The following table sets forth selected consolidated financial data for MIG at and for each of the years in the five year period ended December 31, 2009. You should read this data in conjunction with the Group’s consolidated financial statements and accompanying notes, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and other financial information included elsewhere in this report.
The ratio of net premiums written divided by ending statutory surplus.
MIG, through its property and casualty insurance subsidiaries, provides a wide array of property and casualty insurance products designed to meet the insurance needs of individuals in New Jersey and Pennsylvania, and small and medium-sized businesses throughout Arizona, California, Nevada, New Jersey, Oregon and Pennsylvania. The Group also writes a limited amount of business in New York which supports accounts in adjacent states.
limitation on available business arising from a need to maintain the pricing and quality of underwritten risks;
the Group’s ability to maintain it’s A (“Excellent”) rating by A.M. Best;
the availability, cost and terms of reinsurance and the financial condition of our reinsurers;
We perform a comprehensive annual review of loss reserves for each of the lines of business we write in connection with the determination of the year end carried reserves. The review process takes into consideration the variety of trends and other factors that impact the ultimate settlement of claims in each particular class of business. A similar review is performed prior to the determination of the June 30 carried reserves. Prior to the determination of the March 31 and September 30 carried reserves, we review the emergence of paid and reported losses relative to expectations and make necessary adjustments to our carried reserves. There are also a number of analyses of claims experience and reserves undertaken by management on a monthly basis.
Some of our business relates to coverage for short-tail risks and, for these risks, the development of losses is comparatively rapid and historical paid losses and case reserves, adjusted for known variables, have been a reliable guide for purposes of reserving. “Tail” refers to the time period between the occurrence of a loss and the settlement of the claim. The longer the time span between the incidence of a loss and the settlement of the claim, the more the ultimate settlement amount can vary. Some of our business relates to long-tail risks, where claims are slower to emerge (often involving many years before the claim is reported) and the ultimate cost is more difficult to predict. For these lines of business, more sophisticated actuarial methods, such as the Bornhuetter-Ferguson loss development method, are employed to project an ultimate loss expectation, and then the related loss history must be regularly evaluated and loss expectations updated, with a likelihood of variability from the initial estimate of ultimate losses. A substantial portion of the business written by FPIC is this type of longer-tailed casualty business.
The reported or incurred loss development method relies on the assumption that, at any given state of maturity, ultimate losses can be reasonably predicted by multiplying cumulative reported losses (paid losses plus case reserves) by a cumulative development factor. The validity of the results of this method depends on the stability of claim reporting and settlement rates, as well as the consistency of case reserve levels. Case reserves do not have to be adequately stated for this method to be effective; they only need to have a fairly consistent level of adequacy at comparable stages of maturity. Historical “age-to-age” loss development factors are calculated to measure the relative development of an accident year from one maturity point to the next. We then select age-to-age loss development factors based on these historical factors and use the selected factors to project the ultimate losses.
FPIC evaluates commercial multi-peril liability reserves by segregating pre- and post-Montrose activity as well as segregating contractor versus non-contractor experience. An inception to date ground-up incurred loss database was created as the basis for this new analysis. The pre-Montrose activity is evaluated on a report year basis, which eliminates the accident year development distortions caused by the effects of the Montrose Decision. For policy years 1997 and later, the reserves are analyzed using the more traditional accident year analysis.
In the years ended December 31, 2009, 2008 and 2007, we recorded a pre-tax charge to earnings of $0.8 million, $6.2 million and $0.1 million, respectively, for write-downs of other than temporarily impaired securities (OTTI).
Many of the reinsurance treaties participated in by the Group prior to 2007, and primarily FPIC treaties, have included provisions that establish minimum and maximum cessions and allow limited participation in the profit of the ceded business. Generally, the Group shares on a limited basis in the profitability of our reinsurance treaties through contingent ceding commissions. The Group’s exposure in the loss experience is contractually defined at minimum and maximum levels. The terms of such contracts are fixed at inception. Since estimating the emergence of claims to the applicable reinsurance layers is subject to significant uncertainty, the net amounts that will ultimately be realized may vary significantly from the estimated amounts presented in the Group’s results of operations.
The availability of reinsurance at reasonable pricing is an important part of our business. Effective January 1, 2009, we increased our retention to $1,000,000 (from a maximum retention of $850,000 and $750,000 in 2008 and 2007, respectively) on the casualty, property and workers’ compensation lines of business. As we increase the net retention of the business we write, net premiums written and earned will increase and ceded losses will decrease. The impact of increased retentions under our reinsurance program in 2009, 2008 and 2007 was offset in part by a decline in direct written premiums due to the contraction of the economy in our markets and the competitive marketplace, particularly as it relates to new construction contractors we insure. As older reinsurance treaties run off, the impact described above of the new reinsurance program will become more evident in net premiums written, net premiums earned and net losses incurred.
YEAR ENDED DECEMBER 31, 2009 COMPARED TO YEAR ENDED DECEMBER 31,
Interest expense of $1.4 million and $1.3 million in 2009 and 2008, respectively, represents interest expense on the trust preferred securities obligations of FPIG.
In 2009 investment income on fixed income securities increased $1.1 million, or 7.2%, to $15.9 million, as compared to $14.8 million in 2008. This was driven by an increase in the average investments held in fixed income securities, and a focus on expanding our corporate and industrial sector fixed income holdings. Our tax equivalent yield (yield adjusted for tax-benefit received on tax-exempt securities) on fixed income securities increased slightly to 5.14% in 2009, as compared to 5.06% in 2008.
The estimated fair value and unrealized loss for securities in a temporary unrealized loss position as of December 31, 2009 are as follows:
There are 4 common stock securities that are in an unrealized loss position at December 31, 2009. All of these securities have been in an unrealized loss position for less than 6 months. There is one preferred stock security that has been in an unrealized loss position for more than twelve months. The Group does not believe these declines are other than temporary as a result of reviewing the circumstances of each such security in an unrealized loss position. The Group currently has the ability and intent to hold these securities until recovery.
In 2009 our commercial lines direct premiums written decreased by $11.8 million, or 8.2%, to $131.5 million, as compared to direct premium written in 2008 of $143.3 million. The decline in direct premiums written is attributed to several factors, including a decline in construction related activity due to a weak economy, increased negative audit premium on our contractors book, increased competition on large accounts, and increased competition in the California contractor market and the east coast habitational market. Our California contractors book reflects the significant decrease in new construction activity in the California construction market. Since the insurance premiums for these contractors generally reflect their level of economic activity, the average premium per policy has fallen as the insured’s business has contracted, resulting in lower insurance exposures for these contractors. The retention levels in this book remain attractive, and policy count is up year-over-year, despite the decline in direct premiums written. See additional discussion above in the “2009 vs. 2008 Revenue” discussion.
Personal lines direct premiums written declined to $21.5 million in 2009 as compared to $22.1 million in 2008, representing a decline of $0.6 million or 2.6%. Our personal lines have also been impacted by increased competition, as in the case of our commercial lines.
Underwriting expenses decreased by $3.6 million, or 6.7%, to $50.9 million in 2009, as compared to $54.5 million in 2008. The decrease in underwriting expenses primarily reflects a decrease in the amortization of deferred acquisition costs in 2009. The amortization of deferred acquisition costs decreased in 2009 as compared to 2008 due in part to the decrease in net earned premiums. In addition, in the fourth quarter of 2008 the Group undertook a significant expense reduction program, resulting in significant cost reductions which are reflected in lower other underwriting expenses in 2009 and, subject to the deferred acquisition cost methodology, to some extent in 2009 amortization of deferred acquisition costs. Underwriting expenses also reflect lower share-based compensation expense and lower contingent commission expense.
We received $4.3 million in 2007 as a reimbursement of protested payments of retaliatory tax, including accrued interest thereon, previously made by us for the periods 1999-2004. The refund was recorded, after reduction for Federal income tax, in the amount of $2.8 million in the 2007 consolidated statement of earnings. The allocation of the refund to 2007 pre-tax earnings included an increase to net investment income
of $720,000 for the interest received on the refund, and $3.6 million as a reduction to other expense to recognize the recovery of amounts previously charged to other expense. This is a non-recurring item which significantly affected the earnings for the year ended December 31, 2007, and related performance metrics such as the combined ratio.
In 2008, direct premiums written declined $17.5 million or 9.6% to $165.4 million as compared to $182.9 million in 2007. The decline in direct premiums written is attributable to a more difficult economic environment and competitive market conditions. A decline in construction related activity and related audit premium in California, increased competition on large accounts, as well as the return of a number of competitors to the California contractor market and the East Coast habitational market contributed to this decline.
The decline in year-to-date direct premiums written reflects a continuing competitive marketplace and declining levels of economic activity in our operating territories. The current market is highly competitive, with pricing and coverage competition being seen in virtually all classes of commercial accounts, package policies, commercial automobile policies and in the Pennsylvania personal auto market and Pennsylvania and New Jersey homeowners markets, all of which makes it more challenging to retain our accounts on renewal, or to renew a policy at the expiring premium. Competition also continues on large accounts, particularly in the East Coast habitational and California construction contracting programs, as competitors aggressively compete for these higher premium accounts. Pricing in the property and casualty insurance industry historically has been and remains cyclical. During a soft market cycle, such as the current market condition, price competition is prevalent, which makes it challenging to write and retain properly priced personal and commercial lines business. We continue to work with our agents to target classes of business and accounts compatible with our underwriting appetite, which includes certain types of religious institution risks, contracting risks, small business risks and property risks. Despite the pricing pressures of the marketplace, management maintains a strong focus on its policy of disciplined underwriting and pricing standards, declining business which it determines is inadequately priced for its level of risk. In spite of these competitive market conditions, our Group’s policy retention on renewal has been favorable across most product lines.
In the fourth quarter of 2008, a new Business Owners Policy for California risks was introduced. This product targets small to medium sized businesses, which have been shown to be somewhat less price sensitive than larger accounts. This product also helps to balance FPIC’s business between property and casualty exposures. Additionally, a new contracting product which specializes in covering artisan contractors was introduced in 2009 in Arizona and California, and is being developed for introduction in Nevada and Oregon in 2010. Artisan contractors primarily provide repair and maintenance services, and this segment
tends to experience less severe market fluctuations compared to the real estate construction industry.
Among our portfolio holdings, the only subprime exposure consists of asset-backed securities (ABS) within the home equity subsector. The ABS home equity subsector totaled $0.6 million (book value) on December 31, 2008, representing 4.1% of the ABS holdings, 0.7% of the total structured product holdings, and 0.2% of total fixed income portfolio holdings. The subprime related exposure consists of three individual securities, of which two are insured by a monoline insurer against default of principal and interest. However, since FGIC and AMBAC have been downgraded from their previous AAA status, the two insured securities are now rated according to the higher of the underlying collateral or the monoline rating. One bond is rated Baa1/A while the other is rated Baa3/BB. With regard to the remaining security without monoline insurance, it is rated Aa2/AA by Moody’s and S&P, respectively. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations” under the subsection entitled “Quantitative and Qualitative Information about Market Risk.”
In 2008 our commercial lines net premiums earned increased by $7.0 million or 5.6% to $132.4 million as compared to net premiums earned in 2007 of $125.4 million. Net premiums earned increased 5.6% despite a 8.6% decline in net premiums written, with the decline in net premiums written caused primarily by the 10.5% decline in direct premiums written, offset by the positive impact on net premiums written of the change in our reinsurance structure as described above. Offsetting these factors was the reduction in audit premium recorded in 2008, which is earned immediately upon booking.
Personal lines direct premiums written declined to $22.1 million in 2008 as compared to $22.9 million in 2007, representing a decline of $0.8 million or 3.4%. Our personal lines have also been impacted by increased competition, similar to our commercial lines.
In the personal lines segment for 2008 we had an underwriting loss of $1.4 million, a GAAP combined ratio of 107.1%, a GAAP loss and loss adjustment expense ratio of 69.5% and a GAAP underwriting expense ratio of 37.6%, compared to underwriting income of $0.2 million, a GAAP combined ratio of 98.9%, a GAAP loss and loss adjustment expense ratio of 70.1% and a GAAP underwriting expense ratio of 28.8% in 2007. Our personal lines loss ratio for 2007 reflected increased severity, due to large losses related to a variety of causes including an increase in water and freeze related claims. In addition, the 2007 expense ratio benefited from the retaliatory tax refund previously noted.
Underwriting expenses increased by $5.2 million, or 10.6%, to $54.5 million in 2008, as compared to $49.3 million in 2007. The increase in underwriting expenses primarily reflects an increase in the amortization of deferred acquisition costs in 2008 and the inclusion in 2007 of the non-recurring retaliatory tax refund, which reduced other underwriting expenses by $3.6 million in 2007. The amortization of deferred acquisition costs increased in 2008 as compared to 2007 due to the increase in net earned premiums. Underwriting expenses also reflect lower share-based compensation expense and lower net contingent commission expense. Lastly, underwriting expenses are impacted by the previously discussed changes in the 2008 and 2007 reinsurance program whereby less ceded premium is being recorded and accordingly less ceding commission is received, which increases underwriting expenses and net acquisition costs.
Federal income tax expense was $2.2 million and $5.8 million for 2008 and 2007, respectively. The effective tax rate was 20.8% and 28.8% for 2008 and 2007, respectively. The 2007 effective tax rate was impacted by an unusually high amount of taxable income in the period caused by the retaliatory tax refund, which increased the effective tax rate. The 2008 effective tax rate was impacted by the higher level of other than temporary investment impairments, which caused tax-advantaged income (municipal bond interest) to represent a higher proportion of income, reducing the effective tax rate.
On April 16, 2008, the Holding Company was authorized by the Board of Directors to repurchase, at management’s discretion, up to 5% of its outstanding stock. Any such purchases will be funded by the Holding Company’s existing resources, dividends from subsidiaries, or the credit line, or any combination of these resources. As of December 31, 2009, the Holding Company had purchased, pursuant to the authority granted by the Board on April 16, 2008, a total of 123,300 shares of outstanding stock at an average cost of $15.89 per share, and is holding the stock as treasury stock. In addition, 1,303 and 1,659 shares of stock were repurchased from employees in 2009 and 2008, respectively, in order to pay the required tax withholdings on the vesting of restricted stock under the stock incentive plan.
MIG began paying quarterly dividends of $0.05 per common share in the second quarter of 2006. On April 16, 2008, MIG’s Board of Directors increased the quarterly dividend from $0.05 per share of common stock to $0.075 per share of common stock, effective with the payment of the June 27, 2008 dividend. The amount of dividends paid during 2009 and 2008 totaled $1.9 million and $1.7 million, respectively. The shareholder dividend was funded from the Group’s insurance companies, for which approval was sought and received (where necessary) from each of the insurance companies’ primary regulators.
The Group adopted a stock-based incentive plan at its 2004 annual meeting of shareholders. Pursuant to that plan, the Group may issue a total of 876,555 shares, which amount will increase automatically each year by 1% of the number of shares outstanding at the end of the preceding year. At December 31, 2009, the shares authorized under the plan have been increased under this provision to 1,206,091 shares. During 2009, the Group made no grants of restricted stock, incentive stock options and non-qualified stock options. There were 10,000 stock options which expired unexercised in 2009.
Total assets increased 5%, or $26.4 million, to $595.4 million, at December 31, 2009, as compared to $569.0 million at December 31, 2008. The Group’s cash and invested assets increased $33.5 million or 9%, primarily due to net cash provided by operating activities. Premiums receivable increased $2.2 million or 7%, primarily due to timing differences in the recording and collecting of premium. Reinsurance receivables decreased $6.8 million or 8%, reflecting the decrease in ceded loss and loss adjustment expense reserves. Prepaid reinsurance premiums decreased $1.2 million or 17%, principally due to changes in certain of the Group’s reinsurance contracts, whereby fewer unearned premium reserves are ceded. Property and equipment increased $5.4 million, or 33%, due primarily to construction of a new building in Rocklin, California, as well as capitalization of internally developed software costs. Additionally, the deferred income tax asset decreased $4.9 million or 50%, due to the change in deferred taxes on the unrealized gains on securities as well as changes in a variety of temporary differences items.
Total stockholders’ equity increased $22.9 million or 17%, to $160.2 million, at December 31, 2009, from $137.3 million at December 31, 2008, primarily due to net income of $13.8 million, changes in unrealized holding gains and losses on securities of $9.8 million, stock compensation plan amortization of $0.3 million, and ESOP shares committed to be allocated to participants of $1.0 million, offset by stockholder dividends of $1.9 million and changes in valuation for the defined benefit pension plan of $0.1 million.
Inflation also often results in increases in the general level of interest rates, and, consequently, generally results in increased levels of investment income derived from our investments portfolio.
In December 2007, the Financial Accounting Standards Board (“FASB”) issued guidance on how in a business combination an acquirer recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed and any noncontrolling interest in the acquiree. In addition, it provides revised guidance on the recognition and measurement of goodwill acquired in the business combination, and provides guidance specific to the recognition, classification, and measurement of assets and liabilities related to insurance and reinsurance contracts acquired in a business combination. The guidance applies to business combinations for acquisitions occurring on or after January 1, 2009, and accordingly does not impact the Group’s previous transactions involving purchase accounting.
The Group and its subsidiaries have no significant contractual obligations at December 31, 2009, other than their insurance obligations under their policies of insurance, trust preferred securities, a line of credit obligation, and operating lease obligations. Projected cash disbursements pertaining to these obligations at December 31, 2009, are as follows:
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Mercer Insurance Group, Inc. and subsidiaries as of December 31, 2009 and 2008, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2009, in conformity with U.S. generally accepted accounting principles.
Mercer Insurance Group, Inc. (MIG) and subsidiaries (collectively, the Group) includes Mercer Insurance Company (MIC), its subsidiaries Mercer Insurance Company of New Jersey, Inc. (MICNJ), Franklin Insurance Company (FIC), and BICUS Services Corporation (BICUS), and Financial Pacific Insurance Group, Inc. (FPIG) and its subsidiaries Financial Pacific Insurance Company (FPIC) and Financial Pacific Insurance Agency (FPIA), which is currently inactive. FPIG also holds an interest in three statutory business trusts that were formed for the purpose of issuing Floating Rate Capital Securities (see note 18).
The Group’s business is subject to concentration risk with respect to geographic concentration. Although the Group’s operating subsidiaries are licensed collectively in twenty two states, direct premiums written for three states, California, New Jersey and Pennsylvania, constituted 52%, 30% and 9% of the 2009 direct premium written, 54%, 28% and 8% of the 2008 direct premium written, and 55%, 27%, and 7% of the 2007 direct premium written, respectively. Consequently, changes in the California, New Jersey or Pennsylvania legal, regulatory or economic environment could adversely affect the Group.
For the year ending December 31, 2009, 2008 and 2007, there were no agents in the Group that individually produced greater than 5% of the Group’s direct written premiums.
Investments - The fair values for fixed-income securities available for sale are based on readily observable market data for similar securities or valuations based on models where significant inputs are observable. If not available, fair values are based on values obtained from investment brokers. Fair values for marketable equity securities are based on quoted market prices.
Cash and cash equivalents - The carrying amounts reported in the consolidated balance sheet
The Group cedes insurance to unrelated insurers to limit its maximum loss exposure through risk diversification. Ceded reinsurance receivables and unearned premiums are reported as assets; loss and loss adjustment expense reserves are reported gross of ceded reinsurance credits, unless the reinsurance contract includes a right of offset. Premiums receivable is recorded gross of ceded premiums payable. An allowance for estimated uncollectible reinsurance is recorded based on an evaluation of balances due from reinsurers and other available information.
Premiums include direct writings plus reinsurance assumed less reinsurance ceded to other insurers and are recognized as revenue over the period that coverage is provided using the daily pro-rata method. Audit premiums and premium adjustments are recorded when they are considered probable and adequate information exists to estimate the premium. Unearned premiums represent that portion of direct premiums
written that are applicable to the unexpired terms of policies in force and is reported as a liability. Prepaid reinsurance premiums represent the unexpired portion of premiums ceded to reinsurers and is reported as an asset. Premiums receivable are reported net of an allowance for estimated uncollectible premium amounts. Revenue related to service fees is earned over the installment period. Agency commission and related fees are recognized based on the policy issue date.
The Group recognizes the expense in its financial statements based on the fair value of the grants on the grant date. The after-tax compensation expense recorded in the consolidated statements of earnings for stock options (net of forfeitures) for the years ended December 31, 2009, 2008 and 2007 was $166, $234, and $439 respectively. The after-tax compensation expense recorded in the consolidated statements of earnings for restricted stock (net of forfeitures) for the years ended December 31, 2009, 2008, and 2007 was $110, $195, and $336 respectively.
The Group entered into three interest rate swap agreements to hedge against interest rate risk on its floating rate Trust preferred securities. Interest rate swaps are contracts to convert, for a period of time, the floating rate of the Trust preferred securities into a fixed rate without exchanging the instruments themselves.
The Group has designated the interest rate swaps as non-hedge instruments. Accordingly, the Group recognizes the fair value of the interest rate swaps as assets or liabilities on the consolidated balance sheets with the changes in fair value recognized in the consolidated statement of earnings. The estimated fair value of the interest rate swaps is based on valuations received from the financial institution counterparties.
In February 2008, the FASB provided guidance which delayed the application of fair value measurement until January 1, 2009 for non-financial assets and non-financial liabilities, except those that are recognized or disclosed at fair value in the consolidated financial statements on a recurring basis. The delayed application did not have a material impact on the Group’s results of operations, financial condition, or liquidity.
The Group adopted this guidance as of January 1, 2009. As the Group did not hold any debt securities at January 1, 2009 that were the subject of previous other than temporary impairment charges which were non-credit in nature, the adoption of this guidance did not result in the recognition of a cumulative-effect adjustment. Adoption of this guidance did not have a material impact to the Group’s results of operations, financial condition, or liquidity. In April 2009, the FASB issued guidance which addresses the factors that determine whether there has been a significant decrease in the volume and level of activity for an asset or liability when compared to the normal market activity. This guidance provides that if it has been determined that the volume and level of activity has significantly decreased and that transactions are not orderly, further analysis is required and significant adjustments to the quoted prices or transactions might be needed. The guidance is effective for interim and annual reporting periods ending after June 15, 2009. Adoption did not have a material impact on the Group’s results of operations, financial condition, or liquidity.
In May 2009, the FASB issued guidance which establishes the standards of accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued. The Company adopted this standard, which did not have a material impact on the Company’s consolidated financial statements.
In August 2009, the FASB issued guidance related to fair value measurements and disclosures for liabilities, which amends earlier guidance related to fair value measurements and disclosures. The new guidance provides clarification in circumstances where a quoted price in an active market for an identical liability is not available, and a reporting entity is required to measure fair value using one or more valuation techniques. In addition, the new guidance also addresses practical difficulties where fair value measurements based on the price that would be paid to transfer a liability to a new obligor and contractual or legal requirements that prevent such transfers from taking place. The Company adopted the new standard which became effective for the annual reporting period ended December 31, 2009. The adoption of the new standard did not have a material impact on the Company’s consolidated financial statements.
Net investment income, net realized investment gains (losses), and change in unrealized gains (losses) on investment securities are as follows.
The cost and estimated market value of available-for-sale fixed-income and equity investment securities at December 31, 2009 and 2008 are shown below.
The following table shows our Industrial and miscellaneous fixed income securities and equity holdings by industry sector:
The estimated market value and unrealized loss for securities in a temporary unrealized loss position as of December 31, 2009 are as follows:
Fixed maturity investments with unrealized losses for less than twelve months are primarily due to changes in the interest rate environment. At December 31, 2009 the Group has 3 fixed maturity securities with unrealized losses for more than twelve months. Of the 3 securities with unrealized losses for more than twelve months, all of them have fair values of no less than 92% of book value. The Group does not believe these declines are other than temporary due to the credit quality of the holdings. We currently have no intention or expectation that we will have to sell these securities before recovery.
There are 4 common stock securities that are in an unrealized loss position at December 31, 2009. All of these securities have been in an unrealized loss position for less than 6 months. There is one preferred stock security that has been in an unrealized loss position for more than twelve months. The Group does not believe these declines are other than temporary as a result of reviewing the circumstances of each such
security in an unrealized loss position. The Group currently has the ability and intent to hold these securities until recovery.
The amortized cost and estimated fair value of fixed-income securities at December 31, 2009, by contractual maturity, are shown below (note that mortgage-backed securities in the below table include securities backed by the U.S. government and agencies). Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
The amortized cost of invested securities on deposit with regulatory authorities at December 31, 2009 and 2008 was $4,819 and $4,911, respectively.
The balance at December 31, 2009, 2008, and 2007 is recorded net of reserves for salvage and subrogation in the amounts of $8,561, $7,629, and $6,140, respectively.
The following table presents, by line of business, the change in the liability for unpaid losses and loss adjustment expenses incurred in the years ended December 31, 2009, 2008 and 2007, for insured events of prior years.
We evaluate our estimated ultimate liability by line of business on a quarterly basis. The establishment of loss and loss adjustment expense reserves is an inherently uncertain process and reserve uncertainty stems from a variety of sources. Court decisions, regulatory changes and economic conditions, among other factors, can affect the ultimate cost of claims that occurred in the past as well as create uncertainties regarding future loss cost trends. Similarly, actual experience, including the number of claims and the severity of claims, to the extent it varies from data previously used or projected, will be used to update the projected ultimate liability for losses, by accident year and line of business. Changes in estimates, or differences between estimates and amounts ultimately paid, are reflected in the operating results of the period during which such changes are made. A discussion of factors contributing to an (increase) decrease in the liability for unpaid losses and loss adjustment expenses (as shown in the chart immediately above) for the Group’s major lines, representing 92% of net loss and loss adjustment reserves at December 31, 2009, follows:
The commercial automobile line of business experienced favorable prior year development of $4.2 million in 2009, $3.0 million in 2008, and $2.5 million in 2007.
Workers compensation reserves developed favorably in 2009 by $0.0 million, in 2008 by $0.4 million, and in 2007 by $0.8 million, respectively.
The remaining lines of business collectively contributed approximately $1.0 million in favorable development and adverse development of $0.4 million and $5.6 million for the years ended December 31, 2009, 2008, and 2007, respectively. These lines did not individually reflect any significant trends related to prior year development, in 2009 or 2008. The adverse development in 2007 was mainly on the Other Liability line of business and related to an unexpected increase in litigation activity. At December 31, 2009, Other Liability recorded reserves, net of reinsurance, totaled $5.0 million or 2% of net loss and loss adjustment reserves (as compared to $12.4 million or 6% of net loss and loss adjustment reserves at December 31, 2007).
event and the severity of the event. Most catastrophes are restricted to small geographic areas. However, hurricanes and earthquakes may produce significant damage in large, heavily populated areas. The Group generally seeks to reduce its exposure to catastrophe through individual risk selection and the purchase of catastrophe reinsurance.
In conjunction with the renewal of the reinsurance program in 2009, and 2008, the prior year reinsurance treaties were terminated on a run-off basis, which requires that for policies in force as of the prior year end, these reinsurance agreements continue to cover losses occurring on these policies in the future. Therefore, the Group will continue to remit premiums to and collect reinsurance recoverables from these syndicates of reinsurers as the underlying business runs off.
Prior to 2007, some of the Group’s reinsurance treaties (primarily FPIC treaties) included provisions that establish minimum and maximum cessions and allow limited participation in the profit of the ceded business. Generally, the Group shares on a limited basis in the profitability through contingent ceding commissions. Exposure to the loss experience is contractually defined at minimum and maximum levels, and the terms of such contracts are fixed at inception. Since estimating the emergence of claims to the applicable reinsurance layers is subject to significant uncertainty, the net amounts that will ultimately be realized may vary significantly from the estimated amounts presented in the Group’s results of operations.
The effect of reinsurance on unearned premiums as of December 31, 2009 and 2008 is as follows:
The Group has an unfunded noncontributory defined benefit plan for its directors. The plan provides for monthly payments for life upon retirement, with a minimum payment period of ten years. The net periodic benefit cost for this plan amounted to $135, $118, and $166 for 2009, 2008, and 2007 respectively. Assumptions used in estimating the projected benefit obligation of the plan are the discount rate (5.65% in 2009 and 6.5% in 2008) and retirement age (65). Benefit payments for the plan were $43 in 2009, and $34 in 2008 and 2007. Costs accrued under this plan amounted to $1,433 and $1,315 at December 31, 2009 and 2008, respectively. In 2009, in order to conform with tax requirements, the plan paid out a settlement of a portion of the benefit, which amounted to $54.
The Group has purchased Company-owned life insurance covering key individuals. The Group’s cost, net of increases in cash surrender value, for the Company-owned life insurance was $(113), $125 and $(208) for the years ended December 31, 2009, 2008 and 2007, respectively. The cash surrender value of the Company-owned life insurance totaled $1,804 and $1,557 at December 31, 2009 and 2008, respectively, and is included in other assets.
The Group manages its business in three segments: commercial lines insurance, personal lines insurance, and investments. The commercial lines insurance and personal lines insurance segments are managed based on underwriting results determined in accordance with U.S. generally accepted accounting principles, and the investment segment is managed based on after-tax investment returns.
In determining the results of each segment, assets are not allocated to segments and are reviewed in the aggregate for decision-making purposes.
The Group’s insurance companies are required to file statutory financial statements with various state insurance regulatory authorities. Statutory financial statements are prepared in accordance with accounting principles and practices prescribed or permitted by the various states of domicile. Prescribed statutory accounting practices include state laws, regulations, and general administrative rules, as well as a variety of publications of the National Association of Insurance Commissioners (NAIC). Furthermore, the NAIC adopted the Codification of Statutory Accounting Principles effective January 1, 2001. The codified
The Group carries goodwill on its balance sheet in connection with the acquisitions of FHC and FPIG. There was no change in the carrying amount of goodwill for these acquisitions for the years ended December 31, 2009 and 2008, with $5,416 carried as of each of those dates.
Information regarding 2009 stock option activity in the Plan is presented below:
Information regarding stock option activity in the Plan in 2008 is presented below:
Rental expenses of $414, $422, and $437 were incurred for the years ended December 31, 2009, 2008, and 2007, respectively.
Thomas, Thomas & Hafer of Harrisburg, PA is a law firm the Group uses for claims handling assistance. The brother of the Chief Executive Officer of the Group is a partner of the firm. Fees to Thomas,
FPIG formed three statutory business trusts for the purpose of issuing Floating Rate Capital Securities (Trust preferred securities) and investing the proceeds thereof in Junior Subordinated Debentures of FPIG. FPIG holds $488 of common stock securities issued to capitalize the Trusts. Trust preferred securities totaling $15,500 were issued to the public.
Financial Pacific Statutory Trust I (Trust I) is a Connecticut statutory business trust. The Trust issued 5,000 shares of the Trust preferred securities at a price of $1 per share for $5,000. The Trust purchased $5,155 in Junior Subordinated Debentures from the Group that mature on December 4, 2032. The annual effective rate of interest at December 31, 2009 is 8.74%.
Financial Pacific Statutory Trust II (Trust II) is a Connecticut statutory business trust. The Trust issued 3,000 shares of the Trust preferred securities at a price of $1 per share for $3,000. The Trust purchased $3,093 in Junior Subordinated Debentures from the Group that mature on May 15, 2033. The annual effective rate of interest at December 31, 2009 is 8.9%.
Financial Pacific Statutory Trust III (Trust III) is a Delaware statutory business trust. The Trust issued 7,500 shares of the Trust preferred securities at a price of $1 per share for $7,500. The Trust purchased $7,740 in Junior Subordinated Debentures from the Group that mature on September 30, 2033. The annual effective rate of interest at December 31, 2009 is 8.89%.
The Group is party to interest rate swap agreements to hedge the floating interest rate on the Junior Subordinated Debentures purchased by Trust I, Trust II and Trust III. The variable-rate debt obligations expose the Group to variability in interest payments due to changes in interest rates. Management believes it is prudent to limit the variability of its interest payments. To meet this objective, management enters into swap agreements to manage fluctuations in cash flows resulting from interest rate risk. These swaps change the variable-rate cash flow exposure on the debt obligations to fixed-rate cash flows. Under the terms of the interest rate swaps, the Group makes fixed interest rate payments and receives variable interest rate payments, thereby creating the equivalent of fixed-rate debt.
A summary of the fair values of interest rate swaps outstanding as of December 31, 2009 and 2008 follows:
A summary of the effect of derivative instruments on the consolidated statements of earnings for the years ended December 31, 2009, 2008, and 2007:
The Group’s financial assets and financial liabilities measured at fair value are categorized into three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. These levels are:
Level 2 - Valuations based on quoted prices for similar assets in active markets; quoted prices for identical or similar assets in inactive markets; or valuations based on models where the significant inputs are observable (e.g., interest rates, yield curves, prepayment speeds, default rates, loss severities, etc.) or can be corroborated by observable market data.
The Group reviews its securities measured at fair value and discusses the proper classification of such investments with industry contacts and others. A review process is performed on prices received from the pricing service. In addition, a review is performed of the pricing service’s processes, practices and inputs, which include any number of financial models, quotes, trades and other market indicators. Pricing of the portfolio is reviewed on a monthly basis and securities with changes in prices exceeding defined tolerances are verified to other sources (e.g. broker, Bloomberg, etc.). Any price challenges resulting from this review are based upon significant supporting documentation which is provided to the pricing service for their review. The Group does not adjust quotes or prices obtained from the pricing service without first going through this process of challenging the price with the pricing service.
Securities are generally assigned to Level 3 in cases where non-binding broker/dealer quotes are significant inputs to the valuation and there is a lack of transparency as to whether these quotes are based on information that is observable in the marketplace. The Group’s Level 3 securities consist of three holdings totaling $1.4 million, or less than 0.44% of the Group’s total investment portfolio. These three securities were valued primarily through the use of non-binding broker quotes.
Included in Level 2, Other Liabilities are interest rate swap agreements which the Group is a party to in order to hedge the floating interest rate on its Trust Preferred Securities, thereby changing the variable rate exposure to a fixed rate exposure for interest on these obligations. The estimated fair value of the interest rate swaps is obtained from the third-party financial institution counterparties.
The changes in Level 3 assets and liabilities measured at fair value on a recurring basis are summarized as follows at December 31, 2009 and 2008: