Mutual Insurance Holding Companies and for Certain Long-Duration Participating Contracts.” SOP 00-3 addresses financial statement presentation and accounting for stock conversion expenses and accounting for retained earnings and other comprehensive income at the date of the stock conversion.
Income of the Company attributable to the minority interest in Franklin Holding Company, which interest was acquired immediately after the Conversion for shares of the Company.
Unallocated ESOP shares at December 31, 2004 and 2003, are not reflected in weighted average shares.
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 condensed 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.
Mercer Insurance Company of New Jersey, Inc., a New Jersey property and casualty stock insurance corporation offering insurance coverages to businesses and individuals located in New Jersey; and
Our income is principally derived from insurance premiums received from insureds in the commercial lines (businesses insured) and personal lines (individuals insured) segments, less the costs of underwriting the insurance policies, the costs of settling and paying claims reported on the policies, and from investment income reduced by investment expenses, and from gains or losses on holdings in our investment portfolio. Variability in our income is caused by a variety of circumstances, some within the control of our companies
and some not within their control. Premium volume is affected by, among other things, the availability of quality, properly-priced underwriting risks being produced by our agents, the ability to retain on renewal existing good-performing accounts, competition from other insurance companies, regulatory rate approvals, our reputation, and other limitations created by the marketplace or regulators. Our underwriting costs are affected by, among other things, the amount of commission and profit-sharing we pay our agents to produce the underwriting risks we receive premiums for, the cost of issuing insurance policies and maintaining our customer and agent relationships, marketing costs, taxes we pay to the states we operate in on the amount of premium we collect, and other assessments and charges imposed on our companies by the regulators in the states in which we do business. Our claim and claim settlement costs are affected by, among other things, the quality of our underwriting accounts, severe weather in our operating region, the nature of the claim, the regulatory and legal environment in our territories, inflation in underlying medical and property repair costs, and the availability and cost of reinsurance. Our investment income and realized gains and losses are determined by, among other things, market forces, the rates of interest and dividends paid on our portfolio holdings, the credit or investment quality of the issuer and the success of its underlying business, the market perception of the company invested in, and other factors such as ratings by rating agencies and analysts.
The property and casualty industry has incurred substantial aggregate losses from claims related to asbestos-related illnesses, environmental remediation, product and construction defect liability, mold, and other uncertain or environmental exposures. We have not experienced significant losses from these types of claims.
In evaluating the potential impairment of equity securities, the Investment Committee will evaluate certain factors, including but not limited to the following: the relationship of market price per share versus
carrying value per share at the date of acquisition and the date of evaluation, the price-to-earnings ratio at the date of acquisition and the date of evaluation, any rating agency announcements, the issuer’s financial condition and near-term prospects, including any specific events that may influence the issuer’s operations, the independent auditor’s report on the issuer’s financial statements; and any buy/sell/hold recommendations or price projections by outside investment advisors.
We have one significant non-traded equity security, a non-voting common stock in Excess Reinsurance Company, which is carried at $1.1 million. Excess Reinsurance Company paid a special dividend in 2004 to the Group in the amount of $274,000. Its fair value is estimated at the statutory book value as reported to the National Association of Insurance Commissioners (NAIC). Other non-traded securities, which are not material in the aggregate, are carried at cost.
We defer policy acquisition costs, such as commissions, premium taxes and certain other underwriting expenses that vary with and are directly related to the production of business. These costs are amortized over the effective period of the related insurance policies. The method followed in computing deferred policy acquisition costs limits the amount of deferred costs to their estimated realizable value, which gives effect to the premium to be earned, related investment income, loss and loss adjustment expenses, and certain other costs expected to be incurred as the premium is earned. Future changes in estimates, the most significant of which is expected loss and loss adjustment expenses, may require acceleration of the amortization of deferred policy acquisition costs.
We use the asset and liability method of accounting for income taxes. Deferred income taxes arise from the recognition of temporary differences between financial statement carrying amounts and the tax bases of our assets and liabilities. A valuation allowance is provided when it is more likely than not that some portion of the deferred tax asset will not be realized. The effect of a change in tax rates is recognized in the period of the enactment date.
Revenue and income by segment is as follows for the years ended December 31, 2004, 2003 and 2002
Our growth in premiums and underwriting results have been, and continue to be, influenced by market conditions. Pricing in the property and casualty insurance industry historically has been cyclical. During a soft market cycle, price competition is prevalent and makes it difficult to write and retain properly priced personal and commercial lines business. Our policy is to maintain our disciplined underwriting and pricing standards during soft markets, even at the expense of premium growth. After a sustained soft market cycle, the insurance industry entered into a hard market cycle in approximately early 2000, which continued into 2004. Beginning in 2004, the industry has seen increasing competition and a softening of rates in many markets, many of which we compete in, and particularly in property exposures. If market rates continue to soften, it may have a negative impact on our ability to grow, and on our underwriting margins. The cyclicality of the market, and its potential impact on our results, is difficult to predict with any significant reliability.
tornados, and windstorms, all of which resulted in a higher than usual frequency of claims throughout most of 2003.
Loss development of prior year net loss and loss adjustment expense reserves was a favorable $0.9 million in 2004 and was generally attributable to accident years 2002 and 2003 for commercial multi-peril, commercial auto and other liability. Loss reserves for these and all other lines of business have been established based on company trends and our consideration of industry trends, and recent settlement of reported cases has been favorable. This favorable development is a reflection of the disciplined underwriting employed by the Company in its risk selection process.
Direct premiums written increased 7.6% to $65.8 million in 2004, reflecting the return of the market to a more competitive pricing posture and the Company’s reluctance to take on underwriting risks which are priced inappropriately. Net premiums written increased 12.7% in 2004, a higher growth rate over that of the direct premiums written reflecting the increased retention under the Company’s reinsurance program in 2004. Net premiums earned increased by 16.5% to $55.8 million in 2004.
In implementing the investment policy guidelines and directions of the Investment Committee of the Board of Directors, the fixed income securities managers have changed the composition of the fixed income securities portfolio to be more heavily weighted in tax-exempt securities, industrial and miscellaneous fixed income securities, and mortgage-backed securities, and less heavily weighted towards U.S government and government agencies fixed income securities. The portfolio remains invested 100% in investment grade fixed income securities, with, as of December 31, 2004, an average rating of AAA, an average duration of 3.7 years (excluding mortgage-backed securities), and average tax equivalent yield of 4.17%. Our average portfolio duration exceeds that of our insurance liabilities, however the portfolio maturities are laddered to ensure adequate liquidity.
Underwriting expenses increased by $4.9 million, or 22.4%, to $27.0 million for 2004, from 2003. This increase was principally attributable to an increase in other underwriting expenses, growth in commissions resulting from higher 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 2003. In 2004, the Company had pre-tax costs associated with Sarbanes - Oxley compliance of $832,000, for which there were no costs in 2003, pre-tax costs of $383,000 associated with grants of restricted stock, for which there were no costs in 2003, and pre-tax costs of $874,000 associated with the allocation of shares to employee participants by the ESOP for 2004, for which the 2003 pre-tax cost was $568,000.
Federal income tax expense was $1.1 million for 2004, an effective rate of 25.1%, compared to $174,000, an effective rate of 19.6%, in 2003. The increase in the effective tax rate in 2004 is primarily attributable to the fact that tax-exempt investment income and dividend income (which reduce the effective tax rate) represented a smaller percentage of net income in 2004 than in 2003.
For the year ended December 31, 2003, the Company had net income of $583,000 compared to $2.2 million for the same period in 2002. Although the underwriting gain from our commercial lines segment for 2003 increased 7.5% from the prior year to $3.1 million, our personal lines segment incurred an underwriting loss of $5.0 million in 2003, an increased loss of $3.5 million over the prior comparable period. In our investment segment, net investment income decreased in 2003 by $354,000, when compared to 2002, and realized gains for 2003 were $703,000, as compared to a net realized loss of $220,000 for 2002.
In the personal lines segment for 2003, we had an underwriting loss of $5.0 million, a combined ratio of 122.6%, a loss and loss adjustment expense ratio of 80.3% and an underwriting expense ratio of 42.3%, compared to an underwriting loss of $1.4 million, a combined ratio of 107.0%, a loss and loss adjustment expense ratio of 62.8% and an underwriting expense ratio of 44.2% for 2002.
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 settlement of reported cases has been favorable. In addition, we originally had expected a development of losses that was more in line with the industry, but this has not occurred. These factors have resulted in the favorable development indicated and are a reflection of the disciplined underwriting employed by the Company. Favorable development was also present in other lines of business and resulted from the normal claims review process, and not from changes in key assumptions or reserving philosophy.
We also expect underwriting expenses to moderate in future periods because we intend to significantly reduce the amount of business written in Mercer Insurance Company, the New Jersey business of which became subject to New Jersey’s retaliatory premium tax when it redomesticated to Pennsylvania in 1997. We plan to do this by renewing, to the extent possible, Mercer Insurance Company premium volume in Mercer Insurance Company of New Jersey, Inc., our New Jersey domestic insurer that is not subject to this retaliatory tax. We had not previously renewed policies in our New Jersey subsidiary because only policyholders of Mercer Insurance Company, domiciled in Pennsylvania, had subscription and voting rights. Therefore, renewing policies in the New Jersey subsidiary before completion of the Conversion would have denied subscription rights to Mercer Insurance Company’s policyholders and disenfranchised them. The cost of the additional premium tax was $738,000 for 2003 and $607,000 for 2002.
The principal source of liquidity for Mercer Insurance Group will continue to be the net proceeds it retained from the Conversion stock offering, and dividend payments (when allowed by regulators) 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.
law sets the maximum amount of dividends that may be paid, which amount cannot exceed the greater of 10% of Mercer Insurance Company of New Jersey, Inc.’s statutory surplus as reported on the most recent annual statement filed with New Jersey, or the net income, not including realized capital gains, for the period covered by the annual statement. The New Jersey Department has the power to limit or prohibit dividend payments if certain conditions exist. These restrictions or any subsequently imposed restrictions may affect our future liquidity. As of December 31, 2004, the amount available for payment of dividends by Mercer Insurance Company of New Jersey, Inc. to Mercer Insurance Company in 2005 without the prior approval of New Jersey Department of Banking and Insurance is approximately $1.6 million.
Total assets increased 2.6%, or $4.6 million to $180.4 million, at December 31, 2004 from December 31, 2003. Increased premium volume drove increases in premium receivables of $2.1 million, or 23%, and deferred policy acquisition costs of $627,000, or 8%. Reinsurance receivables decreased $2.5 million, or 60%, due to higher retentions under the Company’s reinsurance agreements. Investments increased $1.8 million, or 1%, to $125.1 million, and cash balances increased $939,000, or 6%. Other assets decreased $1.6 million, or 59%, to $1.1 million, principally due to a Federal Income Tax refund received in 2004.
Total liabilities increased 3%, or $2.5 million, in 2004, to $80.0 million. Increased premium volume is primarily responsible for the increase in unearned premium reserves of $3.7 million, or 12%. Loss and loss expense reserves decreased $1.2 million, or 3%, as a result of the payment of a large number of case reserves related to claims accrued but unpaid at the end of 2003, and which related to the unusually high claims frequency experienced by the Company in late 2003.
In connection with the Conversion, the ESOP was established, and purchased 626,111 shares from the Company in return for a note bearing interest at 4% on the principal amount of $6,261,110. Mercer Insurance Company will make annual contributions to the ESOP sufficient to repay that loan to the Company. It is anticipated that the loan will be repaid in 10 equal annual installments, and that, in proportion to annual principal and interest payments, approximately 10% of the original ESOP shares will be allocated annually to employee participants of the ESOP. An expense charge will be booked ratably during each year for the shares committed to be allocated to participants that year, determined with reference to the fair market value of the Company’s stock at the time the commitment to allocate the shares is accrued and recognized. The issuance of the shares to the ESOP was fully recognized in the Additional Paid-in Capital account at Conversion, with a contra account entitled Unearned ESOP Shares established in the Stockholders’ Equity section of the balance sheet for the unallocated shares at an amount equal to their original per-share purchase price.
Mercer Insurance Group 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, 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, or 250,000 shares, may be used to make restricted stock awards under the stock-based incentive plan. The number of shares available for issuance under the plan will increase automatically each year by 1% of the number of shares outstanding at the end of the preceding year. 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. 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. As described in the following paragraph, the Company undertook to repurchase shares as a partial offset to the stock incentive plan issuances. During 2004, the Company made grants of 215,000 shares
The Company and its subsidiaries have no significant contractual obligations at December 31, 2004, other than its insurance obligations under its policies of insurance. Projected cash disbursements pertaining to these insurance obligations, as projected at December 31, 2004, are as follows:
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Mercer Insurance Group, Inc. and subsidiaries as of December 31, 2004 and 2003, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2004, in conformity with U.S. generally accepted accounting principles.
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 both gross revenue and geographic concentration. Approximately 24%, 24% and 22% of the Company’s direct premiums written were produced in 2004, 2003 and 2002, respectively, by two agents, including one who is a related party (see Note 16 for information about related party transactions). In addition, the Company’s operating territory is limited to New Jersey and Pennsylvania, with 78%, 77%, and 77% of direct premiums written attributable to New Jersey for 2004, 2003, and 2002, respectively, and the balance attributable to Pennsylvania. Consequently, changes in
production by these two agents or in the New Jersey or Pennsylvania legal, regulatory or economic environment could adversely affect the Company.
The fair value of an equity security 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 investee or its other shareholders at the lower of statutory book value or the offered price. The investee also has the ability to determine that the potential purchaser is not appropriate and void such an offer. The carrying value of this investment was $1,116 and $1,203 at December 31, 2004 and 2003, respectively.
The liability for losses includes the amount of claims which have been reported to the Group and are unpaid at the statement date as well as provision for claims incurred but not reported, after deducting anticipated salvage and subrogation. The liability for loss adjustment expenses is determined as a percentage of the liability for losses based on the historical ratio of paid adjustment expenses to paid losses by line of business.
Management believes that the liabilities for losses and loss adjustment expenses at December 31, 2004 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.
Stock-based compensation plans are accounted for under the provisions of Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. Accordingly, no compensation expense is recognized for fixed stock option grants. Compensation expense would be recorded on the date of a stock option grant only if the current market price of the underlying stock exceeded the exercise price. The following table illustrates the effect on net income and earnings per share as if the provisions of Statement of Financial Accounting Standards (SFAS) No. 123 (as amended by SFAS No. 148), “Accounting for Stock-Based Compensation,” had been applied to all periods presented.
The Group uses the asset and liability method of accounting for income taxes. Deferred income taxes arise from the recognition of temporary differences between financial statement carrying amounts and the tax bases of the Group’s assets and liabilities and operating loss carryforwards. A valuation allowance is provided when it is more likely than not that some portion of the deferred tax asset will not be realized. The effect of a change in tax rates is recognized in the period of the enactment date.
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 Statement No. 141, “Business Combinations”. The residual fair value after this allocation is the implied fair value of the reporting unit goodwill. The Group has only one reporting unit with goodwill. The Group performed the annual impairment tests as of December 31, 2004 and 2003, and the results indicated that the fair value of the reporting unit exceeded its carrying amount.
There are three equity securities that are in an unrealized loss position at December 31, 2004. All three securities have been in an unrealized loss position for less than six months. The Group believes these declines are temporary.
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
The amortized cost and estimated fair value of fixed-income securities at December 31, 2004, 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.
The amortized cost of invested securities on deposit with regulatory authorities at December 31, 2004 and 2003 was $201 and $202, respectively.
The effect of reinsurance on unearned premiums as of December 31, 2004 and 2003 is as follows:
The Group also maintains a deferred compensation plan for its directors and officers. Under the plan, participants may elect to defer receipt of all or a portion of their fees or salary amounts. Amounts deferred, 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 $888 and $749 at December 31, 2004 and 2003, 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 $5, $32, and $133 for the years ended December 31, 2004, 2003, and 2002, respectively. The cash surrender value of the Company-owned life insurance totaled $767 and $597 at December 31, 2004 and 2003, respectively, and is included in other assets.
The utilization of the above net operating losses is subject to an annual limitation of approximately $379 per year.
The Group markets its products through independent insurance agents, which sell commercial lines of insurance to small to medium-sized businesses and personal lines of insurance to individuals.
The Group’s insurance companies are required by law to maintain a certain minimum surplus on a statutory basis, and are subject to risk-based capital requirements and to regulations under which payment of a dividend from statutory surplus is restricted and may require prior approval of regulatory authorities. A condition imposed in connection with the approval by the Pennsylvania Department of Insurance of the Conversion is that 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
The Company 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. The Plan limits 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 authorized in the plan is 876,555 shares, with an annual increase equal to 1% of the shares outstanding at the end of the previous year. 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 1 month for nonqualified stock options, and the option price may not be less than fair market value on the date of grant. The 2004 grants have vesting periods of 3 or 5 years on restricted stock, incentive stock options, and nonqualified stock options.
Included in the 2004 stock option grants were grants of 173,000 Incentive Stock Options, and 364,700 non-qualified stock options.
Grants of 215,000 shares of restricted stock were awarded to employees and non-employee Directors in 2004. The weighted average price per share on the grant date was $12.21 per share.
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 2004, 2003, and 2002, premiums written through Davis totaled 12%, 13% and 14%, respectively, of the Group’s direct written premiums. Commissions paid to Davis were $1,336, $1,314 and $1,182 in 2004, 2003, and 2002, respectively.
Note 1 - Earnings per share data for 2003 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.
Note 2 - Earnings per share for the periods prior to December 16, 2003 are not applicable because the Group was then organized as a mutual insurance company.