The following table sets forth selected consolidated financial data for Mercer Insurance Group, Inc. for the year of the Conversion, as well as the four years prior to the year of conversion. You should read this data in conjunction with the Company’s consolidated financial statements and accompanying notes, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and other financial information included elsewhere in this report.
(3) Includes Net Income and the change in Unrealized Gains and Losses of the investment portfolio.
(8) Unallocated ESOP shares at December 31, 2003, are not reflected in weighted average shares.
• Franklin Insurance Company, a property and casualty stock insurance company offering private passenger automobile and homeowners insurance to individuals located in Pennsylvania.
We manage our business and report our operating results in three operating segments: commercial lines insurance, personal lines insurance and the investment function. See Note 9 of the notes to our consolidated financial statements included in this report. However, assets are not allocated to segments and are reviewed in the aggregate for decision-making purposes. Our commercial lines insurance business consists primarily of multi-peril and general liability and related coverages. Our personal lines insurance business consists primarily of homeowners and private passenger automobile insurance coverages. We market both the commercial and personal insurance lines through independent producers.
The liability for losses and loss adjustment expenses represents estimates of the ultimate unpaid cost of all losses incurred, including losses for claims that have not yet been reported to our insurance companies. The amount of loss reserves for reported claims is based primarily upon a case-by-case evaluation of the type of risk involved, knowledge of the circumstances surrounding each claim and the insurance policy provisions relating to the type of loss. The amounts of loss reserves for unreported claims and loss adjustment expenses are determined using historical information by line of insurance as adjusted to current conditions. Inflation is implicitly provided for in the reserving function through analysis of costs, trends and reviews of historical reserving results over multiple years.
Reserves are closely monitored and are recomputed periodically using the most recent information on reported claims and a variety of statistical techniques. Specifically, on 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 by line of business. We then apply these expected loss and loss adjustment expense ratios to in-force business to derive a reserve level for each line of business. This amount, together with reserves required by new reported claims and changes to existing case reserves, is compared to existing reserves to establish the adjustment to reserves that is required. 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, and legal and judicial trends with respect to theories of liability. Because of the nature of our business, which generally provides coverage for short-term risks, loss development is comparatively rapid and historical paid losses have been a reliable predictive measure of future losses.
In the discussions that follow, we use the term “loss development,” which refers to the calendar year income statement impact of changes in the provision for loss and loss adjustment expenses incurred in prior accident years.
If an equity security has a fair value below 50% of cost or remains below 80% of cost for more than three months, a review of the financial condition and operating prospects of the company is performed by the Investment Committee of the Board of Directors to determine if the decline in fair value is other than temporary. A specific determination is made for each such security. Other equity securities in an unrealized loss position not meeting these quantitative thresholds are evaluated considering, among other things, the magnitude and reasons for the decline and the prospects for the fair value of the securities to recover in the near term. If it is determined that the decline in fair value is judged to be “other than temporary” then the cost basis of the security is written down to “realizable value” and the amount of the write down is accounted for as a realized loss. “Realizable value” is defined as the quoted
A fixed maturity security review for collectibility is done if any of the following situations occur:
• A review of the financial condition and prospects of the company performed by the Investment Committee indicates that the security should be evaluated.
• Moody’s or Standard & Poors rate the security below investment grade.
• The security has a fair value below 70% of amortized cost at quarter end due to deterioration in credit quality.
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 appropriate 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.
Our results of operations are influenced by factors affecting the property and casualty insurance industry in general. The operating results of the United States property and casualty insurance industry are subject to significant variations due to competition, weather, catastrophic events, regulation, general economic conditions, judicial trends, fluctuations in interest rates and other changes in the investment environment.
Revenue and income by segment is as follows for the years ended December 31, 2003, 2002 and 2001:
Net investment income decreased $354,000, or 17.2%, to $1.7 million in 2003, due to declining interest rates and an increase in investment expenses. Net realized gains increased to $703,000 in 2003, from a realized loss of $220,000 in 2002. In 2003, realized investment gains of $703,000 were comprised of gains on securities sales of $1,396,000, offset by other than temporary writedowns of $454,000 and losses on securities sales of $239,000. Of the equities included in the $454,000 of other than temporary writedowns, equities representing $358,000 of that total were sold in 2003 at a gain of $49,000. The losses from securities sales were comprised of $35,000 from the sale of bonds and $204,000 from the sale of equities. The following table summarizes the period of time that equity securities sold at a loss during 2003 had been in a continuous unrealized loss position:
Net loss and loss adjustment expenses incurred increased overall by $7.6 million, or 38.2%, to $27.7 million for 2003 from 2002. The increase in loss and loss adjustment expenses reflects the increase in commercial and personal lines volume and an increase in the frequency of personal lines losses. The increase in personal lines losses is attributable to harsher weather conditions for 2003 compared to 2002. After a number of winters with relatively mild weather conditions in our operating region, our first and fourth quarters suffered from unusually cold weather conditions. In addition, there was considerably more snow during the first quarter of 2003 compared to the same period in 2002. These conditions lead to losses from frozen pipes, structural collapses, more frequent automobile losses and slip-and-fall accidents. We also had unusual weather events in the second and third quarters, including hail, tornados, and windstorms, all of which resulted in a higher than usual frequency of claims. The increase in these losses is evidenced by the increase in the homeowners loss and loss expense ratio to 74.3% for 2003, compared to 68.1% for 2002, and an increase in the personal automobile loss and loss expense ratio to 94.5% for 2003, compared to 67.8% for 2002. Loss development of prior year net loss and loss adjustment expense reserves was a favorable $0.6 million and was generally attributable to accident years 1998 through 2002 for commercial multi-peril and commercial workers’ compensation. Loss reserves for the commercial multi-peril and workers’ compensation lines have been established based on company trends and our consideration of industry trends. Recent
Underwriting expenses increased by $3.0 million, or 16.1%, to $22.0 million for 2003, from 2002. This increase was principally attributable to an increase in expenses due to higher amortization of deferred policy acquisition costs resulting from higher premium volume, and the charge of $778,000 (pre-tax) associated with the allocation of shares to employee participants by the ESOP for 2003. We are currently in the process of converting our information system. When completed, we expect some costs to moderate as conversion costs and costs associated with operating dual systems end. These reduced costs will be offset by some higher staffing costs, but we also should be positioned to expand premium volume without material incremental expense because of increased processing capacity.
Federal income tax expense was $174,000 for 2003, an effective rate of 19.6%, compared to $1,155,000, an effective rate of 32.7%, in 2002. The decrease in the effective tax rate in 2003 is attributable to tax-exempt investment income being a larger percentage of net income than in the prior year.
Total revenues for 2002 were $42.6 million, which were $9.2 million or 27.4%, greater than 2001 revenues of $33.4 million. This increase was due to a $9.7 million increase in net premiums earned from 2001 to 2002, which is described below.
Net investment income decreased $364,000, or 15.0%, to $2.1 million for the year ended December 31, 2002, compared to the same period in 2001 due to declining interest rates. Net realized investment gains decreased by $262,000 for the year ended December 31, 2002, to a loss of $220,000 compared to a gain of $42,000 for the year ended December 31, 2001. This net realized loss was largely attributable to the writedown of $647,000 relating to equity securities that we determined were other than temporarily impaired compared to a writedown in 2001 of $185,000. Charges relating to securities that we determined were other than temporarily impaired are measured by comparing the market value of the security at the time of determination versus the cost basis of the security. These charges are included in net realized investment gains or losses.
At December 31, 2002, our bond portfolio was concentrated in U.S. government and government agency bonds with 80.2% of the bond portfolio in such bonds. None of the unrealized loss at December 31, 2002, pertained to bonds below investment grade or in securities not rated. Nearly all bonds were of investment grade and only 0.1% of bonds were below investment grade. The one below investment grade bond was carried at a fair value in excess of its cost because it had been written down in value in 2000. At December 31, 2002, our equity portfolio had a concentration in the financial services sector with 40% of equities invested in such securities. No other industry accounted for more than 10% of our equity portfolio.
For the year ended December 31, 2002, we had a combined ratio of 96.4%, a loss and loss adjustment expense ratio of 49.6% and an underwriting expense ratio of 46.8%, compared to a combined ratio of 93.6%, a loss and loss adjustment expense ratio of 47.3% and an underwriting expense ratio of 46.3% for the year ended December 31, 2001.
For the year ended December 31, 2002, loss and loss adjustment expense reserves for accident years 2001 and prior demonstrated favorable development of $2.1 million. This favorable development was attributable to a variety of lines of business and accident years. Homeowners accident year 1996 showed favorable loss development of $211,000 due to lower payouts on losses from a pooling agreement with other insurance carriers which was terminated in 1997 as well as lower payouts on Mercer’s losses. Homeowners accident year 2000 showed favorable development of $119,000 as reported losses for that accident year were lower than the provision established for claims incurred but not reported. Personal lines fire, allied and marine loss and loss adjustment expenses for accident year 2001 showed favorable development of $207,000 as Mercer’s share of mandatory residual market losses and loss expense were lower than expected as well as lower payouts on our own loss and loss expenses. Commercial multi-peril accident year 1998 showed favorable development of $114,000 due to settlement of losses at better than expected terms. Commercial multi-peril accident year 2001 showed favorable development of $424,000 as reported losses for that accident year were lower than the provision established for claims incurred but not reported. Provisions for such losses were established after consideration of industry trends, however, subsequent analysis indicated that Mercer’s book of business was performing better than the industry, largely because of strong underwriting and the absence of certain long tail exposures such as asbestos and environmental liabilities. Commercial general liability accident year 1998 showed favorable development of $322,000 as reported losses for that accident year were lower than the provision established for claims incurred but not reported. The reporting of losses for commercial general liability occurs sometimes long after the actual loss and thus estimated reserves are established for these incurred but not reported losses. A reevaluation of commercial general liability loss reserves for
the 1998 accident year indicated that loss and loss expenses are expected to be lower than originally estimated. The remaining favorable loss development was spread among all lines of business and accident years. In all cases, the favorable development resulted primarily from our normal claims review process during 2002 and not from any change in trends relating to the number of incurred or outstanding claims or settlement amounts, key assumptions or reserving philosophy. Multiple small changes in estimates occurred across all lines of business in 2002 as part of the normal review process, and there was no specific material change in estimate that should have been recognized in a prior period.
Our insurance companies generate sufficient funds from their operations and maintain a high degree of liquidity in their investment portfolios. The primary source of funds to meet the demands of claim settlements and operating expenses are premium collections, investment earnings and maturing investments. Mercer Insurance Company is expanding its existing facilities in Pennington, New Jersey, at a cost estimated at $2.7 million as of December 31, 2003. We are also in the process of building an information system platform that will allow our producers to conduct
their business through the Internet or through the method they have historically used. As of December 31, 2003, we have spent $2.1 million on the development of this platform, which includes license fees for software used in the platform. It is anticipated to be completed by June 30, 2005, at an additional cost of $1.0 million. Mercer Insurance Company possesses sufficient resources for these future expenditures without incurring any debt.
The principal source of liquidity for Mercer Insurance Group will be the net proceeds it retained from the Conversion stock offering of approximately $25 million, and dividend payments and other fees received from Mercer Insurance Company. For a period of three years after the Conversion, Mercer Insurance Company may not declare or pay any dividend to Mercer Insurance Group without the approval of the Pennsylvania Insurance Department. After this three-year period, Mercer Insurance Company will be restricted by the insurance laws of Pennsylvania as to the amount of dividends or other distributions it may pay to its holding company. Under Pennsylvania law, there is a maximum amount that may be paid by Mercer Insurance Company 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.
If the dividend restrictions imposed on Mercer Insurance Company related to the Conversion were not in effect, then as of December 31, 2003, the amounts available for payment of dividends from Mercer Insurance Company in 2004, without the prior approval of the Pennsylvania Insurance Department would have been approximately $5.8 million.
Total stockholders’ equity increased by $61.3 million, or 66%, due principally to the new capital received on the Conversion. Unrealized gains on the investment portfolio increased $1.5 million (after tax), or 50% in 2003 due principally to the strong equities market performance. This increased capitalization should permit us to (i) increase direct premium volume to the extent competitive conditions permit, (ii) increase net premium volume by decreasing our reliance on reinsurance, and (iii) enhance investment income by increasing our capital available for investment. Our 2003 investment income was not significantly affected by the new capital available for investment because the proceeds of the Conversion were received approximately two weeks prior to the end of 2003.
Mercer Insurance Group expects to adopt a stock-based incentive plan, subject to the approval of its shareholders at Mercer Insurance Group’s 2004 annual meeting of shareholders. Pursuant to that plan, Mercer Insurance Group may issue a total number of shares equal to 14% of the shares of common stock that were issued in the Conversion. Of this amount, an amount equal to 4% of the shares of common stock issued in the Conversion may be used to make restricted stock awards under the stock-based incentive plan. If the stock-based incentive plan is approved in 2004, the Company may purchase shares of its common stock in the open market and contribute those shares to the stock-based incentive plan for use in making restricted stock awards under that plan. Any such purchase will require the prior approval of the Pennsylvania Insurance Department. The fair market value of any common stock used for restricted stock awards will initially represent unearned compensation. As Mercer Insurance Group accrues compensation expense to reflect the vesting of such shares, unearned compensation will be reduced accordingly. This compensation expense will be deductible for federal income tax purposes upon vesting.
We have audited the accompanying consolidated balance sheets of Mercer Insurance Group, Inc. and subsidiaries (the Group) as of December 31, 2003 and 2002, 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, 2003. These consolidated financial statements are the responsibility of the Group’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
As discussed in note 1, the Group adopted the provisions of Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets, effective January 1, 2002.
The consolidated financial statements include the accounts of each member of the Group since the date of acquisition. The insurer affiliates within the Group participate in a reinsurance pooling arrangement (the Pool) whereby each insurer affiliate’s underwriting results are combined and distributed proportionately to each participant. Each insurer’s share in the Pool is based on their respective statutory surplus as of the beginning of each year. The effects of the Pool as well as all other significant intercompany accounts and transactions have been eliminated in consolidation. The consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America, which differ in some respects from those followed in reports to insurance regulatory authorities.
Due to periodic shifts in the portfolio arising from income tax and asset-liability matching, as well as securities markets and economic factors, management considers the entire portfolio of fixed-income securities as available for sale. Fixed-income securities available for sale and equity securities are stated at fair value with changes in fair value, net of deferred income tax, reflected in stockholders’ equity as accumulated other comprehensive income. Realized gains and losses are determined on the specific identification basis. A decline in the market value of an investment below its cost that is deemed other than temporary is charged to earnings.
Investments - The fair values for fixed-income securities available for sale are based on quoted market prices, when available. If not available, fair values are based on values obtained from investment brokers. Fair values for marketable equity securities are based on quoted market prices and on statutory equity for the security indicated below.
Premium and reinsurance receivables - The carrying amounts reported in the balance sheet for these instruments approximate their fair values.
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 monthly pro-rata method. Unearned premiums represent that portion of premiums written that are applicable to the unexpired terms of policies in force.
Management believes that the liabilities for losses and loss adjustment expenses at December 31, 2003 are adequate to cover the ultimate net cost of losses and claims to date, but these liabilities are necessarily based on estimates, and the amount of losses and loss adjustment expenses ultimately paid may be more or less than such estimates. Changes in the estimates for losses and loss adjustment expenses are recognized in the period in which they are determined.
In July 2002, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards (SFAS) No. 142, Goodwill and Other Intangible Assets. SFAS No. 142 applies to all acquired intangible assets whether acquired singularly, as part of a group, or in a business combination. SFAS No. 142 changes the accounting for goodwill and intangible assets with indefinite lives from an amortization method to an impairment-only approach. The Group adopted SFAS No. 142 on January 1, 2002. The amortization of goodwill from past business combinations ceased upon adoption of this statement.
Prior to the adoption of SFAS No. 142, goodwill was amortized on a straight-line basis over the expected periods to be benefited, of 15 years, and assessed for recoverability by determining whether the amortization of the goodwill balance over its remaining life could be recovered through undiscounted future operating cash flows of the acquired operation.
The cost and estimated fair value of available-for-sale investment securities at December 31, 2003 and 2002 are shown below.
(1) Original cost of equity securities; original cost of fixed-income securities adjusted for amortization of premium and accretion of discount.
The unrealized losses on fixed maturity investments with unrealized losses for less than twelve months were primarily due to changes in the interest rate environment. The Group has twelve fixed maturity securities with unrealized losses for more than twelve months. Of the twelve securities with unrealized losses for more than twelve months, eleven of them have fair values of 98% or more of cost, and the other security has a fair value greater than 96% of cost. The Group believes these declines are temporary.
The amortized cost and estimated fair value of fixed-income securities at December 31, 2003, by contractual maturity, are shown below. 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.
Proceeds from the sales of available-for-sale securities were $34,919, $35,594, and $33,262 in 2003, 2002, and 2001, respectively.
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. At December 31, 2003, one independent reinsurer accounted for approximately $1,700 of amounts recoverable for paid and unpaid losses and loss adjustment expenses.
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, 2003 and 2002.
During the year ended December 31, 2002, the Group reversed its previously recorded valuation allowance related to deferred tax assets of FHC based on revised estimates of future taxable income of FHC. In accordance with SFAS No. 109, Accounting for Income Taxes, this resulted in a reduction to goodwill, totaling $336 and an increase in minority interest in subsidiary totaling $349 (note 12).
On December 15, 2003, MIC converted from a mutual form of ownership to a stock form of ownership. The Group incurred $66 and $95 in 2003 and 2002, respectively, in the mutual to stock conversion.
On December 15, 2003, at the time of the Conversion the Group acquired the remaining minority interest in FHC in exchange for 502,525 shares of Group, with the result that at December 31, 2003 the Group owns 100% of FHC. Additional goodwill of $1,797 was recorded at the time the minority interest was acquired.
The changes in the carrying amount of goodwill for the years ended December 31, 2003 and 2002 are as follows:
The consolidated statements of earnings for the year ended December 31, 2001 include $98 of goodwill amortization. Following the adoption of SFAS No. 142, no goodwill amortization expense was recognized for the years ended December 31, 2003 and 2002. The following table adjusts the reported net income for the year ended December 31, 2001 on a pro forma basis assuming the provisions of SFAS No. 142 were adopted effective January 1, 2001:
As described in Note 1, the Conversion resulted in the issuance of common shares of the Group on December 15, 2003. Earnings per share are computed by dividing net income for the period subsequent to the Conversion by the weighted average number of common shares outstanding for the period of 6,252,884. There were no dilutive potential common shares outstanding during this period.
The Group produces a large percentage of its business through one insurance agent who is also an officer and board member of the companies within the Group, Davis Insurance Agency (Davis). In 2003, 2002, and 2001, premiums written through Davis totaled 13%, 14% and 10%, respectively, of the Group’s direct written premiums. Commissions paid to Davis were $1,314, $1,182 and $630 in 2003, 2002, and 2001, respectively.
Note 1 - Earnings per share data reflects only the net loss for the period from December 16, 2003, through December 31, 2003, the period subsequent to the Conversion. Net loss during this period was $477.