. If this occurs, we may have to write down a
Based on our evaluation of reinsurance receivables at December 31, 2005, we have established an allowance for amounts that we have concluded are uncollectible at the balance sheet date. In evaluating collectibility, we considered historical payment performance of our reinsurers, the fact that our reinsurers are current on their obligations to our insurance subsidiaries, and any known disputes or collection issues as of the balance sheet date. To these factors, we applied our informed judgment in ascertaining the appropriate level of allowance for uncollectible amounts. At December 31, 2005, approximately $10.5 million of uncollateralized reinsurance receivables, including $4.7 million due for ceded IBNR, are due from reinsurers who have ratings that declined to below “Adequate,” defined as B++ or below by A.M. Best, in 2005 or who were under regulatory supervision or in liquidation in 2005.
For additional information about reinsurance receivables, see Note 5 to the Consolidated Financial Statements as well as “Reinsurance” beginning on page 44.
Premiums, including estimates of additional premiums resulting from audits of insureds’ records, and premiums from ceding companies which are typically reported on a delayed basis, are earned principally on a pro rata basis over the terms of the policies. As discussed in “PMA Insurance Group - Premiums” beginning on page 37, in the fourth quarter of 2003, The PMA Insurance Group recorded $35 million of retrospectively rated premiums under
The premiums on reinsurance business ceded are recorded as incurred on a pro rata basis over the contract period. Certain ceded reinsurance contracts contain provisions requiring us to pay additional premiums based on a percentage of ceded losses or reinstatement premiums in the event that losses of a significant magnitude are ceded under such contracts. Under accounting rules, we are not permitted to establish reserves for potential additional premiums or record such amounts until a loss occurs that would obligate us to pay such additional or reinstatement premiums. As a result, the net benefit to our results from ceding losses to our retrocessionaires in the event of a loss may be reduced by the payment of additional premiums and reinstatement premiums to our retrocessionaires.
Except for historical information provided in Management’s Discussion and Analysis and otherwise in this report, statements made throughout are forward-looking and contain information about financial results, economic conditions, trends and known uncertainties. Words such as “believe,” “estimate,” “anticipate,” “expect” or similar words are intended to identify forward-looking statements. These forward-looking statements are based on currently available financial, competitive and economic data and our current operating plans based on assumptions regarding future events. Our actual results could differ materially from those expected by our management.
our ability to effect an efficient withdrawal from the reinsurance business, including the commutation of reinsurance business with certain large ceding companies, without incurring any significant additional liabilities;
changes in general economic conditions, including the performance of financial markets, interest rates and the level of unemployment;
other factors or uncertainties disclosed from time to time in our filings with the Securities and Exchange Commission.
Reinsurance receivables (net of valuation allowance: 2005 - $9,552; 2004 - $9,002)
The accompanying consolidated financial statements include the accounts of PMA Capital Corporation and its subsidiaries (collectively referred to as “PMA Capital” or the “Company”). PMA Capital Corporation is an insurance holding company that operates the companies comprising The PMA Insurance Group and manages the run-off of its former reinsurance and excess and surplus lines operations.
The PMA Insurance Group- The PMA Insurance Group writes workers’ compensation and, to a lesser extent, other standard lines of commercial insurance, primarily in the eastern part of the United States. Approximately 88% of The PMA Insurance Group’s business for 2005 was produced through independent agents and brokers.
Run-off Operations- Run-off Operations consists of the results of the Company’s former reinsurance and excess and surplus lines businesses. The Company’s former reinsurance operations offered excess of loss and pro rata property and casualty reinsurance protection mainly through reinsurance brokers. In November 2003, the Company decided to withdraw from the reinsurance business. In May 2002, the Company withdrew from the excess and surplus lines business.
Certain of the Company’s assumed and ceded reinsurance contracts are funds held arrangements. In a typical funds held arrangement, the ceding company retains the premiums instead of paying them to the reinsurer and losses are offset against these funds in an experience account. Because the reinsurer is not in receipt of the funds, the reinsurer will generally earn interest on the experience fund balance at a predetermined credited rate of interest. The Company generally earns an interest rate of between 6% and 8% on its assumed funds held arrangements and generally pays interest at a rate of between 6% and 7% on its ceded funds held arrangements. The interest earned or credited on funds held arrangements is included in net investment income in the Statement of Operations. In addition, interest on funds held arrangements will continue to be earned or credited until the experience account is fully depleted, which can extend many years beyond the expiration of the coverage period.
F. Deferred Acquisition Costs - Costs that directly relate to and vary with the acquisition of new and renewal business are deferred and amortized over the period during which the related premiums are earned. Such direct costs include commissions or brokerage and premium taxes, as well as other policy issuance costs and underwriting expenses. The Company determines whether acquisition costs are recoverable considering future losses and LAE, maintenance costs and anticipated investment income. To the extent that acquisition costs are not recoverable, the deficiency is charged to income in the period identified.
H. Dividends to Policyholders - The PMA Insurance Group sells certain workers’ compensation insurance policies with dividend payment features. These policyholders share in the underwriting results of their respective policies in the form of dividends declared at the discretion of the Board of Directors of The PMA Insurance Group’s operating companies. Dividends to policyholders are accrued during the period in which the related premiums are earned and are determined based on the terms of the individual policies.
I. Income Taxes - The Company records deferred tax assets and liabilities to the extent of the tax effect of differences between the financial statement carrying values and tax bases of assets and liabilities. A valuation allowance is recorded for deferred tax assets where it appears more likely than not that the Company will not be able to recover the deferred tax asset. See Note 12 for additional information.
temporarily impaired. The Company has applied the disclosure provisions of EITF 03-1 to its consolidated financial statements. In September 2004, the Financial Accounting Standards Board (“FASB”) issued Staff Position (“FSP”) EITF 03-1-1, which delayed the effective date of the application of the recognition and measurement provisions of EITF 03-1. In 2005, the FASB decided not to provide additional guidance on the meaning of other-than-temporary impairment and directed its staff to finalize proposed FASB Staff Position (FSP) EITF 03-1-a, “Implementation Guidance for the Application of Paragraph 16 of EITF Issue No. 03-1.” The final FSP, retitled as FSP FAS 115-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” was finalized in the fourth quarter of 2005 and will be subject to adoption for reporting periods beginning after December 15, 2005. The Company does not believe that the adoption of this guidance will have a material impact on its financial condition or results of operations.
In December 2004, the FASB revised Statement of Financial Accounting Standards (“SFAS”) No. 123, “Share-Based Payment,” to require the recognition of expenses relating to share-based payment transactions, including employee stock options, based on the fair value of the equity instruments issued. The Company is required to adopt the revised SFAS No. 123 in the first quarter of 2006. Effective with the first quarter of 2006, the Company will recognize an expense over the required service period for any stock options granted, modified, cancelled, or repurchased after that date and for the portion of grants for which the requisite service has not yet been rendered, based on the grant-date fair value of those awards. See Note 2-J for the effect on net income (loss) if the fair value based method had been applied.
The amortized cost and fair value of the Company’s investment portfolio are as follows:
Included in realized losses for 2005, and 2003 were impairment losses of $1.0 million, $334,000 and $2.6 million, respectively. The impairment losses for 2005 were related to securities issued by two auto manufacturers and one retail department store. The impairment losses for 2004 were related to an asset-backed security and a security issued by an airline company. The impairment losses for 2003 primarily related to securities issued by airline companies and an asset-backed security. The write-downs were measured based on public market prices and the Company’s expectation of the future realizable value for the security at the time when the Company determined the decline in value was other than temporary.
The realized losses on the change in fair value of derivative related to the increase in the fair value of the derivative component of the 6.50% Convertible Debt. See Note 6 for additional information.
During 2005, the Run-off Operations recorded unfavorable prior year loss development of $28.8 million, which included a $30 million charge taken in first quarter. In the first quarter of 2005, company actuaries identified higher than expected claim frequency and severity on policies covering contractors’ liability for construction defects from accident years 1998 to 2001 written by the Company’s former excess and surplus lines operation and an increase in reported losses and continued volatility in pro rata professional liability reinsurance business written from accident years 1997 to 2001. See Note 5 for information regarding applicable reinsurance coverage.
The PMA Insurance Group recorded favorable prior year loss development of $2.0 million and $2.1 million in 2005 and 2004, respectively, primarily reflecting better than expected loss experience from rent-a-captive workers’
The Company’s analysis was enhanced by an extensive review of specific accounts, comprising about 40% of the carried reserves of the reinsurance business for accident years 1997 to 2000. The Company’s actuaries visited a number of former ceding company clients, which collectively comprised about 25% of the reinsurance business total gross loss and LAE reserves from accident years to 2000, to discuss reserving and reporting experience with these ceding companies. The Company’s actuaries separately evaluated an additional number of other ceding companies, representing approximately 15% of the reinsurance business total gross loss and LAE reserves from accident years 1997 to 2000, to understand and examine data trends.
Unpaid losses and LAE for the Company’s workers’ compensation claims, net of reinsurance, at December 31, 2005 and 2004 were $428.9 million and $448.7 million, net of discount of $40.4 million and $48.2 million, respectively. The discount rate used was approximately 5% at December 31, 2005 and 2004.
The Company’s loss reserves were stated net of salvage and subrogation of $25.7 million and $30.8 million at December 31, 2005 and 2004, respectively.
Includes United States Fidelity & Guaranty Insurance Company ($58.7 million), Mountain Ridge Insurance Company ($12.6 million) and other affiliated entities ($7.1 million).
The 6.50% Convertible Debt is secured equally and ratably with the Company's $57.5 million 8.50% Monthly Income Senior Notes due 2018 (the “8.50% Senior Notes”) by a first lien on 20% of the capital stock of the Company's principal operating subsidiaries. The Convertible Debt may be converted at any time, at the holder’s option, at $16.368 per share for $69.1 million principal amount and at $15.891 per share for $5.0 million principal amount. The indenture governing the 6.50% Convertible Debt contains restrictive covenants with respect to limitations on the Company’s ability to incur indebtedness, enter into transactions with affiliates or engage in a merger or sale of all or substantially all of the Company’s assets.
On June 30, 2009, holders of the 6.50% Convertible Debt will have the right to require the Company to repurchase for cash any amounts outstanding for 114% of the principal amount of the debt plus accrued and unpaid interest, if any, to the settlement date. In 2006, in the event PMA Capital Corporation receives any extraordinary dividends from its subsidiaries, the Company will be required to use 50% of those dividends to redeem up to $35 million principal amount of the 6.50% Convertible Debt at 110% of the original principal amount. Holders may elect to receive any premium over the principal amount (“Put Premium”) in either cash or Class A Common stock, with the number of shares determined based on a value of $8.00 per share.
The Put Premium and conversion features of the 6.50% Convertible Debt constitute a derivative which requires bifurcation. Any change in the fair value of the derivative component of the 6.50% Convertible Debt is recognized in net realized investment gains (losses). The Company recorded net realized losses of $3.7 million in 2005 and $3.8 million in 2004 for increases in the fair value of the derivative component of the 6.50% Convertible Debt.
In 2003, the Company issued $43.8 million of 30-year floating rate junior subordinated debentures to three wholly-owned statutory trusts. The Company used all of the $41.2 million of net proceeds to pay down a portion of its then outstanding bank credit facility and for general corporate purposes. The junior subordinated debt matures in 2033 and is redeemable, in whole or in part, in 2008 at the stated liquidation amount plus accrued and unpaid interest. Interest on the junior subordinated debt equals the three-month LIBOR plus 4.10%, 4.20% and 4.05% and is payable on a quarterly basis. At December 31, 2005, the weighted average interest rate on the junior subordinated securities was 8.53%.
The Company has the right to defer interest payments on the junior subordinated securities for up to twenty consecutive quarters but, if so deferred, it may not declare or pay cash dividends or distributions on its Class A Common stock. The Company has guaranteed the obligations of these statutory trusts with respect to distributions and payments on the trust preferred securities issued by these trusts.
The Company leases certain facilities, office equipment and automobiles under noncancelable operating leases. Future minimum net operating lease obligations as of December 31, 2005 are as follows:
Net of sublease rentals of $1.5 million in 2006, $1.6 million in 2007, 2008, 2009 and 2010 and $6.2 million thereafter.
Until December 31, 2003, the Company had an executive loan program, through which a financial institution provided personal demand loans to the Company’s officers. The Company had provided collateral and agreed to purchase any loan in default. In November 2003, the financial institution sold the Company’s collateral partially securing the loans of two former officers of the Company in satisfaction of their loans in the aggregate amount of
$2.0 million. The Company received $1.7 million in repayment for the loans of one former officer in 2004, and in consideration of the Company forgiving $166,000 of indebtedness, the former officer executed an agreement, which, among other things, includes a release of the Company and its officers, employees and affiliates from any and all claims as of the date of that agreement. The loan of the other former officer in the outstanding principal amount of $185,000 was paid in 2005.
The Company and certain of its directors and key executive officers are defendants in several purported class actions that were filed in 2003 in the United States District Court for the Eastern District of Pennsylvania by alleged purchasers of the Company’s Class A Common stock, 4.25% Convertible Debt and 8.50% Senior Notes. On June 28, 2004, the District Court issued an order consolidating the cases under the caption In Re PMA Capital Corporation Securities Litigation (civil action no. 03-6121) and appointing Sheet Metal Workers Local 9 Pension Trust, Alaska Laborers Employers Retirement Fund and Communications Workers of America for Employees’ Pension and Death Benefits as lead plaintiff. On September 20, 2004, the plaintiffs filed an amended and consolidated complaint on behalf of an alleged class of purchasers of the Company’s securities between May 5, 1999 and February 11, 2004. The complaint alleges, among other things, that the defendants violated Section 10(b) of the Exchange Act, and Rule 10b-5 thereunder by making materially false and misleading public statements and material omissions during the class period regarding the Company’s underwriting performance, loss reserves and related internal controls. The complaint alleges, among other things, that the defendants violated Sections 11, 12(a) (2) and 15 of the Securities Act by making materially false and misleading statements in registration statements and prospectuses about the Company’s financial results, underwriting performance, loss reserves and related internal controls. The complaint seeks unspecified compensatory damages, the right to rescind the purchases of securities in the public offerings, interest, and plaintiffs’ reasonable costs and expenses, including attorneys’ fees and expert fees. The Company intends to vigorously defend against the claims asserted in this consolidated action. By Order dated July 27, 2005, the District Court partially granted the Company’s previously filed Motion to Dismiss the Amended Complaint, dismissing all allegations with respect to The PMA Insurance Group, and otherwise denied the Motion to Dismiss. By virtue of the Order, the alleged class period was reduced to November 6, 2003. The lawsuit is in its earliest stages; therefore, it is not possible at this time to reasonably estimate the impact on the Company. However, the lawsuit may have a material adverse effect on the Company’s financial condition, results of operations and liquidity.
lieu of a portion of their retainer under the 2004 Directors Plan. In 2004, the Company issued 262,600 shares of restricted Class A Common stock to employees under the Company’s 2002 Equity Incentive Plan and 79,326 shares of restricted Class A Common stock to its Directors under the 2004 Directors Plan. The Company also issued 16,422 shares of Class A Common stock to Directors in 2004 in lieu of a portion of their retainer under the 2004 Directors Plan. The restricted stock vests (restrictions lapse) between one and three years.
Upon vesting of a restricted stock award, employees may remit cash or shares of Class A Common stock to satisfy their tax obligations relating to the award. During 2005, employees remitted 54,694 shares to the Company to satisfy their payment of withholding taxes for vested awards.
The Company determines the cost of restricted stock awarded, which is recognized as compensation expense over the vesting period, based on the market value of the stock at the time of the award. The Company recorded expenses of $841,000 and $1.3 million during 2005 and 2004, respectively, for restricted stock awards, including $119,000 and $112,000 in 2005 and 2004, respectively, for Class A Common stock issued to Directors in lieu of their retainer.
The Company declared dividends on its Class A Common stock of $0.315 per share in 2003. In November 2003, the Company’s Board of Directors suspended dividends on the Company’s Class A Common stock.
In June 2004, the Pennsylvania Insurance Department approved the application for the Pooled Companies, previously subsidiaries of PMACIC, to become direct, wholly-owned subsidiaries of PMA Capital Corporation. However, in its Order approving the transfer of the Pooled Companies from PMACIC to PMA Capital Corporation, the Pennsylvania Insurance Department prohibited PMACIC, the Company’s reinsurance subsidiary which is currently in run-off, from any declaration or payment of dividends, return of capital or any other types of distributions in 2004 and 2005 to PMA Capital Corporation. In 2006, PMACIC may declare and pay ordinary dividends or returns of capital without the prior approval of the Pennsylvania Insurance Department if, immediately after giving effect to the dividend or returns of capital, PMACIC’s risk-based capital equals or exceeds 225% of Authorized Control Level Capital as defined by the National Association of Insurance Commissioners (“NAIC”). PMACIC is permitted to request an “extraordinary” dividend, as defined under Pennsylvania law, in 2006 subject to the same risk-based capital requirements. Such “extraordinary” dividend must be approved by the Pennsylvania Insurance Department prior to payment. In 2007 and beyond, PMACIC may make dividend payments, as long as such dividends are not considered “extraordinary.” At December 31, 2005, the Company’s risk-based capital was 547% of Authorized Control Level Capital.
The effect of 2.1 million, 1.5 million and 2.9 million stock options were excluded from the computation of diluted earnings per share for 2005, 2004 and 2003, respectively, because they would have been anti-dilutive. The effects of 176,688 shares of restricted stock were excluded from the computation of diluted earnings per share for 2005 because they were anti-dilutive.
As of December 31, 2005 and December 31, 2004, the carrying amounts for the Company’s financial instruments approximated their estimated fair value. The Company measures the fair value of fixed maturities, the Convertible Debt and the Senior Notes based upon quoted market prices or by obtaining quotes from dealers. Certain financial instruments, specifically amounts relating to insurance and reinsurance contracts, are excluded from this disclosure.
The decline in Qualified Pension Plan asset performance in 2000 to 2002, combined with historically low interest rates (which are the key assumption in estimating plan liabilities) caused the Company to record a $24.0 million increase in its accrued Qualified Pension Plan liability and to take a $15.6 million non-cash charge to equity in the fourth quarter of 2003. The Company further increased its additional minimum liability by $1.2 million in 2004 and $5.1 million in 2005, and recorded non-cash charges to equity of $806,000 and $3.3 million, respectively. These charges did not impact earnings or cash flow, and could reverse in future periods if either interest rates increase or market performance and plan asset returns improve.
Qualified Pension Plan benefits will be paid from the pension trust assets which have a fair value of $67.7 million at December 31, 2005. Non-qualified Pension Plan benefits will be paid from the general assets of the Company.
As a result of the decision to exit from and run off the reinsurance business, results for the Run-off Operations for 2003 included a charge of $2.6 million pre-tax, mainly for employee termination benefits. Approximately 100 employees at PMA Re have been terminated in accordance with the Company’s exit plan and 38 positions, primarily claims and financial, remain. The Company has established an employee retention arrangement for the remaining employees. Under this arrangement, the Run-off Operations recorded expenses of $1.4 million and $1.7 million, which included retention bonuses and severance, for 2005 and 2004, respectively, and expects to record expenses of approximately $1 million for 2006. Employee termination benefits and retention bonuses of approximately $4.6 million have been paid in accordance with this plan as of December 31, 2005, including $2.8 million in 2004. Additionally, in 2004 the Run-off Operations paid a $1 million fee to shorten the term of its Philadelphia office lease from fifteen years to seven and reduce the leased space by approximately 75% effective October 1, 2004.
In 2003, the Company and certain of its subsidiaries provided certain administrative services to the PMA Foundation (the “Foundation”), for which the Company and its subsidiaries received reimbursement. The Foundation, a not-for-profit corporation qualified under Section 501(c)(6) of the Internal Revenue Code, whose purposes include the promotion of the common business interests of its members and the economic prosperity of the Commonwealth of Pennsylvania, owned 5,242,150 shares, or 16.7%, of the Company’s Class A Common stock as of December 31, 2003. As of December 31, 2004, the Foundation owned less than 5% of the Company’s Class A Common stock. Total reimbursements amounted to $13,000 for 2003. The Foundation also leased its Harrisburg, Pennsylvania headquarters facility from a subsidiary of the Company under an operating lease which required rent payments of $25,000 per month, and reimbursed a subsidiary of the Company for its use of office space. Rent and related reimbursements paid to the Company’s affiliates by the Foundation was $304,000 in 2003. In 2004, the Company sold this building to the Foundation for gross proceeds of $1.6 million, resulting in a gain of $458,000, which is included in other revenues in the Statement of Operations.
These consolidated financial statements vary in certain respects from financial statements prepared using statutory accounting practices that are prescribed or permitted by the Pennsylvania Insurance Department and the Delaware Insurance Department (collectively, “SAP”). Prescribed SAP includes state laws, regulations and general administrative rules, as well as a variety of NAIC publications. Permitted SAP encompasses all accounting practices that are not prescribed. The Codification of Statutory Accounting Principles (“Codification”) guidance is the NAIC’s primary guidance on statutory accounting. The principal differences between GAAP and SAP are in the treatment of acquisition expenses, reinsurance, deferred income taxes, fixed assets and investments.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
We have audited management’s assessment, included in the accompanying Management’s Report on Internal Controls over Financial Reporting, that PMA Capital Corporation and subsidiaries (the Company) maintained effective internal control over financial reporting as of December 31, 2005 based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of PMA Capital Corporation and subsidiaries as of December 31, 2004, and the results of their operations and their cash flows for each of the two years in the period ended December 31, 2004, in conformity with accounting principles generally accepted in the United States of America.