Mercer Insurance Company also owns a 32,000 square foot office facility in Lock Haven, Pennsylvania. Mercer Insurance Company sub-leases a portion of this facility.
Financial Pacific Insurance Company leases approximately 25,000 square feet for the Group’s west coast operations headquarters in Rocklin, California. Financial Pacific owns 2.9 acres of land adjacent to its office building, carried at $1.3 million. Financial Pacific also owns a townhouse, used for corporate purposes, in Rocklin, California carried at $0.4 million.
Unallocated ESOP shares at December 31, 2006, 2005, 2004 and 2003, are not reflected in weighted average shares.
Mercer Insurance Group, Inc., 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.
changes in prices of equity securities generally and those held by the Group specifically.
The reported loss development method relies on the assumption that, at any given state of maturity, ultimate losses can be 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 all stages of maturity. Historical “age-to-age” loss development factors were calculated to measure the relative development of an accident year from one maturity point to the next. We then selected appropriate age-to-age loss development factors based on these historical factors and use the selected factors to project the ultimate losses.
Financial Pacific evaluates commercial multi-peril liability reserves by segregating pre- and post-Montrose activity as well as segregating contractors 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.
The chart below displays case and IBNR reserves for the Group as of December 31, 2006 and 2005 by line of business:
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 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. In the years ended December 31, 2006, 2005 and 2004, we recorded a pre-tax charge to earnings of $121,000, $517,000, and $15,000, respectively, for write-downs of other than temporarily impaired securities. In 2006, these charges related to fixed income securities, in 2005 these charges related to preferred stocks and fixed income securities, and in 2004 these charges were primarily with respect to equity securities that we determined were other than temporarily impaired. Adverse investment market conditions, poor operating performance, or other adversity encountered by companies whose stock or fixed maturity securities we own could result in impairment charges in the future. The Group’s 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”, 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.
Amounts recoverable from property and casualty reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policy. Amounts paid for reinsurance contracts are expensed over the contract period during which insured events are covered by the reinsurance contracts.
Ceded unearned premiums and reinsurance balances recoverable on paid and unpaid loss and loss adjustment expenses are reported separately as assets, instead of being netted with the related liabilities, because reinsurance does not relieve us of our legal liability to our policyholders. Reinsurance balances recoverable are subject to credit risk associated with the particular reinsurer. Additionally, the same uncertainties associated with estimating unpaid loss and loss adjustment expenses affect the estimates for the ceded portion of these liabilities.
Many of the reinsurance treaties participated in by the Group 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.
Revenue and income by segment is as follows for the years ended December 31, 2006, 2005 and 2004:
Our premiums earned growth reflects the Group’s focus on growing the commercial lines book, while working within our underwriting standards. As the Group increases the net retention of the business it writes,
net premiums earned will increase. It is possible in 2007 that direct commercial and personal lines written premium may decline due to increased competition. The impact of increased retentions under our reinsurance program in 2007 may be offset in part by a decline in direct commercial lines written premium due to the increasingly competitive marketplace.
Dividend income and interest income on cash and cash equivalents was stable in 2006 at $0.5 million and $0.9 million, respectively, as compared to 2005 at $0.6 million and $0.7 million, respectively.
Investment expenses increased 15.3%, or $0.3 million, to $2.3 million in 2006 from $2.0 million in 2005. Although a full year of expenses are included for Financial Pacific as compared to only a quarter in 2005, investment expenses increased by only 15.3% in 2006 as compared to a 91.0% increase in gross investment income. This reflects cost savings achieved by the Group in consolidating investment strategies, policies and external advisors. As of January 1, 2006, the Group consolidated investment managers and uses only one manager/advisor for all insurance subsidiaries in the Group.
In the personal lines segment for 2006, we had an underwriting loss of $2.0 million, a GAAP combined ratio of 109.0%, a GAAP loss and loss adjustment expense ratio of 69.6% and a GAAP underwriting expense ratio of 39.4%, compared to an underwriting loss of $1.8 million, a GAAP combined ratio of 107.8%, a GAAP loss and loss adjustment expense ratio of 59.7% and a GAAP underwriting expense ratio of 48.1% in 2005.
Our personal lines performance, while benefiting from rate increases initiated in 2005 on our homeowners line of business and a redirection of our Pennsylvania personal auto book to better performing tiers of business, underperformed in both 2006 and 2005. The frequency and severity of losses in the personal lines book in 2006 was within the range of our normal expectations.
Underwriting expenses increased by $18.3 million, or 66.3%, to $45.9 million in 2006, as compared to $27.6 million in 2005. The 66.3% increase in underwriting expenses primarily reflects the 84.2% increase in net premiums earned, offset by the inclusion of Financial Pacific which operates at a lower expense ratio than that of the balance of the Group.
relating to grants of restricted stock. In addition to the charge relating to the transition to SFAS 123R, the Group’s 2006 underwriting expenses included a pre-tax charge of $687,000 associated with grants of restricted stock. During 2005, underwriting expenses included a pre-tax charge of $693,000 associated with grants of restricted stock.
Total revenues for 2005 were up 36.7%, or $21.8 million, over 2004 revenues to $81.3 million. This increase was due primarily to inclusion of the revenue of Financial Pacific since its acquisition, which added $15.9 million of revenue, or 26.7 percentage points of the 36.7% increase in revenue in 2005. Net premiums earned increased 34.0 %, or $19.0 million, to $74.8 million, with 24.9 percentage points, or $13.9 million of the 2005 increase, relating to the inclusion of Financial Pacific in the Group’s results. In 2005, net investment income increased 57.2% to $4.5 million, driven by higher short-term interest rates, and the inclusion of Financial Pacific’s net investment income since acquisition, which added $1.4 million, or 50.8 percentage points of the 57.2% increase. Realized gains increased 161.8% in connection with sales of mostly equity securities to fund the Financial Pacific acquisition. Realized gains also included in 2005 a gain of $122,000 relating to the mark-to-market fair value adjustment on interest rate swaps related to the floating-rate trust preferred securities.
In 2005, direct premiums written increased 40.2% over 2004 to $92.2 million from $65.8 million, or $26.5 million. Inclusion of Financial Pacific since its acquisition by the Group added $27.9 million in direct written premium, with the balance of the change attributable to a modest decline in personal lines premium as that book was re-directed, and more competitive pricing existed in the commercial lines marketplace.
The fixed income portfolio is invested 100 % in investment grade securities, with, as of December 31, 2005, an average rating of AAA, an average maturity of 5.3 years (excluding mortgage-backed securities), and an average tax equivalent yield of 4.57%. In order to enhance the yield on our fixed income
securities, our investments generally have a longer average maturity than the life of our liabilities. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations” under the subsection entitled “Quantitative and Qualitative Information about Market Risk.”
Fixed maturity investments with unrealized losses for less than twelve months are primarily due to changes in the interest rate environment. At December 31, 2005 the Group has 53 fixed maturity securities with unrealized losses for more than twelve months. Of the 53 securities with unrealized losses for more than twelve months, 46 of them have fair values of no less than 96% or more of cost, and the other 7 securities have a fair value greater than 92% of cost. The fixed income portfolio is invested 100% in investment grade securities, as of December 31, 2005, and these unrealized losses primarily reflected the current interest rate environment. The Group believes these declines are temporary.
The following table summarizes the length of time equity securities with unrealized losses at December 31, 2005 have been in an unrealized loss position:
In 2005, our commercial lines direct premiums written increased by $26.8 million, or 65.6%, to $67.7 million, as compared to the same period in 2004. The acquisition of Financial Pacific added $27.9 million, or 68.3 percentage points of the total. Commercial lines net premiums written increased $15.8 million, or 43.3%, to $52.3 million in the same period, of which $16.0 million, or 43.7 percentage points is attributable to the Financial Pacific acquisition. Net premiums earned increased 60.5% in 2005, or $19.6 million, to $52.0 million. Financial Pacific contributed $13.9 million, or 42.9 percentage points of the total increase. In an unusual situation impacting both direct and net written premium, the Group had a large master account with a premium of approximately $2.5 million, which was originally written on a thirteen month policy in December 2004, renew in January, 2006. Although the earned premium relating to this policy in 2005 is reported in the net premium earned above, it is not reflected in the direct and net written premium above because of its renewal date in 2006.
In the commercial lines segment for 2005, we had underwriting income of $5.6 million, a GAAP combined ratio of 89.3%, a GAAP loss and loss adjustment expense ratio of 57.3% and a GAAP underwriting expense ratio of 32.0%, compared to an underwriting gain of $5.6 million, a GAAP combined ratio of 82.8%, a GAAP loss and loss adjustment expense ratio of 31.9% and an underwriting expense ratio of 50.9% for the same period in 2004. Our commercial lines loss ratio for 2005 has been adversely affected by a modestly higher amount of large property and casualty losses as compared to 2004, however the volume of new claims in 2005 is generally favorable. In addition, Financial Pacific’s commercial lines tend to operate with higher loss ratios and lower expense ratios than the Group’s commercial lines business prior to the acquisition of Financial Pacific.
Personal lines direct premiums written decreased in 2005 by 1.5% to $24.5 million. Net premiums written was approximately flat with 2004, and net premiums earned decreased by 2.6%, or $611,000, to $22.8 million.
Besides the improved loss frequency resulting from the more moderate weather in 2005, the personal lines book benefited from the underwriting initiatives undertaken in both the homeowners and Pennsylvania personal automobile lines in the last two years. These initiatives included the reclassification of certain homeowners risks from our preferred program to our standard program, resulting in a higher premium, as well as modified underwriting standards relating to the types of Pennsylvania personal automobile risks the Group will write.
Underwriting expenses increased by $642,000, or 2.4%, to $27.6 million in 2005, as compared to 2004. This increase was principally attributable to an increase in other underwriting expenses, growth in commissions resulting from higher earned premium volume, and increased charges relating to corporate expenses and compensation expenses, including bonuses and agents profit-sharing, which were at higher levels than in 2004. In 2005, the Group had pre-tax external expense associated with Sarbanes - Oxley compliance of $693,000, and pre-tax expense of $693,000 associated with grants of restricted stock, for which expenses were $832,000 and $383,000, respectively, in 2004.
As part of the funding of the acquisition, Mercer Insurance Company, with the approval of the Pennsylvania Department of Insurance, paid an extraordinary dividend of $10 million on September 30, 2005, to Mercer Insurance Group, Inc. Mercer Insurance Company also entered into a loan agreement with Mercer Insurance Group, Inc., by which it advanced on September 30, 2005, a loan of $10 million with a 20-year note and a fixed interest rate of 4.75%, repayable in 20 equal annual installments. Mercer Insurance Group has no special limitations on its ability to take periodic dividends from its insurance subsidiaries except for normal dividend restrictions administered by the respective domiciliary state regulators as described above. Additionally, there is a covenant in the Group’s line of credit agreement that requires the Group to maintain at least 50% of its insurance companies capacity to pay dividends without state regulation pre-approval. The Group believes that the resources available to Mercer Insurance Group, Inc., will be adequate for it to meet its obligation under the note to Mercer Insurance Company, the line of credit and its other expenses.
Total liabilities increased 14%, or $47.8 million, to $391.1 million, at December 31, 2006, from $343.3 million at December 31, 2005, primarily a result of the increase in loss and loss adjustment expense reserves of $38.8 million or 18%. Other reinsurance balances increased $6.0 million or 32%, primarily due to an increase in contingent ceding commission payable relating to the profit share on reinsurance contracts.
Mercer Insurance Group, Inc. adopted a stock-based incentive plan at its 2004 annual meeting of shareholders. Pursuant to that plan, Mercer Insurance Group may issue a total of 876,555 shares, which
The retaliatory tax generally is imposed on foreign insurers when the foreign company’s home state (i.e., its state of incorporation or domicile) has a higher rate of premium tax than the state imposing the tax, in this case New Jersey. The basis for the Group’s protests was that the Division was denying the Group the benefits of New Jersey’s premium tax cap, which limits the premiums tax to the lesser of the Group’s New Jersey premiums or 12.5 percent of the Group’s total premiums received from both New Jersey and out-of-state policyholders. In its protests, the Group argued that the Division’s position was unconstitutional and was based on an incorrect interpretation of New Jersey law. The protests currently are pending with the Division’s Conferences and Appeals branch.
For several years, and concurrent with the processing of the Group’s protests of the retaliatory tax, certain other foreign insurers have been litigating virtually identical issues in New Jersey state courts. As a result of such litigation, the Division has held off on making a determination regarding the Group’s protests until a final judicial determination is made in such cases.
The Group expects that the Division shortly will issue a final determination with respect to the Group’s protests based on the opinion issued by the New Jersey Supreme Court. If, as the Group expects, the Division grants the Group’s protests, a portion or all of the retaliatory tax previously paid by the Group will be refunded. Any such refund would be reduced by related Federal income tax. Due to the contingencies involved, the Group has not accrued any refund of the retaliatory tax.
In June 2006, the FASB issued Interpretation No. 48 (FIN 48), “Accounting for Uncertainty in Income Taxes” which clarifies the accounting for income tax reserves and contingencies recognized in an enterprise’s financial statements in accordance with SFAS No. 109, “Accounting for Income Taxes”. This Interpretation also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. This Interpretation is effective for fiscal years beginning after December 15, 2006. The Group believes that the adoption of FIN 48 will not have a significant effect on operations, financial condition or liquidity.
In February 2006, the FASB issued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments”. This accounting standard permits fair value re-measurement for any hybrid financial instrument containing an embedded derivative that otherwise would require bifurcation; clarifies which interest-only strips and principal-only strips are not subject to the requirements of SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities”; establishes a requirement to evaluate interests in securitized financial assets to identify them as freestanding derivatives or as hybrid financial instruments containing an embedded derivative requiring bifurcation; clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives; and amends SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities”, to eliminate the prohibition on a qualifying special-purpose entity from holding a derivative financial instrument pertaining to a beneficial interest other than another derivative financial instrument. SFAS No. 155 is effective for all financial instruments acquired or issued after the beginning of an entity’s first fiscal year beginning after September 15, 2006. The Group is currently evaluating the impact that SFAS No. 155 will have, if any, on its consolidated financial statements.
In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities-Including an amendment of FASB Statement No. 115.” SFAS No. 159 permits companies to choose to measure many financial instruments and certain other items at fair value at specified election dates. Upon adoption, an entity shall report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting date. Most of the provisions apply only to entities that elect the fair value option. However, the amendment to SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” applies to all entities with available for sale and trading securities. SFAS No. 159 is effective as of the beginning of an entity’s first fiscal year that begins after November 15, 2007. The Group is currently evaluating the impact that SFAS No. 159 will have, if any, on its consolidated financial statements.
The Group and its subsidiaries have no significant contractual obligations at December 31, 2006, other than its insurance obligations under its policies of insurance, Trust preferred securities, a line of credit obligation, and operating lease obligations. Projected cash disbursements pertaining to these obligations, as projected at December 31, 2006, are as follows:
We have audited the accompanying consolidated balance sheets of Mercer Insurance Group, Inc. and subsidiaries as of December 31, 2006 and 2005, and the related consolidated statements of earnings, stockholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2006. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
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, 2006 and 2005, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2006, in conformity with U.S. generally accepted accounting principles.
The Company adopted Statement of Financial Accounting Standards No. 123 (R), Share Based Payment, effective January 1, 2006.
Mercer Insurance Group, Inc. and subsidiaries (collectively, the Group) includes Mercer Insurance Company (MIC), its subsidiaries Queenstown Holding Company, Inc. (QHC) and its subsidiary Mercer Insurance Company of New Jersey, Inc. (MICNJ), Franklin Holding Company, Inc. (FHC) and its subsidiary Franklin Insurance Company (FIC), and BICUS Services Corporation (BICUS). Effective October 1, 2005, Financial Pacific Insurance Group, Inc. (FPIG) was acquired through a subsidiary of MIG, and its subsidiaries Financial Pacific Insurance Company (FPIC) and Financial Pacific Insurance Agency (FPIA).
The Group’s business activities are separated into three operating segments, which are commercial lines of insurance, personal lines of insurance and the investment function. The commercial lines of business consist primarily of multi-peril and commercial auto coverage. These two commercial lines represented 61% and 14%, respectively, of the Group’s net premiums written in 2006. The personal lines business consists primarily of homeowners insurance in Pennsylvania and New Jersey and private passenger automobile insurance in Pennsylvania. These two personal lines represented 10% and 4%, respectively, of net written premiums in 2006.
The preparation of the accompanying financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the
reported amounts of revenues and expenses during the reporting period. Significant items subject to such estimates include liabilities for losses and loss adjustment expenses, deferred policy acquisition costs, reinsurance, deferred income tax assets and other than temporary impairment of investments. Actual results could differ from those estimates.
Mercer’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 53%, 28% and 8% of the 2006 direct premium written, 25%, 54%, and 16% of the 2005 direct premium written, and 0%, 78% and 22% of the 2004 direct premium written. Consequently, changes in the California, New Jersey or Pennsylvania legal, regulatory or economic environment could adversely affect the Group.
Due to periodic shifts in the portfolio arising from income tax planning strategies and asset-liability matching, as well as the need to be flexible in responding to changes in the securities markets and economic factors, management considers the entire portfolio of fixed-income securities as available for sale. Fixed-income securities available for sale are stated at fair value. Equity securities are carried at fair value. 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.
Cash and cash equivalents as of December 31, 2006 and 2005 include restricted cash of $683 and $1,057, respectively, consisting of funds held for surety bonds.
The fair value of an equity security the Group holds in a reinsurance company is estimated based on statutory book value because the security is not traded and because of restrictions placed on the investors. After receipt of a bona fide offer to purchase this security, the stock must first be offered to the investors or its other shareholders at the lower of statutory book value or the offered price. The investors also have the ability to determine that the potential purchaser is not appropriate and void such an offer. The carrying value of this investment was $938 and $1,134 at December 31, 2006 and 2005, respectively.
The Group applies the provisions of Statement of Position (SOP) 98-1, “Accounting for the Costs of Computer Software Developed or Obtained for Internal Use” to account for internally developed computer software costs. In accordance with SOP 98-1, the Group has capitalized $625, $718, and $916 in software development costs, respectively, in 2006, 2005 and 2004. These costs are amortized over their useful lives, ranging from three to five years, from the dates the systems technology becomes operational.
The Group makes grants of qualified (ISO’s) and non-qualified stock options (NQO’s), and non-vested shares (restricted stock) under its stock option plan. Stock options are granted at prices that are not less than market price at the date of grant, and are exercisable over a period of ten years for ISO’s and ten years and one month for NQO’s. Restricted stock grants vest over a period of three to five years.
As of December 31, 2006, the Group has $2,214 of unrecognized total compensation cost related to non-vested stock options and restricted stock. That cost will be recognized over the remaining weighted-average vesting period of 1.9 years, based on the estimated grant date fair value.
Goodwill is tested annually for impairment, and is tested for impairment more frequently if events and circumstances indicate that the asset might be impaired. An impairment loss is recognized to the extent that the carrying amount exceeds the asset’s fair value. This determination is made at the reporting unit level and consists of two steps. First, the Group determines the fair value of a reporting unit and compares it to its carrying amount. Second, if the carrying amount of a reporting unit exceeds its fair value, an impairment loss is recognized for any excess of the carrying amount of the reporting unit’s goodwill over the implied fair value of that goodwill. The implied fair value of goodwill is determined by allocating the fair value of the reporting unit in a manner similar to a purchase price allocation, in accordance with SFAS No. 141, “Business Combinations”. The residual fair value after this allocation is the implied fair value of the reporting unit goodwill. The Group has two reporting units with goodwill as of December 31, 2006 and 2005. The Group performed the annual impairment tests as of December 31, 2006 and 2005, and the results indicated that the fair value of the reporting units exceeded their carrying amounts.
The Group entered into five 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.
In September 2006, the Financial Accounting Standards Board (FASB) issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans.” This statement requires an employer to recognize the overfunded or underfunded status of a single-employer defined benefit postretirement plan as an asset or liability in its statement of financial position and to recognize changes in the funded status in the year in which the changes occur through comprehensive income. The adoption of SFAS No. 158 did not have a significant effect on operations, financial condition or liquidity.
In February 2006, the FASB issued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments”. This accounting standard permits fair value re-measurement for any hybrid financial instrument containing an embedded derivative that otherwise would require bifurcation; clarifies which interest-only strips and principal-only strips are not subject to the requirements of SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities”; establishes a requirement to evaluate interests in securitized financial
In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements”, which defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. The provisions of SFAS No. 157 are effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The Group is currently evaluating the impact that SFAS No. 157 will have, if any, on its consolidated financial statements.
The cost and estimated fair value of available-for-sale fixed-income and equity investment securities at December 31, 2006 and 2005 are shown below.
The estimated fair value and unrealized loss for securities in a temporary unrealized loss position as of December 31, 2006 are as follows :
There are 12 equity securities that are in an unrealized loss position at December 31, 2006. All of these securities have been in an unrealized loss position for less than six months. The Group believes these declines are temporary.
The amortized cost and estimated fair value of fixed-income securities at December 31, 2006, 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 gross realized investment losses included write-downs for the other than temporary impairment of securities totaling $121, $517, and $15 for the years ended 2006, 2005 and 2004, respectively.
Accumulated other comprehensive income was net of deferred income taxes of $1,451 and $1,469 applicable to net unrealized investment gains at December 31, 2006 and 2005, respectively.
As a result of changes in estimates of insured events in prior years, the liabilities for losses and loss adjustment expenses increased by $8.4 million in 2006 and decreased by $0.5 million and $0.9 million in 2005 and 2004, 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, 2006 by line of business. Amounts shown in the 2005 column of the table include information relating to Financial Pacific Insurance Company, which was acquired on October 1, 2005, and accounted for as a purchase business combination.
The Group performs credit reviews of its reinsurers, focusing on financial stability. To the extent that a reinsurer may be unable to pay losses for which it is liable under the terms of a reinsurance agreement, the Group is exposed to the risk of continued liability for such losses.
The Group also maintains a nonqualified unfunded retirement plan for its directors. The plan provides for monthly payments for life upon retirement, with a minimum payment period of ten years. The expense for this plan amounted to $145, $115, and $111 for 2006, 2005, and 2004 respectively. Costs accrued under this plan amounted to $897 and $786 at December 31, 2006 and 2005, respectively.
The Group also maintains nonqualified deferred compensation plans for its directors and officers. Under the plans, participants may elect to defer receipt of all or a portion of their fees or salary amounts, although there is no match by the Group. Amounts deferred by directors and officers, together with accumulated earnings, are distributed either as a lump sum or in installments over a period of not greater than ten years. Deferred compensation, including accumulated earnings, amounted to $1,222 and $974 at December 31, 2006 and 2005, respectively.
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 $(23), $16, and $5 for the years ended December 31, 2006, 2005, and 2004, respectively. The cash surrender value of the Company-owned life insurance totaled $1,003 and $865 at December 31, 2006 and 2005, respectively, and is included in other assets.
On December 15, 2003, Mercer Insurance Group, Inc. was formed from the conversion of Mercer Mutual Insurance Company from the mutual to the stock form of ownership (“the Conversion”). The Group established an Employee Stock Ownership Plan (ESOP) and issued 626,111 shares to the ESOP at the Conversion offering price. 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%. 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 described in the plan. During 2006, 2005 and 2004, 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 2006, 2005 and 2004 the Group recognized compensation expense of $1,253, $832 and $779, respectively, related to the ESOP. As of December 31, 2006, the cost of the 375,667 shares issued to the ESOP but not yet allocated to its employee participants is classified within equity as unearned ESOP shares.
Under Pennsylvania law, there is a maximum amount of dividends that may be paid by Mercer Insurance Company to Mercer Insurance Group during any twelve-month period after notice to, but without prior approval of, the Pennsylvania Insurance Department. This limit is the greater of 10% of Mercer Insurance Company’s statutory surplus as reported on its most recent annual statement filed with the Pennsylvania Insurance Department, or the net income of Mercer Insurance Company for the period covered by such annual statement. As of December 31, 2006, the amounts available for payment of dividends from Mercer Insurance Company in 2007, without the prior approval of the Pennsylvania Insurance Department is approximately $5.9 million. In 2005, Mercer Insurance Company applied for, and received, approval to pay an extraordinary dividend of $10 million, which was used in connection with the acquisition of Financial Pacific Insurance Group, Inc. (see note 11).
On October 1, 2005, the Group acquired all of the outstanding common stock of Financial Pacific Insurance Group, Inc. for $41,107 in cash (including related transaction costs), and its results of operations have been included in the consolidated financial statements of the Group since that date (see note 1(a)). The acquisition was made through a merger whereby FPIG Acquisition Corp, a Delaware corporation wholly owned by the Group, merged with and into Financial Pacific Insurance Group, Inc., which then became the surviving entity operating under the Certificate of Incorporation and Bylaws of FPIG Acquisition Corp. as a wholly owned subsidiary of the Group. Accordingly, this transaction has been accounted for as a purchase business combination by applying fair value estimates to the acquired assets, liabilities and commitments of Financial Pacific Insurance Group, Inc. as of October 1, 2005. A holdback of 11% of the purchase price was held in escrow for a period of one year relating to the terms of the acquisition agreement. This holdback was released without reduction in 2006.
The following unaudited pro forma information presents the combined results of operations of Mercer Insurance Group, Inc. and Financial Pacific Insurance Group, Inc. for the twelve months ended December 31, 2005 and 2004, respectively, with pro forma purchase accounting adjustments as if the acquisition had been consummated as of the beginning of the periods presented. This pro forma information is not necessarily indicative of what would have occurred had the acquisition and related transactions been made on the dates indicated, or of future results of the Group.
The goodwill associated with the acquisition of Financial Pacific Insurance Group, Inc. will not be tax-deductible.
The denominator for diluted earnings per share does not include the effect of outstanding stock options that have an anti-dilutive effect. As of December 31, 2006, 40,000 stock options were considered to be anti-dilutive and were excluded from the earnings per share calculation.
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 January 1, 2007, the Plan’s authorization has been increased under this feature to 1,075,870 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 price may not be less than fair market value on the date of grant. The 2004, 2005 and 2006 grants 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 2006, the Group made grants of 10,000 shares of restricted stock, grants of 26,550 incentive stock options and grants of 13,450 non-qualified stock options. A total of 14,000 shares of restricted stock, 35,075 incentive stock options and 27,425 non-qualified stock options were forfeited during 2006. No options granted under the plan have been exercised as of December 31, 2006. Upon exercise, it is anticipated that new shares will be issued to the option holder.
The Group becomes involved with certain claims and legal actions arising in the ordinary course of business operations. Such legal actions involve disputes by policyholders relating to claims payments
During 2003 and 2004 the Group paid an aggregate of $3.2 million, plus interest, to the New Jersey Division of Taxation (the “Division”) in retaliatory tax. In conjunction with making such payments, the Group filed notices of protest with the Division with respect to the retaliatory tax imposed. The payments were made in response to notices of deficiency issued by the Division to the Group.
As of December 31, 2006, the Group occupied office space and leased equipment and vehicles under various operating leases that have remaining noncancelable lease terms in excess of one year. Operating leases extending beyond 2009 represent two five-year lease option extensions relating to the FPIG office building in Rocklin, California. Although these options are cancelable, the Group currently intends on exercising these lease extension options. A summary of minimum future lease commitments, including the options on the FPIG building, as of December 31, 2006 follows:
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 2006, 2005, and 2004, premiums written through Davis totaled 4%, 8% and 12%, respectively, of the Group’s direct written premiums. Commissions paid to Davis were $1,187, $1,231 and $1,336 in 2006, 2005, and 2004, respectively.
Van Rensselaer, Ltd., which is owned by William V.R. Fogler, a director, has provided equities investment management services to the Group since the year 2000. Fees to Van Rensselaer, Ltd. amounted to $117, $161 and $166 in 2006, 2005 and 2004.
Thomas, Thomas & Hafer of Harrisburg, PA is a law firm the Company uses for claims handling assistance. The brother of the Chief Executive Officer of the Group is a partner of the firm. Fees to Thomas, Thomas & Hafer amounted to $73, $52 and $16 in 2006, 2005 and 2004, respectively.
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 $1,000 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, 2006 is 9.37%.
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 $1,000 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, 2006 is 9.42%.