FPIC owns a 41,000 square foot building it constructed in 2009 at a cost of $5.1 million, which serves as its headquarters and operations facility. FPIC also owns a townhouse, used for corporate purposes, in Rocklin, California carried at $0.3 million at December 31, 2010.
(4) The ratio of net premiums written divided by ending statutory surplus
(7) The 2007 results include a non-recurring refund of state premium retaliatory taxes, plus interest, in the after-tax amounts of $2.8 million, or $0.44 per diluted share.
The following presents management’s discussion and analysis of our financial condition and results of operations as of the dates and for the periods indicated. You should read this discussion in conjunction with the consolidated financial statements and notes thereto included in this report, and the “Description of Business” contained in Item 1 of this report. This discussion contains forward-looking information that involves risks and uncertainties. Actual results could differ significantly from these forward-looking statements.
· limitation on available business arising from a need to maintain the pricing and quality of underwritten risks;
· specific adverse events affecting the issuers of debt obligations held by the Group;
The Group seeks to manage each of the foregoing to the extent within its control. Many of the foregoing factors are partially, or entirely, outside the control of the Group.
Reserves are closely monitored and recomputed periodically using the most recent information on reported claims and a variety of projection techniques. Specifically, on at least a quarterly basis, we review, by line of business, existing reserves, new claims, changes to existing case reserves, and paid losses with respect to the current and prior accident years. We use historical paid and incurred losses and accident year data to derive expected ultimate loss and loss adjustment expense ratios (to earned premiums) by line of business. We then apply these expected loss and loss adjustment expense ratios to earned premiums to derive a reserve level for each line of business. In connection with the determination of the reserves, we also consider other specific factors such as recent weather-related losses, trends in historical paid losses, economic conditions, and legal and judicial trends with respect to theories of liability. Any changes in estimates are reflected in operating results in the period in which the estimates are changed.
When a claim is reported to us, our claims personnel establish a “case reserve” for the estimated amount of the ultimate payment. This estimate reflects an informed judgment based upon general insurance reserving practices and the experience and knowledge of the estimator. The individual estimating the reserve considers the nature and value of the specific claim, the severity of injury or damage, and the policy provisions relating to the type of loss. Case reserves are adjusted by our claims staff as more information becomes available. It is our policy to periodically review and revise case reserves and to settle each claim as expeditiously as possible.
Retrospective tests of the ratios of the loss reserves to earned premiums and to estimated ultimate incurred losses;
Ratios of cumulative average paid loss per claim closed with payment and average case reserve per pending claim.
The Bornhuetter-Ferguson expected loss projection method based on reported loss data relies on the assumption that remaining unreported losses are a function of the total expected losses rather than a function of currently reported losses. The expected losses used in this analysis are selected judgmentally based upon the historical relationship between premiums and losses for more mature accident years, adjusted to reflect changes in average rates and expected changes in claims frequency and severity. The expected losses are multiplied by the unreported percentage to produce expected unreported losses. The unreported percentage is calculated as one minus the reciprocal of the selected reported loss development factors. Finally, the expected unreported losses are added to the current reported losses to produce ultimate losses.
The calculations underlying the Bornhuetter-Ferguson expected loss projection method based on paid loss data are similar to the reported Bornhuetter-Ferguson calculations with the exception that paid losses and unpaid percentages replace reported losses and unreported percentages.
For the homeowners and commercial multi-peril lines of business (excluding California CMP business for policy years 1996 and prior) we generally rely on the incurred loss development and incurred Bornhuetter-Ferguson methods in estimating loss reserves. These two methods yield more consistent results although the two paid methods yielded reserves that were similar in total to the incurred methods.
Reserves are estimates because there are uncertainties inherent in the determination of ultimate losses. Court decisions, regulatory changes and economic conditions can affect the ultimate cost of claims that occurred in the past as well as create uncertainties regarding future loss cost trends. Accordingly, the ultimate liability for unpaid losses and loss settlement expenses will likely differ from the amount recorded at December 31, 2010.
Unrealized investment gains or losses on investments carried at fair value, net of applicable income taxes, are reflected directly in stockholders’ equity as a component of accumulated other comprehensive income and, accordingly, have no effect on net income. A decline in fair value of an investment below its cost that is deemed other than temporary and due to credit concerns is charged to earnings as a realized loss. We monitor our investment portfolio and review investments that have experienced a decline in fair value below cost to evaluate whether the decline is other than temporary. These evaluations involve judgment and consider the magnitude and reasons for a decline and the prospects for the fair value to recover in the near term. Adverse investment market conditions, poor operating performance, or other adversity encountered by companies whose stock or fixed maturity securities we own could result in other than temporary impairment charges in the future. Our policy on impairment of value of investments is as follows: if a security has a market value below cost it is considered impaired. For any such security a review of the financial condition and prospects of the company will be performed by the Investment Committee to determine if the decline in market value is other than temporary. If it is determined that the decline in market value is “other than temporary” and caused by credit concerns, the carrying value of the security will be written down to “realizable value” and the amount of the write down accounted for as a realized loss. “Realizable value” is defined for this purpose as the market price of the security. Write down to a value other than the market price requires objective evidence in support of that value.
In the years ended December 31, 2010, 2009 and 2008, we recorded a pre-tax charge to earnings of $0.1 million, $0.8 million and $6.2 million, respectively, for write-downs of other than temporarily impaired securities (OTTI).
During the second half of 2008 (and early 2009), there were significant disruptions to the financial and equity markets. This resulted from, in part, failures of financial institutions on an unprecedented scale, and caused a significant reduction in liquidity and trading flows in the credit markets in addition to a dramatic widening in credit spreads. Such impacts affected the valuations of both the fixed income and equity securities held by the Group, and resulted in pre-tax charge to earnings in 2008 of $6.2 million for write-downs of other-than-temporarily impaired securities. Of the $6.2 million in 2008 impairments $3.9 million related to 11 fixed-income securities, and $2.3 million related to 33 equity securities. The fixed income security impairments related to one residential mortgage-backed security ($0.5 million) which experienced increased delinquency and default rates, four asset-backed securities ($0.8 million) whose underlying collateral deteriorated, and six corporate bonds ($2.6 million) whose issuers were a experiencing deteriorating financial condition. The $2.3 million in 2008 equity security impairments related to twenty-nine common stock securities and four preferred stock securities, which demonstrated weakening fundamentals in their businesses.
The components of income for 2010 and 2009, and the change and percentage change from year to year, are shown in the charts below. The accompanying narrative refers to the statistical information displayed in the chart immediately above the narrative.
Underwriting income in 2010 was $5.0 million, as compared to $3.4 million in 2009. Our GAAP combined ratio for 2010 was 96.4%, as compared to a combined ratio for the prior year of 97.6%. The statutory combined ratio for 2010 and 2009 was 97.1% and 97.5%, respectively. See the discussion below relating to commercial and personal lines performance.
Other revenue of $1.9 million and $2.1 million in 2010 and 2009, respectively, represents primarily service charges recorded on insurance premium payment plans.
Interest expense of $1.4 million and $1.4 million in 2010 and 2009, respectively, represents interest expense on the trust preferred securities obligations of FPIG.
As in the past few years, the decline in year-to-date direct premiums written reflects reduced levels of economic activity in our operating territories, predominantly California. In addition, the current market continues to be very competitive, with pricing and coverage competition present in 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 presents a challenge in retaining our accounts on renewal, or renewing a policy at the expiring premium. Competition also continues on large accounts, including East Coast habitational and California construction contracting programs, as competitors 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.
Audit premium is derived principally from the contractor book of business written by FPIC. The premium on these policies is estimated at policy inception based on a prediction of the volume of the insured’s business operations during the policy period. In addition to endorsing the policy throughout the policy period based on known information, at policy expiration FPIC may conduct an audit of the insured’s business operations in order to adjust the policy premium from an estimate to actual. Contractor liability policy premium tends to vary with local construction activity as well as changes in the nature of the contractor’s operations. The decline in construction related activity and failing businesses in the construction industry caused by the weak California economy has impacted both the volume of premium for the contractor in-force book of business (as well as reducing related exposures) and the related audit premium on expiring policies. Audits, primarily of construction related policies, generated return premium of $3.5 million and $3.7 million in 2010 and 2009, respectively.
Dividend income declined 11.7% to $250,000 in 2010, as compared to $283,000 in 2009, due to a reduction dividend paying equities in the portfolio during 2010. Interest income on cash and cash equivalents declined $19,000, or 11.9%, to $140,000 in 2010, as compared to $159,000 in 2009, primarily as a result of extremely low short term yields in 2010. Investment expenses increased $128,000 to $2.3 million in 2010, from $2.2 million in 2009.
Fixed income investments represent 95.0% of invested assets. As of December 31, 2010, the fixed income portfolio consists of 99.7% investment grade securities, with 0.3% non-investment grade rated securities, which includes one corporate security held with a market value of $0.5 million, three asset-backed securities held with a combined market value of $0.7 million, and one mortgage-backed security with a market value of $0.1 million. The fixed income portfolio has an average rating of Aa3/AA- and an average tax equivalent book yield of 4.63%.
There are two common stock securities that are in an unrealized loss position at December 31, 2010. Both of these securities have been in an unrealized loss position for less than one month. 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 2010 our commercial lines direct premiums written decreased by $4.2 million, or 3.2%, to $127.4 million, as compared to direct premium written in 2009 of $131.5 million. The decline in direct premiums written is attributed to several factors, including a decline in construction related activity due to a weak economy, reduced surety written premium, continued 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 “2010 vs. 2009 Revenue” discussion.
One of our strategies in this market is to introduce new products leveraging our core skills. 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 and demonstrating higher renewal retention than larger accounts. This product also helps to balance FPIC’s business between property and casualty exposures. In 2009, a new contracting product which specializes in covering artisan contractors was introduced in Arizona and California and in Nevada and Oregon during 2010. Artisan contractors primarily provide repair and maintenance services, and this segment tends to experience less severe market fluctuations compared to the construction industry. During 2009, a new Garage Program was introduced in New Jersey and Pennsylvania, which targets repair shops, auto body shops, and gas stations. During 2010 we expanded our refuse haulers product to our east coast markets.
Personal lines direct premiums written declined to $21.2 million in 2010 as compared to $21.5 million in 2009, representing a decline of $0.4 million or 1.7%. Our personal lines have also been impacted by increased competition, as in the case of our commercial lines.
Federal income tax expense was $6.1 million and $5.0 million for 2010 and 2009, respectively. The effective tax rate was 29.2% and 26.7% for 2010 and 2009, respectively. The 2010 effective tax rate was higher than that of 2009 because tax-advantaged income was slightly lower in 2010.
Underwriting income in 2009 was $3.4 million, as compared to $2.8 million in 2008. Our GAAP combined ratio for 2009 was 97.6%, as compared to a combined ratio for the prior year of 98.1%. The statutory combined ratio for 2009 and 2008 was 97.5% and 98.5%, respectively. See the discussion below relating to commercial and personal lines performance.
Net investment income increased $0.3 million or 1.9% to $14.2 million in 2009 as compared to $13.9 million in 2008. This increase was driven by an increase in cash and invested assets. The increase in cash and invested assets was driven by operating cash flow.
Net realized investment gains amounted to $0.6 million in 2009, as compared to a realized loss of $7.1 million in 2008. The Group had gains on the sales of securities of $0.9 million and $0.6 million, and write-downs of other than temporary impairments of $0.8 million and $6.2 million, in 2009 and 2008, respectively. The Group also recorded a gain on the mark-to-market of interest rate swaps in 2009 of $0.5 million, and a loss in 2008 of $1.5 million. These interest rate swaps were entered into to convert the floating interest rate to a fixed rate on the Group’s trust preferred securities obligations, and the mark-to-market gains or losses are recorded as realized gains or losses. See also the discussion of other than temporary impairments on investment securities in the “Critical Accounting Policies” section.
The decline in year-to-date direct premiums written reflects reduced levels of economic activity in our operating territories, predominantly California. In addition, the current market continues to be very competitive, with pricing and coverage competition present in 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 presents a challenge in retaining our accounts on renewal, or renewing a policy at the expiring premium. Competition also continues on large accounts, including East Coast habitational and California construction contracting programs, as competitors 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 2009 net investment income increased $0.3 million, or 1.9%, to $14.2 million, as compared to $13.9 million in 2008. This increase was driven by an increase in cash and invested assets driven by operating cash flow, including the benefits of the 2009 and 2008 reinsurance agreement changes, which result in less premium being ceded to reinsurers.
The estimated fair value and unrealized loss for securities in a temporary unrealized loss position as of December 31, 2009 were as follows:
There are 4 common stock securities that were 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 following table summarizes the period of time that equity securities sold at a loss during 2009 had been in a continuous unrealized loss position:
In 2009 our commercial lines net premiums earned decreased by $11.6 million, or 8.7%, to $120.8 million, as compared to net premiums earned in 2008 of $132.4 million. The decrease in net premiums earned was caused by the 8.2% decline in direct premiums written, offset by the positive impact on net premiums written of the change in our reinsurance structure as described above. Contributing to the decline in net premiums earned was the increase in the negative audit premium discussed above, which is earned immediately upon booking.
In the commercial lines segment for 2009 we had underwriting income of $4.3 million, a slight increase from the underwriting income of $4.2 million in 2008, a GAAP combined ratio of 96.4%, a GAAP loss and loss adjustment expense ratio of 60.0% and a GAAP underwriting expense ratio of 36.4%, compared to a GAAP combined ratio of 96.8%, a GAAP loss and loss adjustment expense ratio of 61.3% and a GAAP underwriting expense ratio of 35.5% in 2008. Our commercial lines loss ratio for 2009 reflects a lower level of adverse prior year loss reserve development.
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.
The principal source of liquidity for the Holding Company (which has modest expenses and does not currently, or for the foreseeable future, need a significant regular source of cash flow to cover these expenses other than its debt service on its indebtedness to MIC, its quarterly dividend to shareholders, and the funding necessary for any stock repurchases pursuant to the currently authorized stock repurchase program) is dividend payments and other fees received from the insurance subsidiaries, and payments it receives on the 10-year note it received from the ESOP (see below) when the ESOP purchased shares at the time of the Conversion. The Holding Company also has access to an existing credit line under which it can draw up to $7.5 million dollars, of which $3.0 million was drawn upon at December 31, 2010.
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, 2010, 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, 315 and 1,303 shares of stock were repurchased from employees in 2010 and 2009, respectively, in order to pay the required tax withholdings on the vesting of restricted stock under the stock incentive plan. The Merger Agreement prohibits any further purchases of Holding Company stock.
Total liabilities decreased 2% or $9.1 million, to $426.0 million at December 31, 2010 as compared to $435.1 million at December 31, 2009, primarily as a result of the decreases in loss and loss adjustment expense reserves of $6.7 million or 2%, and declines in unearned premiums of $2.8 million or 4%. The unearned premiums decline primarily reflected the reduction in written premiums. Accounts payable and accrued expenses declined $0.5 million and were offset by an increase in other reinsurance balances of $0.5 million or 4%. Accounts payable and accrued expenses declined primarily due to cost saving measures reducing operating expenses. Other reinsurance balances increased primarily as a result of increased contingent ceding commissions payable on reinsurance contracts.
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. This Statement also requires the disclosure of the date through which subsequent events have been evaluated. The Company adopted this standard and performed a review of subsequent events through the date of issuance of these financial statements, March 16, 2010, in evaluating the need for disclosure. The guidance did not have a material impact on the Company’s consolidated financial statements.
In June 2009, the FASB issued guidance that establishes the FASB Accounting Standards Codification as the source of authoritative GAAP for nongovernmental entities. The Codification will supersede all existing non-SEC accounting and reporting standards. The Codification is effective for financial statements issued for interim and annual periods ending after September 15, 2009. As the Codification did not change existing GAAP, the guidance did not have an impact on our financial condition or results of operations but did change the way the Company refers to GAAP accounting standards.
In July 2010, the FASB issued ASU 2010-20, Receivables (Topic 310): Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses. This guidance expands the disclosure requirements related to the credit quality of financing receivables and their allowance for credit losses. The majority of these requirements do not apply to our operations as we generally issue insurance policies that are effective for one year, and this guidance excludes accounts receivable that arise from the sale of goods or services with a contractual maturity of one year or less or receivables reported at fair value or the lower of cost or fair value. This guidance is effective for interim and annual periods ending on or after December 15, 2010 and we have included the disclosures applicable to us in this Form 10-K.
In October 2010, the FASB issued ASU 2010-26, Financial Services-Insurance (Topic 944): Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts. This guidance requires that only costs that are incremental or directly related to the successful acquisition of new or renewal insurance contracts are to be capitalized as a deferred acquisition cost. This would include, among other items, sales commissions paid to agents, premium taxes, and the portion of employee salaries and benefits directly related to time spent on acquired contracts. This guidance is effective, either with a prospective or retrospective application, for interim and annual periods beginning after December 15, 2011, with early adoption permitted. Although we are currently evaluating the impact of this guidance, we anticipate that a significant portion of our deferred policy acquisition costs balance may be eliminated under the newly issued guidance, resulting in a reduction to GAAP equity. Deferred policy acquisition cost totaled $18.2 million as of December 31, 2010.
In December 2010, the FASB issued ASU 2010-28, Intangibles - Goodwill and Other (Topic 350): When to Perform Step 2 of the Goodwill Impairment Test for Reporting Units with Zero or Negative Carrying Amounts. This guidance modifies Step 1 of the goodwill impairment test, which assesses whether the carrying amount of a reporting unit exceeds its fair value, for reporting units with zero or negative carrying amounts. It requires that an entity perform Step 2 of the goodwill impairment test, which determines if goodwill has been impaired and measures the amount of impairment, if it is more likely than not that a goodwill impairment exists. In determining whether it is more likely than not that a goodwill impairment exists, an entity should consider the qualitative factors within existing guidance that would require goodwill of a reporting unit to be tested for impairment between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. This guidance is effective for interim and annual periods beginning after December 15, 2010. The adoption of this guidance is not expected to impact our financial condition or results of operations.
In December 2010, the FASB issued ASU 2010-29, Business Combinations (Topic 805): Disclosure of Supplementary Pro Forma Information for Business Combinations. This guidance relates to disclosure of pro forma information for business combinations that have occurred in the current reporting period. It requires that an entity presenting comparative financial statements include revenue and earnings of the combined entity as though the combination had occurred as of the beginning of the comparable prior annual period only. This guidance is effective prospectively for 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, 2010, and therefore, the adoption of this guidance and its corresponding impact will only need to be assessed to the extent that we engage in any future business combinations.
The Group and its subsidiaries have no significant contractual obligations at December 31, 2010, 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, 2010, are as follows:
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Mercer Insurance Group, Inc.’s internal control over financial reporting as of December 31, 2010, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 16, 2011, expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.
(Dollars in thousands, except per share amounts or as otherwise expressed)
The companies in the Group are operated under common management. The Group’s operating subsidiaries are licensed collectively in twenty two states, but are currently focused on doing business in six states; Arizona, California, Nevada, New Jersey, Oregon and Pennsylvania. MIC and MICNJ write a limited amount of business in New York to support accounts in adjacent states. FPIC holds an additional fifteen state licenses outside of the Group’s current focus area. Currently, only direct mail surety is being written in some of these states.
On November 30, 2010, MIG and United Fire & Casualty Company (“United Fire”) of Cedar Rapids, Iowa, issued a joint press release announcing that the Group had entered into an agreement and plan of merger with United Fire (the “Merger Agreement”) pursuant to which it will acquire all of the outstanding shares of MIG for $28.25 per share. The consummation of the merger is subject to United Fire receiving the appropriate regulatory approvals from state insurance regulators, the approval of the Group’s shareholders, and other terms and conditions set forth in the Merger Agreement. The Merger Agreement was unanimously approved by the Board of Directors of MIG.
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 10 % of the 2010 direct premium written, 52%, 30% and 9% of the 2009 direct premium written, and 54%, 28%, and 8% of the 2008 direct premium written, respectively. Consequently, changes in the California, New Jersey or Pennsylvania legal, regulatory or economic environment could adversely affect the Group.
Interest on fixed-income securities is credited to income as it accrues on the principal amounts outstanding, adjusted for amortization of premiums and accretion of discounts computed utilizing the effective interest rate method. Premiums and discounts on mortgage-backed securities are amortized/accreted using anticipated prepayments with changes in anticipated prepayments, which are evaluated semi-annually, accounted for prospectively. The model used to determine anticipated prepayment assumptions for mortgage-backed securities uses separate home sale, refinancing, curtailment, and full pay-off components, derived from a variety of industry sources as determined by the Group’s third party fixed income securities manager.
Cash and cash equivalents as of December 31, 2010 and 2009 include restricted cash of $57, consisting of funds held for surety bonds.
Cash and cash equivalents - The carrying amounts reported in the consolidated balance sheet approximate their fair values.
The Group has capitalized $1,369, $2,067 and $4,530 in software development costs, respectively, in 2010, 2009 and 2008. These costs are amortized over their useful lives, ranging from three to five years, from the dates the systems technology becomes operational. At December 31, 2010 and 2009, the unamortized cost of capitalized software was $6,904 and $7,615, respectively.
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, 2010, 2009 and 2008 was $69, $166, and $234 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, 2010, 2009, and 2008 was $22, $110, and $195 respectively.
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 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 Group 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 Group’s consolidated financial statements.
In December 2009, the FASB issued ASU 2009-17, Consolidations (Topic 810) - Improvements to Financial Reporting by Enterprises Involved with Variable Interest Entities. This guidance requires the reporting entity to perform a qualitative analysis that results in a variable interest entity (“VIE”) being consolidated if the reporting entity: (i) has the power to direct activities of the VIE that significantly impact the VIE’s financial performance; and (ii) has an obligation to absorb losses or receive benefits that may be significant to the VIE. This guidance also requires enhanced disclosures, including disclosure of significant judgments and assumptions as to whether a VIE must be consolidated, and how involvement with a VIE affects the company’s financial statements. The adoption of this guidance, which was effective for fiscal years beginning after November 15, 2009, did not impact the Group’s financial condition or results of operations.
In October 2010, the FASB issued ASU 2010-26, Financial Services-Insurance (Topic 944): Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts. This guidance requires that only costs that are incremental or directly related to the successful acquisition of new or renewal insurance contracts are to be capitalized as a deferred acquisition cost. This would include, among other items, sales commissions paid to agents, premium taxes, and the portion of employee salaries and benefits directly related to time spent on acquired contracts. This guidance is effective, either with a prospective or retrospective application, for interim and annual periods beginning after December 15, 2011, with early adoption permitted. Although the Group is currently evaluating the impact of this guidance, we anticipate that a significant portion of our deferred policy acquisition costs balance may be eliminated under the newly issued guidance, resulting in a reduction to GAAP equity. Deferred policy acquisition cost totaled $18.2 million as of December 31, 2010.
In December 2010, the FASB issued ASU 2010-28, Intangibles - Goodwill and Other (Topic 350): When to Perform Step 2 of the Goodwill Impairment Test for Reporting Units with Zero or Negative Carrying Amounts. This guidance modifies Step 1 of the goodwill impairment test, which assesses whether the carrying amount of a reporting unit exceeds its fair value, for reporting units with zero or negative carrying amounts. It requires that an entity perform Step 2 of the goodwill impairment test, which determines if goodwill has been impaired and measures the amount of impairment, if it is more likely than not that a goodwill impairment exists. In determining whether it is more likely than not that a goodwill impairment exists, an entity should consider the qualitative factors within existing guidance that would require goodwill of a reporting unit to be tested for impairment between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. This guidance is effective for interim and annual periods beginning after December 15, 2010. The adoption of this guidance is not expected to impact the Group’s financial condition or results of operations.
The cost and estimated fair value of available-for-sale fixed-income and equity investment securities at December 31, 2010 and 2009 are shown below.
Original cost of equity and fixed income securities adjusted for other-than-temporary impairment write-downs and amortization of premium and accretion of discount.
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 gross realized gains and losses on investment securities are as follows:
During the second half of 2008, there were significant disruptions to the financial and equity markets. This resulted from, in part, failures of financial institutions on an unprecedented scale, and caused a significant reduction in liquidity and trading flows in the credit markets in addition to a dramatic widening in credit spreads. Such impacts affected the valuations of both the fixed income and equity securities held by the Group, and resulted in pre-tax charge to earnings of $6.2 million for write-downs of other-than-temporarily impaired securities. Of the $6.2 million in 2008 impairments, $3.9 million related to 11 fixed-income securities, and $2.3 million related to 33 equity securities. The fixed income security impairments related to one residential mortgage-backed security ($0.5 million) which experienced increased delinquency and default rates, four asset-backed securities ($0.8 million) whose underlying collateral deteriorated, and six corporate bonds ($2.6 million) whose issuers were a experiencing deteriorating financial condition. The equity security impairments related to twenty-nine common stock securities and four preferred stock securities, which demonstrated weakening fundamentals in their businesses.
The amortized cost of invested securities on deposit with regulatory authorities at December 31, 2010 and 2009 was $4,958 and $4,819, respectively.
The balance at December 31, 2010, 2009, and 2008 is recorded net of reserves for salvage and subrogation in the amounts of $9,187, $8,561 and $7,629, respectively.
As a result of changes in estimates of insured events in prior years, the liabilities for losses and loss adjustment expenses decreased by $2.4 million in 2010 and increased by $0.1 million and $6.1 million in 2009, and 2008, respectively.
The following table presents the (increase) decrease in the liability for unpaid losses and loss adjustment expenses attributable to insured events of prior years incurred in the year ended December 31, 2010 by line of business:
Prior year favorable (unfavorable) development, by line of business, reported in:
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 91% of net loss and loss adjustment reserves at December 31, 2010, follows:
With $182.5 million, $179.8 million, and $163.0 million of recorded reserves, net of reinsurance, at December 31, 2010, 2009 and 2008, respectively, commercial multi-peril is the line of business that carries the largest net loss and loss adjustment expense reserves, representing 79%, 78%, and 75%, respectively, of the Group’s total carried net loss and loss adjustment expense reserves at December 31, 2010, 2009, and 2008.
Workers’ compensation reserves developed favorably in 2010 by $0.2 million, in 2009 by $0.0 million, and in 2008 by $0.4 million, respectivelyWorkers’ compensation losses are impacted heavily by medical cost increases which have been significant recently.
At December 31, 2010 the Group’s recorded reserves, net of reinsurance, totaled $232.0 million and were $17.0 million or 8% above the actuarially derived estimate. At December 31, 2009, the Group’s recorded reserves, net of reinsurance, totaled $231.0 million and were $26.3 million or 13% above the actuarially derived estimate. The Group’s management holds the additional reserves above the actuarially derived estimate to cover the potential for adverse development. These additional reserves primarily relate to west coast commercial multi-peril liability. The $9.3 million reduction in margin between management’s selection and the actuary’s selection includes a $3.0 million reduction in the margin on west coast commercial multi-peril liability reserves.
In the ordinary course of business, the Group seeks to limit its exposure to loss on individual claims and from the effects of catastrophes by entering into reinsurance contracts with other insurance companies. Reinsurance is ceded on excess of loss and pro-rata bases with the Group’s retention not exceeding $1.0 million in 2010 and 2009 and $850 thousand in 2008, per occurrence. Insurance ceded by the Group does not relieve it of its primary liability as the originating insurer.
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. Other underwriting expenses include contingent ceding commission benefit of $1.4 million, $0.6 million and $1.6 million in 2010, 2009 and 2008 respectively, reflecting favorable ceded loss development in these treaties.
The effect of reinsurance on unearned premiums as of December 31, 2010 and 2009 is as follows:
The effect of reinsurance on the liability for losses and loss adjustment expenses 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 $114, $135, and $118 for 2010, 2009, and 2008 respectively. Assumptions used in estimating the projected benefit obligation of the plan are the discount rate (4.96% in 2010 and 5.65% in 2009) and retirement age (65). Benefit payments for the plan were $62, $43, and $34 in 2010, 2009 and 2008, respectively. Costs accrued under this plan amounted to $1,547 and $1,433 at December 31, 2010 and 2009, 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 (benefit), net of increases in cash surrender value, for the Company-owned life insurance was $(107), $(113) and $125 for the years ended December 31, 2010, 2009 and 2008, respectively. The cash surrender value of the Company-owned life insurance totaled $2,046 and $1,804 at December 31, 2010 and 2009, respectively, and is included in other assets.
On December 15, 2003, the Group established an Employee Stock Ownership Plan (ESOP) and issued 626,111 shares to the ESOP at a cost of $10 per share. The ESOP signed a promissory note in the amount of $6,261 to purchase the shares, which is due in 10 equal annual installments with interest at 4%. The shares purchased are held in a suspense account for allocation among participating employees as the loan is repaid, and are allocated to participants based on compensation as provided for in the plan. During 2010, 2009 and 2008, 62,611 shares were allocated to employee participants. Compensation expense equal to the fair value of the shares allocated is recognized ratably over the period that the shares are committed to be allocated to the employees. In 2010, 2009 and 2008 the Group recognized compensation expense of $1,161, $1,019 and $1,014, respectively, related to the ESOP. As of December 31, 2010, the cost of the 125,223 shares issued to the ESOP but not yet allocated to its employee participants is classified within equity as unearned ESOP shares.
In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management believes it is more likely than not the Group will realize the benefits of the deferred tax assets at December 31, 2010 and 2009.
On January 1, 2007, the Group adopted revised rules on accounting for tax exposure matters. As a result of adoption, the Group recognized a previously unrecognized tax benefit of approximately $0.2 million relating to merger-related expenses for the FPIG acquisition that took place October 1, 2005. The application of the revised rules for this unrecognized tax benefit resulted in a corresponding reduction to goodwill relating to the FPIG acquisition of $0.2 million. The adoption of these rules did not result in any adjustments to beginning retained earnings, nor have a significant effect on operations, financial condition or liquidity. As of December 31, 2010, the Group has no unrecognized tax benefits. The Group’s policy is to account for interest and penalties as a component of other expenses. The Group files income tax returns in the federal jurisdiction and various states.
All dividends from MIC to MIG require prior notice to the Pennsylvania Insurance Department. All “extraordinary” dividends require advance approval. A dividend is deemed “extraordinary” if, when aggregated with all other dividends paid within the preceding 12 months, the dividend exceeds the greater of (a) statutory net income (excluding realized capital gains) for the preceding calendar year or (b) 10% of statutory surplus as of the preceding December 31. As of December 31, 2010, the amount available for payment of dividends from MIC in 2011, without the prior approval, is approximately $8.2 million.
All dividends from FPIC to FPIG (wholly owned by MIG) require prior notice to the California Department of Insurance. All “extraordinary” dividends require advance approval. A dividend is deemed “extraordinary” if, when aggregated with all other dividends paid within the preceding 12 months, the dividend exceeds the greater of (a) statutory net income for the preceding calendar year or (b) 10% of statutory surplus as of the preceding December 31. As of December 31, 2010, the amount available for payment of dividends from FPIC in 2011, without prior approval, is approximately $7.7 million.
Intangible assets consist of the following and are carried in Other Assets:
The Group adopted the Mercer Insurance Group, Inc. 2004 Stock Incentive Plan (the Plan) on June 16, 2004. Awards under the Plan may be made in the form of incentive stock options, nonqualified stock options, restricted stock or any combination to employees and non-employee Directors. At adoption, the Plan initially limited to 250,000 the number of shares that may be awarded as restricted stock, and to 500,000 the number of shares for which incentive stock options may be granted. The total number of shares initially authorized in the Plan was 876,555 shares, with an annual increase equal to 1% of the shares outstanding at the end of each year. As of December 31, 2010, the Plan’s authorization has been increased under this feature to 1,270,514 shares. The Plan provides that stock options and restricted stock awards may include vesting restrictions and performance criteria at the discretion of the Compensation Committee of the Board of Directors. The term of options may not exceed ten years for incentive stock options, and ten years and one month for nonqualified stock options, and the option exercise price may not be less than fair market value on the date of grant. All grants made under the Plan employ graded vesting over vesting periods of 3 or 5 years for restricted stock, incentive stock options, and nonqualified stock option grants, and include only service conditions. During 2010 and 2009, the Group made no grants of restricted stock, incentive stock options and non-qualified stock options. There were 2,500 stock options and 1,000 shares of restricted stock forfeited in 2008, and in 2009, 10,000 incentive stock options expired unexercised.
In determining the charge to the consolidated statement of earnings for 2010, 2009 and 2008, the fair value of each option award is estimated on the date of grant using the Black-Scholes-Merton option pricing model. The significant assumptions utilized in applying the Black-Scholes-Merton option pricing model are the risk-free interest rate, expected term, dividend yield, and expected volatility. The risk-free interest rate is the implied yield currently available on U.S. Treasury zero-coupon issues with a remaining term equal to the expected term used as the assumption in the model. The expected term of an option award is based on expected experience of the awards. The dividend yield is determined by dividing the per share-dividend by the grant date stock price. The expected volatility is based on the volatility of the Group’s stock price over a historical period.
Information regarding 2010 stock option activity in the Plan is presented below:
Compensation remaining to be recognized for unvested stock options at December 31, 2010 (millions)
Information regarding unvested restricted stock activity in the Plan in 2010 is below:
Compensation remaining to be recognized for unvested restricted stock at December 31, 2008 (millions)
As of December 31, 2010, the Group leased equipment and vehicles under various operating leases that have remaining non-cancelable lease terms in excess of one year. A summary of minimum future lease commitments as of December 31, 2010 follows:
In 2009, the Group constructed a new 41,000 square foot building for its office in Rocklin, California for a total cost of $5,110. This office space replaced 25,000 square feet the Group previously leased in Rocklin for its west coast operations.
The Group produces a large percentage of its business through one insurance agent, Davis Insurance Agency (Davis), the owner of which is also a Board member of the Group. In 2010, 2009 and 2008, premiums written through Davis totaled 4%, 4% and 4%, respectively, of the Group’s direct written premiums. Commissions paid to Davis were $1,206, $1,203 and $1,115 in 2010, 2009 and 2008, respectively.
As of December 31, 2010 and 2009, FPIG owed $3,000 under a $7,500 bank line of credit. The line of credit bears interest at the bank’s base rate or an optional rate based on LIBOR. The effective annual interest rate as of December 31, 2010 and 2009 was 3.25 %. The line of credit includes covenants to maintain certain financial requirements including, minimum statutory surplus and a requirement that no more than 50% of allowable dividends be distributed from subsidiaries. The Group was in compliance with all covenants as of December 31, 2010 and 2009.
The Group had the following Trust Preferred Securities outstanding as of December 31, 2010:
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, 2010 is 8.74%.
The Group has the right, at any time, so long as there are no continuing events of default, to defer payments of interest on the Junior Subordinated Debentures for a period not exceeding 20 consecutive quarters; but not beyond the stated maturity of the Junior Subordinated Debentures. To date no interest has been deferred. FPIG entered into three interest rate swap agreements to economically hedge the floating interest rate on the Junior Subordinated Debentures (note 18).
The Trust preferred securities are subject to mandatory redemption, in whole or in part, upon repayment of the Junior Subordinated Debentures at maturity or their earlier redemption. The Group has the right to redeem the Junior Subordinated Debentures after December 4, 2007 for Trust I, after May 15, 2008 for Trust II and after September 30, 2008 for Trust III. The Group has not exercised these rights as of December 31, 2010.
Market risk is the adverse effect on the value of a financial instrument that results from a change in interest rates. Credit risk is the potential failure of the counterparty to perform under the terms of the contract. When the fair value of a contract is positive, the counterparty owes the Group, which creates credit risk for the Group. When the fair value of a contract is negative, the Group owes the counterparty and, therefore, it does not possess credit risk. The Group minimizes the credit risk in hedging instruments by entering into transactions with high-quality counterparties whose credit rating is higher than Aa.
The Group uses quoted values and other data provided by a nationally recognized independent pricing service (pricing service) as inputs into its process for determining fair values of its investments. The pricing service covers over 99% of all asset classes, fixed-income and equity securities, domestic and foreign.
The pricing service obtains market quotations and actual transaction prices for securities that have quoted prices in active markets. Fixed maturities other than U.S. Treasury securities generally do not trade on a daily basis. For these securities, the pricing service prepares estimates of fair value measurements for these securities using its proprietary pricing applications which include available relevant market information, benchmark curves, benchmarking of like securities, sector groupings and matrix pricing. Additionally, the pricing service uses an Option Adjusted Spread model to develop prepayment and interest rate scenarios.
The tables below present the balances of assets and liabilities measured at fair value on a recurring basis at December 31, 2010 and 2009.
The changes in Level 3 assets and liabilities measured at fair value on a recurring basis are summarized as follows at December 31, 2010 and 2009:
For the year ended December 31, 2010, there were no assets or liabilities measured at fair value on a nonrecurring basis.