EMC Insurance Group Inc., a 57.0 percent owned subsidiary of Employers Mutual Casualty Company (Employers Mutual), is an insurance holding company with operations in property and casualty insurance and reinsurance. Property and casualty insurance is the most significant segment, representing 81.6 percent of consolidated premiums earned in 2007. For purposes of this discussion, the term “Company” is used interchangeably to describe EMC Insurance Group Inc. (Parent Company only) and EMC Insurance Group Inc. and its subsidiaries. Employers Mutual and all of its subsidiaries (including the Company) and an affiliate are referred to as the “EMC Insurance Companies.”
The Company’s three property and casualty insurance subsidiaries and two subsidiaries and an affiliate of Employers Mutual are parties to reinsurance pooling agreements with Employers Mutual (collectively the “pooling agreement”). Under the terms of the pooling agreement, each company cedes to Employers Mutual all of its insurance business, with the exception of any voluntary reinsurance business assumed from nonaffiliated insurance companies, and assumes from Employers Mutual an amount equal to its participation in the pool. All premiums, losses, settlement expenses, and other underwriting and administrative expenses, excluding the voluntary reinsurance business assumed by Employers Mutual from nonaffiliated insurance companies, are prorated among the parties on the basis of participation in the pool. Employers Mutual negotiates reinsurance agreements that provide protection to the pool and each of its participants, including protection against losses arising from catastrophic events.
Insurance companies collect cash in the form of insurance premiums and pay out cash in the form of loss and settlement expense payments. Additional cash outflows occur through the payment of acquisition and underwriting costs such as commissions, premium taxes, salaries and general overhead. During the loss settlement period, which varies by line of business and by the circumstances surrounding each claim and may cover several years, insurance companies invest the cash premiums; thereby earning interest and dividend income. This investment income supplements underwriting results and contributes to net earnings. Funds from called and matured fixed maturity securities are reinvested at current interest rates. The relatively low interest rate environment of the last several years has had a negative impact on the insurance industry’s investment income.
Insurance pricing has historically been cyclical in nature. Periods of excess capital and increased competition encourage price reductions and liberal underwriting practices (referred to as a soft market) as insurance companies compete for market share, while attempting to cover the inevitable underwriting losses from these actions with investment income. A prolonged soft market generally leads to a reduction in the adequacy of capital in the insurance industry. To cure this condition, underwriting practices are tightened, premium pricing increases and competition subsides as companies strive to strengthen their balance sheets (referred to as a hard market). During 2005, the insurance industry entered into a soft market with premium rate reductions accelerating in most areas of the United States, with the notable exception of rate increases in the Gulf States and other hurricane exposed areas due to the severe 2005 hurricane season. The soft market continued during 2006 and 2007, and market conditions are expected to remain competitive during 2008 as insurance companies continue to compete for good business, which will likely result in additional premium rate reductions.
A substantial determinant of an insurance company’s underwriting results is its loss and settlement expense reserving practices. Insurance companies must estimate the amount of losses and settlement expenses that will ultimately be paid to settle claims that have occurred to date (loss and settlement expense reserves). This estimation process is inherently subjective with the possibility of widely varying results, particularly for certain highly volatile types of claims (asbestos, environmental and various casualty exposures, such as products liability, where the loss amount and the parties responsible are difficult to determine). During a soft market, inadequate premium rates put pressure on insurance companies to under-estimate their loss and settlement expense reserves in order to show a profit. Correspondingly, inadequate reserves play an integral part in bringing about a hard market, because increased profitability from higher premium rate levels can be used to strengthen an insurance company’s loss and settlement expense reserves.
The United States Congress is currently studying, or has placed on its agenda, several issues of critical importance to the Company and the insurance industry. These issues include Federal regulation in addition to, or in place of, current state regulation, tort and class-action lawsuit reform, and the federal government’s role in terrorism insurance. The United States Congress is also considering legislation (referred to as the Insurance Industry Competition Act) that would amend the McCarran-Ferguson Act and permit the Federal Trade Commission and United States Department of Justice to enforce Federal antitrust laws and regulations on the insurance industry. The Company is closely monitoring activities by the United States Congress on these issues through its membership in various organizations.
During 2007, management continued to focus its efforts on two issues of critical importance to the Company: developing and implementing strategies to facilitate profitable growth in the increasingly competitive insurance marketplace, and establishing and maintaining adequate and consistent loss and settlement expense reserves. Management also reviewed its long-term strategies for Farm and City Insurance Company, which was a subsidiary in the property and casualty insurance segment that ceased writing direct nonstandard risk automobile insurance business in 2004, but continued to participate in the pooling agreement. As a result of this review, management determined that there were no identified uses for this company and therefore merged Farm and City into one of the Company’s other property and casualty insurance subsidiaries. In addition, management reviewed the statutory surplus position of each of the Company’s insurance subsidiaries and determined that the reinsurance subsidiary had sufficient surplus to allow the redemption of all $11,000,000 of surplus notes issued to Employers Mutual. Following is a detailed discussion of these issues.
Net premiums written for the EMC Insurance Companies’ pool were nearly unchanged during the past three years due to increased premium rate competition and higher reinsurance costs. The increase in premium rate competition is driven by the high capitalization levels and profitable underwriting results generated by the property and casualty insurance industry in recent years. With the exception of the workers’ compensation line of business, all lines of business experienced a decline in premium rates of varying magnitudes over the past three years. During this period policy retention remained at a high level, but policy count declined as a result of increased competition for good business and Company initiatives to exit unprofitable business. On an overall basis, premium rate levels declined approximately 4.9 percent in 2007 after falling approximately 3.7 percent in 2006; however, premium rates are still considered adequate on an all-lines basis. Given this pricing environment, management is targeting premium growth from new business writings that are carefully selected and adequately priced, and from continuing efforts to maintain, or improve, policy retention. Personal lines growth has been targeted toward selected territories where the best profit potential exists.
Finally, management continues to emphasize those strategies that have been successful. These strategies vary from branch to branch, but generally include defining what products have been well-received in individual marketplaces and concentrating marketing strategies accordingly. Management continues to enhance its efforts to write more homeowner and personal auto accounts in selected territories, more small and medium-sized business accounts, and fidelity and surety bonds. Signs of progress began to emerge during 2006 and continued into 2007 as new business production increased moderately in the targeted areas and lines of business.
During the fourth quarter of 2007, the MRB board of directors approved Farm Bureau Mutual Insurance Company of Michigan to replace Auto-Owners Insurance Company as an assuming company in the MRB pool effective January 1, 2008. As a result, Employers Mutual’s participation in the pool will remain at its current 20 percent in 2008.
The Company experienced an unusually large amount of favorable development on its prior years’ direct case loss reserves during 2007 and 2006. Over the past several years the Company has devoted a substantial amount of time and resources to improving the adequacy and consistency of its case loss reserves by implementing procedures and guidelines that assist claims personnel in establishing and maintaining proper reserve amounts. Because of these improvements in the claims handling process, favorable development on prior years’ case loss reserves was not unexpected in 2007 or 2006; however, the magnitude of the favorable development experienced during this time period was not anticipated. On a direct basis, approximately 50 percent of the favorable development came from case loss reserves and, in aggregate, all of this development is associated with the final settlement of closed claims. Approximately 30 percent of the favorable development came from incurred but not reported (IBNR) reserves, and was partially driven by a decline in IBNR emergence during this period. The remaining favorable development came from settlement expense reserves.
From management’s perspective, investors and potential investors should not place undo emphasis on the composition of the Company’s underwriting results (i.e. the breakdown between the amount of favorable development reported on prior years’ reserves versus the indicated current accident year results) because the Company’s reserving methodology does not lend itself to that type of analysis very well. Management believes that it is important for investors and potential investors to have an appropriate understanding of the Company’s reserving methodology so that they are able to properly interpret the Company’s results of operations and make informed investment decisions. Following is a brief discussion of the Company’s reserving methodology.
At December 31, 2007 and 2006, approximately 60 and 62 percent, respectively, of the property and casualty insurance segment’s carried reserves were represented by case loss reserves, which are the individual reserves established for each reported claim based on the specific facts associated with each claim, and bulk case loss reserves. Individual case loss reserves are based on the probable, or most likely, outcome for each claim, with probable outcome defined as what is most likely to be awarded if the case were to be decided by a civil court in the applicable venue or, in the case of a workers’ compensation case, by that state’s Worker’s Compensation Commission. Bulk case loss reserves are actuarially derived and are allocated to the various accident years on the basis of the underlying aggregate case loss reserves of the applicable lines of business.
The remaining portion (40 percent in 2007 and 38 percent in 2006) of the property and casualty insurance segment’s carried reserves were comprised of IBNR and settlement expense reserves, which are established through an actuarial process for each line of business. The IBNR and certain settlement expense reserves are allocated to the various accident years using historical claim emergence and settlement payment patterns; other settlement expense reserves are allocated to the various accident years on the basis of case loss reserves.
It is management’s intention to continue to apply this reserving methodology on a consistent basis. With reasonably consistent levels of reserve adequacy, management expects earnings from downward development of prior accident year reserves to continue in future years. For that reason, management believes that less emphasis should be placed on the composition of the Company’s underwriting results between the current and prior accident years, and more emphasis should be placed on where the Company’s carried reserves fall within the range of actuarial indications.
At December 31, 2007, the Company’s loss and settlement expense reserves were in the upper quarter of the range of actuarial indications, which is similar to the analysis completed at December 31, 2006. Although the current actuarial analysis indicates that the Company’s loss and settlement expense reserves are at a high level of adequacy, management is not able to predict whether, or to what extent, the Company will continue to experience favorable development on its reserves.
As of December 31, 2007, IBNR loss reserves accounted for $80,645,000, or 19.7 percent, of the property and casualty insurance segment’s total loss and settlement expense reserves, compared to $77,328,000, or 18.9 percent at December 31, 2006. IBNR loss reserves are, by nature, less precise than case loss reserves. A five percent change in IBNR loss reserves at December 31, 2007 would equate to $2,621,000, net of tax, which represents 6.2 percent of net income and 0.7 percent of stockholders’ equity.
The property and casualty insurance subsidiaries have exposure to environmental and asbestos claims arising primarily from the other liability line of business. This exposure is closely monitored by management, and the IBNR loss reserves have been established to cover estimated ultimate losses. Currently, asbestos reserves are based on the results of an independent consultant’s ground-up study of the pool participants asbestos exposures that was completed in 2006. Environmental reserves are established in consideration of the implied three-year survival ratio (ratio of loss reserves to the three-year average of loss payments). Estimation of ultimate liabilities for these exposures is unusually difficult due to unresolved issues such as whether coverage exists, the definition of an occurrence, the determination of ultimate damages and the allocation of such damages to financially responsible parties. Therefore, any estimation of these liabilities is subject to greater than normal variation and uncertainty, and ultimate payments for losses and settlement expenses for these exposures may differ significantly from the carried reserves.
At December 31, 2007, there was no backlog in the processing of assumed reinsurance information. Approximately $80,792,000, or 57 percent, of the reinsurance segment’s statutory carried reserves were reported by the ceding companies. Employers Mutual receives loss reserve and paid loss data from the ceding companies on individual excess-of-loss business. If a claim involves a single or small group of claimants, a summary of the loss and claim outlook is normally provided. Summarized data is provided for catastrophe claims and pro rata business, which is subject to closer review if inconsistencies are suspected.
Carried reserves established in addition to those reported by the ceding companies totaled approximately $60,006,000 on a statutory basis at December 31, 2007. Since many ceding companies in the HORAD book of business do not report IBNR loss reserves, Employers Mutual establishes a bulk IBNR loss reserve to cover the lag in reporting. For the few ceding companies that do report IBNR loss reserves, Employers Mutual carries them as reported. These reported IBNR loss reserves are subtracted from the total IBNR loss reserve calculated by Employers Mutual’s actuaries, with the difference carried as bulk IBNR loss reserves. Except for a small IBNR loss reserve established to cover a one-month lag in reporting, the MRB IBNR loss reserve is established by the management of MRB. Employers Mutual rarely records additional case loss reserves.
Assumed reinsurance losses tend to be reported later than direct losses. This lag is reflected in loss projection factors for assumed reinsurance that tend to be higher than for direct business. The result is that assumed reinsurance IBNR loss reserves as a percentage of total reserves tend to be higher than for direct loss reserves. IBNR loss reserves totaled $82,501,000 and $79,310,000 at December 31, 2007 and 2006, respectively, and accounted for approximately 58 percent and 57 percent, respectively, of the reinsurance segment’s total loss and settlement expense reserves. IBNR loss reserves are, by nature, less precise than case loss reserves. A five percent change in IBNR loss reserves at December 31, 2007 would equate to $2,681,000 net of tax, which represents 6.3 percent of net income and 0.7 percent of stockholders’ equity.
To ensure the accuracy and completeness of the information received from the ceding companies, Employers Mutual’s actuarial department carefully reviews the latest five HORAD policy years on a quarterly basis, and all policy years on an annual basis. Any significant unexplained departures from historical reporting patterns are brought to the attention of the reinsurance department’s staff, who contacts the ceding company or broker for clarification.
Toxic tort claims include those claims where the claimant seeks compensation for harm allegedly caused by exposure to a toxic substance or a substance that increases the risk of contracting a serious disease, such as cancer. Typically the injury is caused by latent effects of direct or indirect exposure to a substance or combination of substances through absorption, contact, ingestion, inhalation, implantation or injection. Examples of toxic tort claims include injuries arising out of exposure to asbestos, silica, mold, drugs, carbon monoxide, chemicals and lead.
Since 1989, the pool participants have included an asbestos exclusion in liability policies issued for most lines of business. The exclusion prohibits liability coverage for “bodily injury”, “personal injury” or “property damage” (including any associated clean-up obligations) arising out of the installation, existence, removal or disposal of asbestos or any substance containing asbestos fibers. Therefore, the pool participant’s current asbestos exposures are primarily limited to commercial policies issued prior to 1989. At present, the pool participants are defending approximately 600 asbestos bodily injury lawsuits, some of which involve multiple plaintiffs. Four former policyholders and one current policyholder dominate the pool participant’s asbestos claims. Most of the defenses are subject to express reservation of rights based upon the lack of an injury within the applicable policy periods, because many asbestos lawsuits do not specifically allege dates of asbestos exposure or dates of injury. The pool participant’s policyholders that have been named as defendants in these asbestos lawsuits are peripheral defendants who have had little or no exposure and are routinely dismissed from asbestos litigation with nominal or no payment (i.e., small contractors, insulators, electrical welding suppliers, furnace manufacturers, gasket and building supply companies).
In 2004, the pool participants were presented with eight contamination claims filed against four of their petroleum marketers in Iowa and Indiana. Claims filed in Indiana were dismissed during 2007. These claims arose out of alleged contamination of municipal public water systems by the gasoline additive Methyl Tertiary Butyl Ether (“MTBE”). All MTBE lawsuits initiated in a number of states, including the states of Iowa and Indiana, were moved to their respective Federal courts and were then transferred to the United States District Court for the Southern District of New York, where they were consolidated. The pool participants are defending these claims under commercial auto policies which afford broadened pollution liability coverage for overfills. These claims are subject to express reservations of rights based upon the lack of property damage within the policy periods, because these lawsuits do not specifically allege dates of property damage or contamination, or any contamination that resulted from an overfill.
The Company’s non-asbestos direct product liability claims are considered to be highly uncertain exposures due to the many uncertainties inherent in determining the loss, and the significant periods of time that can elapse between the occurrence of the loss and the ultimate settlement of the claim. The majority of the pool participant’s product liability claims arise from small to medium-sized manufacturers, contractors, petroleum distributors, and mobile home and auto dealerships. No specific claim trends are evident from the pool participant’s manufacturer policies, as the claims activity on these policies is generally isolated and can be severe. Specific product liability coverage is provided to the pool participant’s mobile home and auto dealership policyholders, and the claims from these policies tend to be relatively small. Certain construction defect claims are also reported under product liability coverage. During 2007, 39 of these claims were reported to the pool participants.
The Company has exposure to construction defect claims arising from general liability policies issued by the pool participants to contractors. Most of the pool participant’s construction defect claims are concentrated in a limited number of states, and the pool participants have taken steps to mitigate this exposure. Construction defect is a highly uncertain exposure due to such issues as whether coverage exists, definition of an occurrence, determination of ultimate damages, and allocation of such damages to financially responsible parties. Newly reported construction defect claims numbered 345, 410, and 394 in 2007, 2006, and 2005, respectively, and produced incurred losses and paid settlement expenses of approximately $2,755,000, $3,315,000, and $3,515,000 in each respective period. Incurred losses and paid settlement expenses on all construction defect claims totaled approximately $4,553,000 in 2007. At December 31, 2007, the Company carried case loss reserves of approximately $5,338,000 on 557 open construction defect claims.
The Company does not determine a range of estimates for all components of the loss and settlement expense reserve at the time those reserves are established. At each year-end, however, an actuarially determined range of estimates is developed for the major components of the loss and settlement expense reserve. All reserves are reviewed, except for the involuntary workers’ compensation pools, for which reliance is placed on a reserve opinion received from the National Council on Compensation Insurance certifying the reasonableness of those reserves. Shown below are the actuarially determined ranges of reserve estimates as of December 31, 2007 along with the statutory-basis carried reserves, which are displayed net of ceded reinsurance. The GAAP-basis loss and settlement expense reserves contained in the Company’s financial statements are reported gross of ceded reinsurance and contain a small number of adjustments from the statutory-basis amounts presented here. The last two columns display the estimated after-tax impact on earnings if the reserves were moved to the high end-point or low end-point of the ranges.
The Company uses independent pricing sources to obtain the estimated fair values of securities. The fair value is based o quoted market prices, where available. In cases where quoted market prices are not available for fixed maturity securities, fair value is based on a variety of valuation techniques depending on the type of security. Many fixed maturity securities do not trade on a daily basis, so available information such as benchmark curves, benchmarking of like securities, reported trades, broker/dealer quotes, issuer spreads, bids, offers, and matrix pricing are utilized in the valuation process. For each type of security, information is gathered from market sources that integrate relevant credit information, perceived market movements and sector news into the pricing process. In addition, models are utilized to develop prepayment and interest rate scenarios. The Company owns one privately-placed equity security for which a quoted market price in not available. The fair value of this equity security is estimated by an independent service using factors such as recent financial information and a third party valuation. The fair values obtained from pricing sources are reviewed for reasonableness and any discrepancies are investigated for final valuation.
Acquisition costs consisting of commissions, premiums taxes and other underwriting expenses that vary with, and are directly related to, the production of business are deferred and amortized to expense as premium revenue is recognized. This adjustment is necessary because statutory accounting principles require that expenses incurred in the production of insurance business be expensed immediately, while premium revenue is recognized ratably over the terms of the underlying insurance policies.
The discount rate utilized in the valuations is based on an analysis of the total rate of return that could be generated by a hypothetical portfolio of high-quality bonds created to generate cash flows that match the plans’ expected benefit payments. No callable bonds are used in this analysis and the discount rate produced by this analysis is compared to interest rates of applicable published indices for reasonableness. The discount rates used in the pension benefit valuations at December 31, 2007, 2006 and 2005 were 6.00 percent, 5.75 percent and 5.75 percent, respectively. The discount rates used in the postretirement benefit valuations at December 31, 2007, 2006 and 2005 were 6.25 percent, 5.75 percent and 5.75 percent, respectively. A 0.25 percentage point decrease in the discount rates used in the 2007 valuations would increase the Company’s net periodic pension and postretirement benefit costs for 2008 by approximately $14,000. Conversely, a 0.25 percentage point increase in the 2007 discount rates would decrease the Company’s net periodic pension and postretirement benefit costs for 2008 by approximately $13,000.
The expected long-term rate of return on plan assets is developed considering actual historical results, current and expected market conditions, the mix of plan assets and investment strategy. The expected long-term rate of return on plan assets produced by this analysis and used in the pension valuations at December 31, 2007, 2006 and 2005 was 7.50 percent. The expected long-term rate of return on plan assets used in the postretirement benefit valuations was 6.00 percent at December 31, 2007 and 2006, and 5.00 percent at December 31, 2005. The actual rate of return earned on plan assets during 2007 was approximately 14.1 percent for the pension plan and 8.5 percent for the postretirement benefit plans. The expected long-term rate of return assumption is subject to the general movement of the economy, but is generally less volatile than the discount rate assumption. A decrease in the expected long-term rate of return assumption increases future expenses, whereas an increase in the assumption reduces future expenses. A 0.25 percentage point change in the 2007 expected long-term rate of return assumption would change the Company’s net periodic pension and postretirement benefit costs for 2008 by $167,000. For detailed information regarding the current allocation of assets within the pension and postretirement benefit plans, see note 11 of Notes to Consolidated Financial Statements under Item 8 of this Form 10-K.
Premiums written for the reinsurance segment increased $4,735,000, or 7.1 percent, in 2007; however, this increase reflects a negative $3,440,000 portfolio adjustment made in the first quarter of 2006 in connection with Employers Mutual’s reduced participation in the MRB pool. Excluding this adjustment, written premiums increased $1,295,000, or 1.9 percent, during 2007.
For the property and casualty insurance segment, the acquisition expense ratio increased slightly to 37.1 percent in 2007 from 37.0 percent in 2006. This increase was driven primarily by the decline in premium rate levels, but also reflects an increase in commission and contingent commission expense, salary expense, and assessments from state guaranty associations. However, much of this increase was offset by declines in policyholder dividend expense, pension expense, and hurricane related assessments (Mississippi Windstorm Underwriting Association assessments for Hurricane Katrina in the second quarter of 2006). Hurricane related assessments are recoverable from reinsurers, with the reinsurance recoveries reflected as a reduction of losses (included in the loss and settlement expense ratio).
Income tax expense decreased 27.9 percent to $16,441,000 in 2007 from $22,818,000 in 2006. The effective tax rates were 27.9 percent in 2007 and 29.9 percent in 2006. The decline in the effective tax rate in 2007 primarily reflects the large decline in pre-tax income earned relative to the amount of tax-exempt interest income earned.
Premiums earned decreased 5.8 percent to $391,615,000 in 2006 from $415,625,000 in 2005. This decrease was primarily attributed to the reinsurance segment and was associated with, most notably, Employers Mutual’s reduced participation in the MRB pool and the revised terms of the quota share agreement; however, the property and casualty insurance segment also experienced a slight decline in premiums earned. On an overall basis, premium rate competition increased moderately in the property and casualty insurance marketplace during 2006, resulting in an approximate 3.7 percent reduction in premium rate levels. For comparative purposes, premium rate levels declined approximate 0.9 percent in 2005.
Premiums earned for the property and casualty insurance segment decreased 0.9 percent to $318,416,000 in 2006 from $321,165,000 in 2005. This decrease reflects (1) a moderate decline in implemented premium rates, (2) increased use of discretionary credits, (3) a reduction in policy count, (4) a decline in mandatory premiums assumed from the National Workers’ Compensation Reinsurance Pool and (5) an increase in the cost of the Company’s outside reinsurance coverage (which in 2005 included $1,302,000 of additional premiums used to reinstate the pool’s catastrophe reinsurance protection after the occurrence of Hurricanes Katrina and Rita). Recent initiatives to develop new business began to produce results, as evidenced by a small increase in premiums earned during the fourth quarter of 2006 over both the third quarter of 2006 and the fourth quarter of 2005. Due to the timing of policy renewals and the earning of premiums ratably over the terms of the underlying policies, the full effect of the recent premium rate reductions was not reflected in premiums earned. Premium rates were still considered adequate in most lines of business and in most territories, but the impact of the recent premium rate reductions was expected to continue to increase. Management attempted to address the loss of policy count through various measures, including programs geared towards small businesses and enhanced automation to make it easier and more efficient for agents to do business with the Company. There were signs of progress toward this objective during 2006 as new-business policy count increased, retention rates remained high, and the rate of decline in total policy count slowed. During 2006, commercial lines new-business premium increased 20.2 percent and personal lines new-business premium increased 13.3 percent; however, it should be noted that commercial lines new-business premium was relatively low in 2005 and the large increase reported for 2006 was therefore somewhat misleading and should be considered in context. Overall policy retention was up slightly to 86.4 percent in commercial lines, 84.4 percent for personal property and 86.5 percent for personal auto. In light of current rate levels and the quality of the Company’s book of business, management was actively pursuing opportunities to write new business, but continued to stress profitable growth.
Premiums earned for the reinsurance segment decreased 22.5 percent to $73,199,000 in 2006 from $94,460,000 in 2005. This decrease was primarily attributed to a decline in MRB premiums and the revised terms of the quota share agreement; however, premium income was also negatively impacted by the loss of a Lloyd’s of London marine syndicate account and a decline in reinstatement premium income. The decline in MRB premiums was primarily due to the addition of two new assuming companies to the pool (an increase from three in 2005 to five in 2006), but also reflected a reduction in the amount of business produced by MRB. In total, MRB premiums earned declined by $15,567,000 in 2006. In conjunction with Employers Mutual’s reduced participation in the MRB pool, the reinsurance subsidiary recorded a negative $3,440,000 portfolio adjustment in its premiums written, which served as an offset to the decline in the unearned premium reserve. Including this adjustment, MRB premiums written declined by $19,052,000 in 2006. Also contributing to the decline in premiums earned was a $1,554,000 decrease in the estimate of earned but not reported (EBNR) premiums (primarily due to MRB), compared to an increase in this estimate of $165,000 during 2005. The reinsurance segment recognized approximately $1,588,000 of reinstatement premium income during 2006, compared to approximately $2,474,000 during 2005 ($1,500,000 of which was attributed to Hurricane Katrina). During the January 2007 renewal period, overall premium rate levels remained relatively flat. Premium rates on accounts with 2006 catastrophe losses increased slightly, as did coastal accounts without Hurricane Katrina losses; reflecting a “catch-up” adjustment to the rates implemented during the July 2006 renewal period (accounts renewing in July, particularly domestic accounts with substantial Hurricane Katrina losses, experienced greater pricing increases than those renewing in January 2006). Due to competitive market conditions, a few new accounts were added and a small number of existing accounts were lost during the January 2007 renewal period.
The loss and settlement expense ratio for the reinsurance segment increased to 68.5 percent in 2006 from 63.5 percent in 2005. The increase in the 2006 ratio was driven by the revised terms of the quota share agreement with Employers Mutual whereby the full cost of the $2,000,000 cap on losses assumed per event was recorded as a reduction to premiums; however, over half of the increase in the loss and settlement expense ratio was offset by a decline in the acquisition expense ratio due to the elimination of the override commission paid in 2005. Excluding the impact of the revised terms of the quota share agreement, the loss and settlement expense ratio would have declined slightly in 2006. Results for 2006 reflect a significant increase in the amount of favorable development experienced on prior years’ reserves and a substantial decline in catastrophe and storm losses, which was attributed to $4,500,000 of losses recorded in 2005 from Hurricanes Katrina, Rita and Wilma. The favorable reserve development experienced in 2006 was primarily from the 2004 and 2005 accident years in the HORAD book of business.
Acquisition and other expenses declined 3.4 percent to $135,248,000 in 2006 from $140,001,000 in 2005. This decline was attributed to the reinsurance segment and was caused by Employers Mutual’s reduced participation in the MRB pool and the revised terms of the quota share agreement. The acquisition expense ratio increased to 34.6 percent in 2006 from 33.6 percent in 2005, primarily as a result of higher salary and benefit costs, consulting fees and dividends to policyholders, as well as the decline in premium income.
For the reinsurance segment, the acquisition expense ratio declined to 24.0 percent in 2006 from 27.5 percent in 2005. This decline was attributed to Employers Mutual’s reduced participation in the MRB pool and the revised terms of the quota share agreement. Also contributing to the decline was a large decrease in commission expense associated with the cancellation of a Lloyd’s of London marine syndicate account.
The revised terms of the quota share agreement contributed to the reduction in the reinsurance subsidiary’s acquisition expense ratio in 2006. The previous terms of the quota share agreement provided for a 4.5 percent override commission payment to Employers Mutual as compensation for the cap on losses assumed per event, which generated $4,166,000 of commission expense in 2005. Effective January 1, 2006, the reinsurance subsidiary no longer paid this override commission, and instead paid a 10.5 percent premium charge. Had the revised terms of the quota share agreement been in place in 2005, the acquisition expense ratio would have been approximately 2.7 percentage points lower after giving consideration to the changes in acquisition and other expenses, premiums earned, and the impact on the calculation of the deferred policy acquisition cost asset.
The Company is a holding company whose principal asset is its investment in its insurance subsidiaries. As a holding company, the Company is dependent upon cash dividends from its insurance company subsidiaries to meet all obligations, including cash dividends to stockholders. State insurance regulations restrict the maximum amount of dividends insurance companies can pay without prior regulatory approval. See note 6 of Notes to Consolidated Financial Statements for additional information regarding dividend restrictions. The maximum amount of dividends that the insurance company subsidiaries can pay to the Company in 2008 without prior regulatory approval is approximately $46,779,000. The Company received $4,750,000, $9,005,000 and $5,696,000 of dividends from its insurance company subsidiaries and paid cash dividends to its stockholders totaling $9,497,000, $8,916,000 and $8,302,000 in 2007, 2006 and 2005, respectively.
The Company considers itself to be a long-term investor and generally purchases fixed maturity securities with the intent to hold them to maturity. Despite this intent, the Company currently classifies purchases of fixed maturity securities as available-for-sale to provide flexibility in the management of its investment portfolio. The Company had net unrealized holding gains, net of deferred taxes, on fixed maturity securities available-for-sale totaling $12,298,000 and $6,319,000 at December 31, 2007 and 2006, respectively. The fluctuation in the market value of these investments is primarily due to changes in the interest rate environment during this time period. Since the Company does not actively trade in the bond market, such fluctuations in the fair value of these investments are not expected to have a material impact on the operations of the Company, as forced liquidations of investments is not anticipated. The Company closely monitors the bond market and makes appropriate adjustments in its portfolio as conditions warrant.
Capital resources consist of stockholders’ equity and debt, representing funds deployed or available to be deployed to support business operations. For the Company’s insurance subsidiaries, capital resources are required to support premium writings. Regulatory guidelines suggest that the ratio of a property and casualty insurer’s annual net premiums written to its statutory surplus should not exceed three to one. All of the Company’s insurance subsidiaries were well under this guideline at December 31, 2007.
The amortized cost and estimated fair value of fixed maturity and equity securities at December 31, 2007 were as follows:
The $11 million of surplus notes issued by the reinsurance subsidiary to Employers Mutual were redeemed in the fourth quarter of 2007, along with accrued interest. The $25 million of surplus notes issued by the property and casualty insurance subsidiaries to Employers Mutual were not redeemed; however, the Inter-Company Committees of the Company and Employers Mutual approved an increase in the interest rate on those notes from the current 3.09 percent to 3.60 percent effective February 1, 2008, subject to regulatory approval. A review of the interest rate on the surplus notes will be conducted by the Inter-Company Committees every five years. Payment of interest and repayment of principal can only be made out of the applicable subsidiary’s statutory surplus and is subject to prior approval by the insurance commissioner of the respective state of domicile. The surplus notes are subordinate and junior in right of payment to all obligations or liabilities of the applicable insurance subsidiaries. The Company’s subsidiaries incurred interest expense of $1,111,000 in 2007 and $1,112,000 in 2006 and 2005 on these surplus notes. At December 31, 2007, the Company’s property and casualty insurance subsidiaries had received approval for the payment of interest accrued on the surplus notes during 2007.
On March 10, 2008, the Company’s Board of Directors authorized a $15 million stock repurchase program. This program became effective immediately and does not have an expiration date. The timing and terms of the purchases will be determined by management based on market conditions and will be conducted in accordance with the applicable rules of the Securities and Exchange Commission. Common stock purchased under this program will be retired by the Company.
The Company has no direct exposure to sub-prime residential lending, holding only $4,447,000 of residential mortgage-backed securities, all of which are seasoned Government National Mortgage Association thirty year fixed maturity securities. No residential collateralized debt obligations or collateralized mortgage obligations are held.
Following is a schedule of gross realized losses recognized in 2007 from the sale of securities and from “other-than-temporary” investment impairments. The schedule is aged according to the length of time the underlying securities were in an unrealized loss position. This schedule does not include realized losses stemming from corporate actions such as calls, pay-downs, redemptions, etc. Fixed maturity securities were not included in the schedule since no realized losses were recognized on these investments stemming from disposals other than corporate actions. Fixed maturity securities are generally held until maturity.
(1) The “other-than-temporary” impairment losses reflects impairment losses on thirteen equity securities in the “three months or less” category, impairment losses on one equity security in the “over three months to six months” category, and impairment losses on one equity security in the “over six months to nine months” category.
Interest expense on long-term debt reflects the interest expense on the surplus notes issued by the Company’s insurance subsidiaries to Employers Mutual. Interest on the surplus notes is subject to approval by the issuing company’s state of domicile. The balance shown under the heading “More than 5 years” represents interest expense for years six through ten. Since the surplus notes have no maturity date, total interest expense could be greater than the amount shown.
Market risk represents the potential for loss due to adverse changes in the fair value of financial instruments. The market risks of the financial instruments of the Company relate to the investment portfolio, which exposes the Company to interest rate and equity price risk and, to a lesser extent, credit quality and prepayment risk. Monitoring systems and analytical tools are in place to assess each of these elements of market risk.
The valuation of the Company’s marketable equity portfolio is subject to equity price risk. In general, equities have more year-to-year price variability than bonds. However, returns from equity securities have been consistently higher over longer time frames. The Company invests in a diversified portfolio of readily marketable equity securities. A hypothetical 10 percent decrease in the S&P 500 index as of December 31, 2007 would result in a corresponding pre-tax decrease in the fair value of the Company’s equity portfolio of approximately $9,256,000.
Fixed maturity securities held by the Company generally have an investment quality rating of “A” or better by independent rating agencies. The following table shows the composition of the Company’s fixed maturity securities, by rating, as of December 31, 2007.
Ratings for preferred stocks and fixed maturity securities with initial maturities greater than one year are assigned by nationally recognized statistical rating organizations (referred to generically as NRSROs, which includes such organizations as Moody’s Investor’s Services, Inc., Standard and Poor, etc.). NRSROs’ rating processes seek to evaluate the quality of a security by examining the factors that affect returns to investors. NRSROs’ ratings are based on quantitative and qualitative factors, as well as the economic, social and political environment in which the issuing entity exists. The quantitative factors include debt coverage, sales and income growth, cash flows and liquidity ratios. Qualitative factors include management quality, access to capital markets and the quality of earnings and balance sheet items. Ratings for securities with initial maturities less than one year are based on ratings of NRSROs, or the credit rating of the issuer’s parent company.
In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities.” SFAS 159 permits reporting entities to choose, at specified election dates, to measure eligible items at fair value (the “fair value option”). The unrealized gains and losses on items for which the fair value option has been elected will be reported in earnings. As it relates to the Company’s financial reporting, the Company would be permitted to elect fair value recognition of fixed maturity and equity investments currently classified as either available-for-sale or held-to-maturity, and report the unrealized gains and losses from these investments in earnings going forward. Electing the fair value option for an existing held-to-maturity security will not call into question the intent of an entity to hold other fixed maturity securities to maturity in the future. The provisions of this statement are effective beginning with the first fiscal year that begins after November 15, 2007. The Company has no current plan to elect the fair value option, therefore adoption of this statement is not expected to have any effect on the operating results of the Company.
In December 2007, the FASB issued SFAS No. 141 (revised 2007) “Business Combinations”. This statement replaces SFAS No. 141 “Business Combinations,” however it retains the fundamental requirements of SFAS No. 141 in that the acquisition method of accounting (referred to as “purchase method” in SFAS 141) be used for all business combinations. SFAS 141 (revised) is to be applied prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. Adoption of this statement is not expected to have any effect on the operating results of the Company.
In 2006 the NAIC adopted its Annual Financial Model Regulation (previously referred to as the Model Audit Rule) that incorporates Sarbanes-Oxley type provisions. The requirements are effective beginning with the reporting period ending December 31, 2010, with the management report of internal control over financial reporting due to be filed 60 days after the entity files its 2010 audited statutory financial statements. The rules apply to insurers with direct written and assumed premiums of $500 million or more and require a management report containing a statement that to the best of management’s knowledge and belief, after diligent inquiry, its internal control over financial reporting is effective to provide reasonable assurance regarding the reliability of financial statements in accordance with statutory accounting principles. An insurer may choose to file instead its Section 404 report with an addendum statement by management that no material processes in the preparation of its audited statutory financial statements were excluded from its Section 404 report, or alternatively include a separate report for controls not covered by its Section 404 report. The incorporated Sarbanes-Oxley type provisions in the Annual Financial Model Regulation will have little consequence to either the Company or the EMC Insurance Companies, as the Company is already subject to the provisions of the Sarbanes-Oxley Act of 2002.
Management assessed the effectiveness of the Company’s internal control over financial reporting based on criteria established in “Internal Control - Integrated Framework,” issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based on this assessment, management believes that, as of December 31, 2007, the Company maintained effective internal control over financial reporting.
We have audited EMC Insurance Group Inc. and Subsidiaries’ internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). EMC Insurance Group Inc. and Subsidiaries’ management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.
In our opinion, EMC Insurance Group Inc. and Subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 31, 2007, based on the COSO criteria.
As discussed in Note 1 to the consolidated financial statements, during 2007 the Company changed its method of accounting for income tax contingencies.
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, as well as the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates.
Acquisition costs consisting of commissions, premium taxes and other underwriting expenses that vary with and are directly related to the production of business have been deferred and are being amortized as premium revenue is recognized. 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 settlement expenses and certain other costs expected to be incurred as the premium is earned.
The Company uses independent pricing sources to obtain the estimated fair value of securities. The fair value is based on quoted market prices, where available. In cases where quoted market prices are not available, the fair value is based on a variety of valuation techniques depending on the type of investment. The fair values obtained from independent pricing sources are reviewed for reasonableness and any discrepancies are investigated for final valuation.
The Company participates in a securities lending program whereby certain fixed maturity securities from the investment portfolio are loaned to other institutions for a short period of time. The Company requires initial collateral equal to 102 percent of the fair value of the loaned securities. The collateral is invested by the lending agent, in accordance with the Company’s guidelines, and generates fee income for the Company that is recognized ratably over the time period the security is on loan. The securities on loan to others are segregated from the other invested assets on the Company’s balance sheet. In accordance with relevant accounting literature, the collateral held by the Company is accounted for as a secured borrowing and is recorded as an asset on the Company’s balance sheet, with a corresponding liability reflecting the Company’s obligation to return this collateral upon the return of the loaned securities.
The Company files a consolidated Federal income tax return with its subsidiaries. Consolidated income taxes/benefits are allocated among the entities based upon separate tax liabilities.
The Company has no stock-based compensation plans of its own; however, Employers Mutual has several stock plans that utilize the common stock of the Company. The Company receives the current fair value for all shares issued under these plans. Employers Mutual also has a stock appreciation rights (SAR) agreement in effect with an executive officer of the Company. The SAR is based upon the common stock of the Company, and because it will be settled in cash, it is considered to be a liability-classified award.
Prior to January 1, 2006, under the provisions of Accounting Principles Board (APB) No. 25 “Accounting for Stock Issued to Employees,” the Company did not recognize any compensation expense from the operation of Employers Mutual’s incentive stock option plans since the exercise price of the options was equal to the fair value of the stock on the date of grant. The Company’s insurance subsidiaries reimburse Employers Mutual for their share of the statutory-basis compensation expense (equal to the excess of the fair value of the stock on the option exercise date over the option’s exercise price) associated with stock option exercises. The statutory-basis compensation expense that was paid by the Company’s subsidiaries to Employers Mutual ($245,441 in 2005) was reclassified as a dividend payment to Employers Mutual in these GAAP-basis financial statements.
The following table illustrates the effect on net income and net income per share if the Company had applied the fair value recognition provisions of SFAS No. 123(R) to Employers Mutual’s incentive stock option plans:
Included in the underlying reinsurance business assumed by Employers Mutual are reinsurance transactions conducted with foreign cedants denominated in their local functional currencies. In accordance with the revised terms of the quota share agreement (see note 2), the reinsurance subsidiary assumes all foreign currency exchange gains/losses associated with contracts incepting on January 1, 2006 and thereafter that are subject to the quota share agreement. Previously, the foreign currency exchange gains/losses were retained by Employers Mutual. The balances resulting from these foreign reinsurance transactions are reported in the Company’s consolidated balance sheets in U.S. dollars based on the foreign currency exchange rates that existed on December 31, 2007 and 2006. The balances reported in the Company’s 2007 and 2006 consolidated statements of income that resulted from these foreign reinsurance transactions are reported in U.S. dollars measured at the foreign currency exchange rates that existed at the inception of each reinsurance contract. The foreign currency exchange rate gains/losses resulting from these re-measurements to U.S. dollars are reported as other income/expense in the consolidated statements of income.
The Company’s basic and diluted net income per share is computed by dividing net income by the weighted average number of common shares outstanding during each period. As previously noted, the Company receives the current fair value for all shares issued under Employers Mutual’s stock plans. As a result, the Company had no potential common shares outstanding during 2007, 2006 and 2005 that would have been dilutive to net income per share.
In February 2006, the FASB issued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments” - an Amendment of FASB Statement Nos. 133 and 140. SFAS 155 simplifies the accounting for certain hybrid financial instruments by permitting fair value re-measurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation, and eliminates a restriction on passive derivative instruments that a qualifying special-purpose entity may hold. The Company adopted SFAS 155 effective January 1, 2007. Adoption of this statement had no effect on the operating results of the Company.
In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities.” SFAS 159 permits reporting entities to choose, at specified election dates, to measure eligible items at fair value (the “fair value option”). The unrealized gains and losses on items for which the fair value option has been elected will be reported in earnings. As it relates to the Company’s financial reporting, the Company would be permitted to elect fair value recognition of fixed maturity and equity investments currently classified as either available-for-sale or held-to-maturity, and report the unrealized gains and losses from these investments in earnings going forward. Electing the fair value option for an existing held-to-maturity security will not call into question the intent of an entity to hold other fixed maturity securities to maturity in the future. The provisions of this statement are effective beginning with the first fiscal year that begins after November 15, 2007. The Company has no current plan to elect the fair value option, therefore, adoption of this statement is not expected to have any impact on the operating results of the Company.
In December 2007, the FASB issued SFAS No. 160 “Noncontrolling Interests in Consolidated Financial Statements - an amendment of ARB No. 51.” This statement amends Accounting Research Bulletin (ARB) No. 51, “Consolidated Financial Statements,” to establish accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. The provisions of this statement are effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008. Adoption of this statement is not expected to have any effect on the operating results of the Company.
Premiums assumed by the reinsurance subsidiary from Employers Mutual amounted to $71,002,733, $66,268,178 and $92,588,093 in 2007, 2006 and 2005, respectively. The large decline in 2006 is primarily attributed to Employers Mutual’s reduced participation in the MRB pool (see note 3). It is customary in the reinsurance business for the assuming company to compensate the ceding company for the acquisition expenses incurred in the generation of the business. Commissions paid by the reinsurance subsidiary to Employers Mutual amounted to $17,386,129, $15,650,305 and $21,508,620 in 2007, 2006 and 2005, respectively.
Effective January 1, 2006, the terms of the quota share agreement between Employers Mutual and the reinsurance subsidiary were revised. The majority of the changes were prompted by the significant amount of hurricane losses retained by Employers Mutual during the severe 2005 hurricane season; however, other changes were made to simplify and clarify the terms and conditions of the quota share agreement. The revised terms of the quota share agreement are as follows: (1) the reinsurance subsidiary’s retention, or cap, on losses assumed per event increased from $1,500,000 to $2,000,000; (2) the cost of the $2,000,000 cap on losses assumed per event is treated as a reduction to premiums written rather than commission expense; (3) the reinsurance subsidiary no longer directly pays for the outside reinsurance protection that Employers Mutual purchases to protect itself from catastrophic losses on the assumed reinsurance business it retains in excess of the cap, and instead pays a higher premium rate (previously accounted for as commission); and (4) the reinsurance subsidiary assumes all foreign currency exchange gain/loss associated with contracts incepting on January 1, 2006 and thereafter that are subject to the quota share agreement. For 2007 and 2006, the premium rate paid by the reinsurance subsidiary to Employers Mutual was 10.50 percent of premiums written. The corresponding rate for 2005 was approximately 8.50 percent (4.50 percent override commission rate plus approximately 4.00 percent for the cost of the outside reinsurance protection). The net foreign currency exchange loss assumed by the reinsurance subsidiary in 2007 and 2006 was $512,281 and $61,055, respectively.
Employers Mutual provides various services to all of its subsidiaries and affiliates. Such services include data processing, claims, financial, actuarial, legal, auditing, marketing and underwriting. Employers Mutual allocates a portion of the cost of these services to its subsidiaries that do not participate in the pooling agreement based upon a number of criteria, including usage of the services and the number of transactions. The remaining costs are charged to the pooling agreement and each pool participant shares in the total cost in accordance with its pool participation percentage. Costs allocated to the Company by Employers Mutual for services provided to the holding company and its subsidiaries that do not participate in the pooling agreement amounted to $2,314,211, $2,081,688 and $1,829,565 in 2007, 2006 and 2005, respectively. Costs allocated to the Company through the operation of the pooling agreement amounted to $66,646,772, $68,369,409 and $61,486,820 in 2007, 2006 and 2005, respectively.
Investment expenses are based on actual expenses incurred by the Company plus an allocation of other investment expenses incurred by Employers Mutual, which is based on a weighted average of total invested assets and number of investment transactions. Investment expenses allocated to the Company by Employers Mutual amounted to $1,455,808, $1,310,193 and $1,011,370 in 2007, 2006 and 2005, respectively.
The effect of reinsurance on premiums written and earned, and losses and settlement expenses incurred, for the three years ended December 31, 2007 is presented below.
For 2007 and 2006, premiums written and earned assumed from affiliates, and losses and settlement expenses incurred assumed from affiliates, reflect a reduction in Employers Mutual’s participation in the MRB pool. The board of directors of the MRB pool approved the admission of two new assuming companies to the pool effective January 1, 2006. This reduced Employers Mutual’s participation in the pool from a one-third share to an approximate one-fifth share (one company is only assuming property exposures). The premiums written assumed from affiliates and net premiums written amounts for 2006 also include a negative $3,440,024 portfolio adjustment which serves as an offset to the decrease in unearned premiums recognized in connection with this change in participation.
For the property and casualty insurance segment, the December 31, 2007 estimate of loss and settlement expense reserves for accident years 2006 and prior decreased $27,976,811 from the estimate at December 31, 2006. This decrease represents 6.8 percent of the December 31, 2006 gross carried reserves and is primarily attributed to the final settlement of closed claims.
For the property and casualty insurance segment, the December 31, 2006 estimate of loss and settlement expense reserves for accident years 2005 and prior decreased $32,255,312 from the estimate at December 31, 2005. This decrease represents 7.9 percent of the December 31, 2005 gross carried reserves and is primarily attributed to the final settlement of closed claims.
For the property and casualty insurance segment, the December 31, 2005 estimate of loss and settlement expense reserves for accident years 2004 and prior decreased $14,808,375 from the estimate at December 31, 2004. This decrease represents 4.8 percent of the December 31, 2004 gross carried reserves and is primarily attributed to downward development of individual case loss reserves and settlement expense reserves. In addition, during the fourth quarter the Company reallocated a portion of a bulk case loss reserve carried in the workers’ compensation line of business to various components of the loss and settlement expense reserve for the other liability line of business (IBNR, asbestos and settlement expense) and eliminated the remainder, resulting in $2,145,000 of favorable development.
The Company has exposure to asbestos and environmental related claims associated with the insurance business written by the parties to the pooling agreement and the reinsurance business assumed from Employers Mutual by the reinsurance subsidiary. These exposures are not considered to be significant. Asbestos and environmental losses paid by the Company have averaged only $424,258 per year over the past five years. Reserves for asbestos and environmental related claims for direct insurance and assumed reinsurance business totaled $7,433,535 and $7,288,116 ($7,400,162 and $7,288,116 net of reinsurance) at December 31, 2007 and 2006, respectively.
Estimating loss and settlement expense reserves for asbestos and environmental claims is very difficult due to the many uncertainties surrounding these types of claims. These uncertainties exist because the assignment of responsibility varies widely by state and claims often emerge long after a policy has expired, which makes assignment of damages to the appropriate party and to the time period covered by a particular policy difficult. In establishing reserves for these types of claims, management monitors the relevant facts concerning each claim, the current status of the legal environment, social and political conditions, and claim history and trends within the Company and the industry.
The amount of retained earnings of the Company’s insurance subsidiaries available for distribution as dividends are limited by law to a percentage of the statutory unassigned surplus of each of the subsidiaries as of the previous December 31, as determined in accordance with accounting practices prescribed by insurance regulatory authorities of the state of domicile of each subsidiary. Subject to this limitation, the maximum dividend that may be paid within a 12 month period without prior approval of the insurance regulatory authorities is generally restricted to the greater of 10 percent of statutory surplus as regards policyholders as of the preceding December 31, or net income of the preceding calendar year on a statutory basis, not greater than earned statutory surplus. At December 31, 2007, $46,778,786 was available for distribution to the Company in 2008 without prior approval.
The amortized cost and estimated fair value of securities held-to-maturity and available-for-sale as of December 31, 2007 and 2006 are as follows.
Temporary differences between the consolidated financial statement carrying amount and tax basis of assets and liabilities that give rise to significant portions of the deferred income tax asset at December 31, 2007 and 2006 are as follows:
Management of the Company carefully reviewed all individually significant tax positions during 2007 and concluded that the recording of any obligation related to an uncertain tax position under FIN 48 was not warranted. During 2007, the Company recognized a $34,736 underpayment penalty relating to its December 31, 2006 U.S. federal tax return. The Company did not recognize any interest or other penalties related to U.S. federal or state income taxes during 2007. It is the Company’s accounting policy to reflect income tax penalties as other expense, and interest as interest expense.
The Company’s property and casualty insurance subsidiaries issued surplus notes totaling $25,000,000 and the reinsurance subsidiary issued $11,000,000 of surplus notes to Employers Mutual. On December 31, 2007, the reinsurance subsidiary redeemed its $11,000,000 of surplus notes, along with accrued interest. The surplus notes carried an annual interest rate of 3.09 percent through 2007 and do not have a maturity date. The Inter-Company Committees of the Company and Employers Mutual approved an increase in the interest rate on the outstanding notes to 3.60 percent effective February 1, 2008, subject to regulatory approval. A review of the interest rate on the surplus notes will be conducted by the Inter-Company Committees every five years. Payment of interest and repayment of principal can only be made out of each subsidiary’s statutory surplus earnings and is subject to approval by the issuing company’s state of domicile. The surplus notes are subordinate and junior in right of payment to all obligations or liabilities of the subsidiaries. Interest expense on surplus notes amounted to $1,111,469 for 2007 and $1,112,400 for 2006 and 2005.
Effective January 1, 2008, benefits will vest after three years of service or the attainment of 55 years of age. This change in the vesting requirement, which is reflected as a plan amendment at December 31, 2007, increased the pension benefit obligation of the plan by $307,631 ($92,026 as the Company’s portion).
Employers Mutual’s supplemental retirement plan provides retirement benefits for a select group of management and highly-compensated employees. This plan enables select employees to receive retirement benefits without the limit on compensation imposed on qualified defined benefit pension plans by the Internal Revenue Service and to recognize elective deferrals of compensation under any non-qualified deferred compensation plans. The plan is unfunded and benefits generally vest after five years of service (three years beginning January 1, 2008).
Employers Mutual maintains a Voluntary Employee Beneficiary Association (VEBA) trust which accumulates funds for the payment of postretirement health care and life insurance benefits. Contributions to the VEBA trust are used to fund the accumulated postretirement benefit obligation, as well as pay current year benefits.
The accumulated benefit obligation for the pension plans amounted to $142,744,894 and $130,839,570 at December 31, 2007 and 2006, respectively.
The following tables set forth the amounts recognized in the Company’s financial statements as a result of the property and casualty subsidiaries’ aggregate 30 percent participation in the pooling agreement and amounts allocated to the reinsurance subsidiary as of December 31, 2007 and 2006:
Amounts recognized in the Company’s consolidated statements of other comprehensive income:
The projected benefit obligation, accumulated benefit obligation and fair value of plan assets of Employers Mutual’s Supplemental Retirement Plan as of December 31, 2007 and 2006 were as follows:
The assumed health care cost trend rate has a significant effect on the service and interest cost components of the net periodic benefit cost and the benefit obligation reported for the postretirement benefit plans. A one-percentage-point change in assumed health care cost trend rates would have the following effects:
The weighted-average asset allocation of Employers Mutual’s defined benefit retirement plan as of the measurement dates of November 1, 2007 and 2006 are as follows:
The weighted-average asset allocation of Employers Mutual’s VEBA trust that is used to fund the postretirement benefit plans as of the measurement dates of November 1, 2007 and 2006 are as follows:
The Company participates in several other retirement plans sponsored by Employers Mutual, including its 401(k) Plan and Board and Executive Non-Qualified Excess Plan. The Company’s share of expenses for these plans amounted to $2,015,481, $1,409,914 and $1,064,546 in 2007, 2006 and 2005, respectively.
The Senior Executive Compensation and Stock Option Committee (the “Committee”) of Employers Mutual’s Board of Directors (the “Board”) grants the awards and is the administrator of the plans. The Company’s Compensation Committee must consider and approve all awards granted to the Company’s senior executive officers.
The weighted average fair value of options granted in 2007, 2006 and 2005 amounted to $3.78, $3.93 and $4.57, respectively. The fair value of each option grant is estimated on the date of grant using the Black-Scholes-Merton option-pricing model and the following weighted-average assumptions:
The expected term of the options granted in 2007 was estimated using historical data that was adjusted to remove the effect of option exercises prior to the normal vesting period due to the retirement of the option holder. The expected term of options granted to individuals who are, or will be, eligible to retire prior to the completion of the normal vesting period has been adjusted to reflect the potential accelerated vesting period. This produced a weighted-average expected term of 2.97 years.
At December 31, 2007, the Company’s portion of the unrecognized compensation cost associated with option awards issued under Employers Mutual’s incentive stock option plans that are not currently vested was $365,578, with a 1.47 year weighted-average period over which the compensation expense is expected to be recognized. A summary of non-vested option activity under Employers Mutual’s incentive stock option plans for 2007, 2006 and 2005 is as follows:
The Company’s portion of the total intrinsic value of options exercised under Employers Mutual’s incentive stock option plans was $176,344, $663,524 and $245,441 in 2007, 2006 and 2005, respectively. As stated earlier, under the terms of the pooling and quota share agreements these amounts were paid to Employers Mutual and the Company received the full fair value for all shares issued under these plans. The Company’s portion of the total fair value of options that vested in 2007, 2006, and 2005 was $200,941, $178,439 and $117,710, respectively. Additional information relating to options outstanding and options vested (exercisable) at December 31, 2007 is as follows:
A total of 500,000 shares of the Company’s common stock have been reserved for issuance under the Employers Mutual Casualty Company 1993 Employee Stock Purchase Plan. Any eligible employee who is employed by Employers Mutual on the first day of the month immediately preceding any option period is eligible to participate in the plan. Participants pay 85 percent of the fair market value of the stock on the date of purchase. The plan is administered by the Board of Employers Mutual and the Board has the right to amend or terminate the plan at any time; however, no such amendment or termination shall adversely affect the rights and privileges of participants with unexercised options. Expenses allocated to the Company in connection with this plan totaled $22,643, $14,724 and $14,062 in 2007, 2006 and 2005, respectively.
During 2007, a total of 19,286 options were exercised at prices of $19.88 and $21.28. Activity under the plan was as follows:
The Company maintains a dividend reinvestment and common stock purchase plan which provides stockholders with the option of reinvesting cash dividends in additional shares of the Company’s common stock. Participants may also purchase additional shares of common stock without incurring broker commissions by making optional cash contributions to the plan and may sell shares of common stock through the plan. Employers Mutual did not participate in this plan in 2007, 2006 or 2005. Activity under the plan was as follows:
On October 19, 2006, Employers Mutual entered into a stock appreciation rights (SAR) agreement with the Company’s Executive Vice President and Chief Operating Officer (Mr. Murray). This SAR agreement is a substitute for a stock option grant Mr. Murray was initially authorized to receive as part of his 2006 compensation arrangement, but was not issued to him due to certain limitations contained in Employers Mutual’s incentive stock option plan. The grant-date fair value of this award was $546,300. Because the SAR agreement will be settled in cash, it is considered to be a liability-classified award under SFAS 123(R). As a result, the value of this agreement must be re-measured at fair value at each financial statement reporting date. The fair value of this agreement at December 31, 2007 and 2006 was $318,825 ($95,648 as the Company’s portion from the pool) and $662,850 ($198,855 as the Company’s portion from the pool), respectively. The full value of this agreement was expensed in 2006 because Mr. Murray is currently eligible for retirement and is entitled to keep the award at retirement. As a result, the award does not have any subsequent service requirements. Subsequent changes in the fair value of this agreement will be reflected as compensation expense until the agreement is ultimately settled in 2016. During 2007, the Company recognized negative compensation expense of $103,207 ($67,085 net of tax) related to this award.
During the second quarter of 2005 Employers Mutual initiated a $15 million stock purchase program under which Employers Mutual will purchase shares of the Company’s common stock in the open market. This purchase program does not have an expiration date. The timing and terms of the purchases are determined by management based on market conditions and are conducted in accordance with the applicable rules of the Securities and Exchange Commission. During 2007, Employers Mutual purchased 65,501 shares of the Company’s common stock under this program at an average cost of $24.02 per share. No purchases were made during 2006 and 497,348 shares of the Company’s common stock were purchased under this plan in 2005 at an average cost of $17.97 per share. As of December 31, 2007, $4,490,561 remained available under this plan for additional purchases.
Securities lending collateral is recorded as an asset on the Company’s balance sheet, with a corresponding liability reflecting the Company’s obligation to return this collateral. The securities lending collateral consisted of cash at December 31, 2007and 2006. These values reflect the fair value at December 31, 2007 and 2006.
We have audited the consolidated financial statements of EMC Insurance Group Inc. and Subsidiaries as of December 31, 2007 and 2006, and for each of the three years in the period ended December 31, 2007, and have issued our report thereon dated March 13, 2008 (included elsewhere in this Annual Report on Form 10-K). Our audits also include the financial statement schedules listed in Item 15(a)2 of this Annual Report on Form 10-K. These schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion based on our audits.
In our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Note 1 to the consolidated financial statements, during 2007 the Company changed its method of accounting for income tax contingencies.