Through various wholly-owned subsidiaries, we also own and occupy additional office facilities in three other locations and rent additional office space for our insurance operations in 14 other locations. We believe that such owned and leased properties are suitable and adequate for our current business operations.
Operating income (loss), which is GAAP net income (loss) excluding net realized investment gains and losses, is the financial performance measure used by our management and Board of Directors to evaluate and assess the results of our insurance businesses because (i) net realized investment gains and losses are unpredictable and not necessarily indicative of current operating fundamentals or future performance of the business segments and (ii) in many instances, decisions to buy and sell securities are made at the holding company level, and such decisions result in net realized gains and losses that do not relate to the operations of the individual segments. Accordingly, we report operating income (loss) by segment in Note 15 of our Consolidated Financial Statements. Operating income (loss) does not replace net income (loss) as the GAAP measure of our consolidated results of operations.
The expense ratio equals the sum of acquisition and insurance-related operating expenses divided by net premiums earned. Acquisition and insurance-related operating expenses for The PMA Insurance Group were $110.1 million, $108.7 million, $129.7 million, $142.7 million and $108.6 million for 2006, 2005, 2004, 2003 and 2002, respectively.
The combined ratio computed on a GAAP basis is equal to losses and loss adjustment expenses, plus acquisition and insurance-related operating expenses and policyholders’ dividends, all divided by net premiums earned.
This Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) contains forward-looking statements, which involve inherent risks and uncertainties. Statements that are not historical facts, including statements about our beliefs and expectations, and statements containing words such as “believe,” “estimate,” “anticipate,” “expect” or similar words are forward-looking statements. These statements are based upon current estimates, assumptions and projections. Actual results may differ materially from those projected in such forward-looking statements, and therefore, you should not place undue reliance on them. See “Cautionary Statements” on page 57 for a list of factors that could cause our actual results to differ materially from those contained in any forward-looking statement. Also, see “Item 1A - Risk Factors” for a further discussion of risks that could materially affect our business.
We are a property and casualty insurance holding company which offers through our subsidiaries workers’ compensation and, to a lesser extent, other standard lines of commercial insurance, primarily in the eastern part of the United States. These products are written through The PMA Insurance Group business segment. The PMA Insurance Group segment also generates service revenues through our Third-Party Administrator (“TPA”) operations, which operates as PMA Management Corp. We have been growing such service revenues at a faster rate than our insurance revenues during the past two years, and such revenues amounted to $27.8 million in 2006, as compared to $23.8 million in 2005 and $23.1 million in 2004.
In September 2006, we entered into an agreement with Midwest General Insurance Agency (“MGIA”) under which MGIA underwrites and services workers’ compensation policies in California using our approved forms and rates. We cede 100% of the direct premiums and related losses on this business to non-affiliated reinsurers selected by us, including Midwest Insurance Company (“Midwest”), an affiliate of MGIA. All of the participating reinsurers, except for Midwest, have current A.M. Best financial strength ratings of “A-” (Excellent) or higher. Midwest does not have an A.M. Best financial strength rating. We have further mitigated our credit risk with Midwest by requiring them to secure amounts owed to us by holding cash in trust. We administer this business by utilizing our existing infrastructure and earn a fee based upon the actual amount of premiums earned. Total direct premiums written under this agreement were $14.8 million in 2006.
The PMA Insurance Group earns revenue and generates cash primarily by writing insurance policies and collecting insurance premiums. We also earn revenues by providing claims adjusting, managed care and risk control services to customers. As time normally elapses between the receipt of premiums and the payment of claims and certain related expenses, we are able to invest the available premiums and earn investment income. The types of payments that we make are:
loss adjustment expenses (“LAE”), which are the expenses of settling claims;
Included in 2006 results were after-tax net realized investment losses of $640,000, compared to after-tax net realized investment gains of $1.4 million in 2005. The after-tax net realized losses for 2006 were offset by $303,000 due to decreases in the fair value of the derivative component of our 6.50% Convertible Debt. The 2005 after-tax net realized investment gains primarily reflect sales reducing our per issuer exposure and general duration management trades. The after-tax net realized gains for 2005 were reduced by $2.4 million due to increases in the fair value of the derivative component of our 6.50% Convertible Debt.
Results for 2004 were also reduced by $3.9 million after-tax ($6.0 million pre-tax) which was attributable to our purchasing reinsurance that protects our statutory capital in the event of further adverse loss development at the Run-off Operations. Also included in 2004 results was an after-tax gain of $4.3 million ($6.6 million pre-tax) on the sale of a partnership interest.
In September 2006, we entered into an agreement with MGIA under which it underwrites and services workers’ compensation policies in California using our approved forms and rates. We cede 100% of the direct premiums and related losses on this business to non-affiliated reinsurers selected by us, including Midwest, an affiliate of MGIA. All of the participating reinsurers, except for Midwest, have current A.M. Best financial strength ratings of “A-” (Excellent) or higher. Midwest does not have an A.M. Best financial strength rating. We have further mitigated our credit risk with Midwest by requiring them to secure amounts owed to us by holding cash in trust. We administer this business by utilizing our existing infrastructure and earn a fee based upon the actual amount of premiums earned. Total direct premiums written under this agreement were $14.8 million in 2006.
Premiums assumed increased $1.1 million in 2006 and decreased $12.3 million in 2005, due primarily to fluctuations in our direct premiums written, compared to the immediately preceding years. Assumed premiums primarily relate to involuntary residual market business assigned to us. Companies that write premiums in certain states generally must share in the risk of insuring entities that cannot obtain insurance in the voluntary market. Typically, an insurer’s share of this residual market business is assigned on a lag based on its market share in terms of direct premiums in the voluntary market. These assignments are accomplished either by direct assignment or by assumption from pools of residual market business.
The operating expense ratio equals insurance-related operating expenses divided by net premiums earned. Insurance-related operating expenses were $36.4 million, $37.4 million and $43.7 million for 2006, 2005 and 2004, respectively. Total operating expenses also include amounts incurred related to our fee-based revenues.
The total expense ratio decreased 0.5 points in 2006, compared to 2005, as the increase in net premiums earned outpaced the increase in expenses. Overall operating expenses increased in 2006, compared to 2005, largely due to the additional amounts incurred related to the increase in our TPA revenues. We earn an administration fee under our agreement with Midwest based on the amount of premiums earned. Our 2006 acquisition expenses were reduced by $188,000 due to fees earned under this agreement. The 2005 total expense ratio increased 0.9 points, compared to 2004, primarily due to lower earned premiums. Overall operating expenses decreased in 2005, compared to 2004, primarily due to a reduction in head count.
Other revenues increased by $4.0 million in 2006, compared to 2005. The increase primarily reflected higher service revenues for claims, risk management and related services provided to self-insured and large deductible clients.
In November 2003, we withdrew from the reinsurance business previously served by our PMA Re operating segment and since that time, we have not written reinsurance business. As a result of this decision, the results of PMA Re are reported as Run-off Operations. Run-off Operations also includes the results of our former excess and surplus lines business, which we withdrew from in May 2002.
The Run-off Operations recorded pre-tax operating income of $1.2 million in 2006, a pre-tax operating loss of $26.9 million in 2005, and pre-tax operating income of $5.5 million for 2004. Net premiums earned, net investment income, losses and LAE, and acquisition and operating expenses decreased significantly in 2006, 2005 and 2004 due to our exit from the reinsurance business. Results of the Run-off Operations for past periods are not indicative of future results as we expect net premiums earned, net investment income, and acquisition and operating expenses to continue to decrease as we run-off this business.
Generally, trends in net premiums earned follow patterns similar to net premiums written. In periods of decreasing premium writings, the decrease in net premiums written will typically be greater than the decrease in net premiums earned, as was the case in 2004. Premiums are earned principally on a pro rata basis over the coverage periods of the underlying policies. However, with respect to policies that provide for premium adjustments, such as experience-rated or exposure-based adjustments, such premium adjustments may be made subsequent to the end of the policy’s coverage period and will be recorded as earned premiums in the period in which the adjustment is made, as was the case in 2006 and 2005.
improvement in 2006, compared to 2005, was primarily due to lower interest expense, which was partially offset by higher stock-based compensation expense. The lower interest expense resulted from reduced principal balances on outstanding debt in 2006, compared to 2005. The reason for the increased loss in 2005, compared to 2004, was primarily due to a higher interest expense. This increase was due to a higher average amount of debt outstanding and a higher average interest rate on our convertible debt.
The results were impacted by the sale of a real estate partnership interest that resulted in a pre-tax gain of $6.6 million, which is included in other revenues. Partially offsetting this gain was a pre-tax loss of $6.0 million related to the convertible debt exchange, including $4.7 million to record the 6.50% Convertible Debt at fair value and $1.3 million to write off the unamortized issuance costs on the 4.25% Convertible Debt.
Our consolidated unpaid losses and LAE, net of reinsurance, at December 31, 2006 and 2005 were $650.2 million and $793.1 million respectively, net of discount of $56.0 million and $59.8 million, respectively. Included in the consolidated unpaid losses and LAE are amounts related to our workers’ compensation claims of $410.7 million and $428.9 million, net of discount of $39.9 million and $40.4 million at December 31, 2006 and 2005, respectively. The discount rate used was approximately 5% at December 31, 2006 and 2005.
Additionally, reinsurers are dependent on their ceding companies for reporting information regarding incurred losses. The nature and extent of information provided to reinsurers may vary depending on the ceding company as well as the type of reinsurance purchased by the ceding company. Ceding companies may also independently adjust their reserves over time
as they receive additional data on claims and go through their own actuarial process for evaluating reserves. For casualty lines of reinsurance, significant periods of time may elapse between when a loss is incurred and reported by the ceding company’s insured, the investigation and recognition of such loss by the ceding insurer, and the reporting of the loss and evaluation of coverage by a reinsurer. As all of our reinsurance business was produced through independent brokers, an additional lag occurs because the ceding companies report their experience to the placing broker, who then reports such information to the reinsurer. Because of these time lags, and because of the variability in reserving and reporting by ceding companies, it takes longer for reinsurers to find out about reported claims than for primary insurers and such claims are subject to more unforeseen development and uncertainty.
We rely on various data in making our estimate of loss reserves for reinsurance. As described above, the reinsurer receives certain information from ceding companies through the reinsurance brokers. We assess the quality and timeliness of claims reporting by our ceding companies. The reinsurer also may supplement the reported information by requesting additional information and conducting reviews of certain of its ceding companies’ reserving and reporting practices. It also reviews its internal operations to assess its capabilities to timely receive and process reported claims information from ceding companies. It assesses its claims data and loss projections in light of historical trends of claims developments, claims payments, and also as compared to industry data as a means of noticing unusual trends in claims development or payment. Based on the data reported by ceding companies, the results of the reviews and assessments noted above, as well as actuarial analysis and judgment, we will develop our estimate of reinsurance reserves.
In the ordinary course of the claims review process, we independently verify that reported claims are covered under the terms of the reinsurance policy or treaty purchased by the ceding company. In the event that we do not believe coverage has been provided, we will deny payment for such claims. Most contracts contain a dispute resolution process that relies on arbitration to resolve any contractual differences. At December 31, 2006, the Run-off Operations did not have any material claims that were in the process of arbitration that have not been recorded as liabilities on the accompanying consolidated financial statements.
We believe that the potential for adverse reserve development is increased because our former reinsurance business is in run-off and we no longer have ongoing business relationships with most of our ceding companies. As a result, to the extent that there are disputes with our ceding companies over claims coverage or other issues, we believe that it is more likely that we will be required to arbitrate these disputes. Although we believe that we have incorporated this potential in our reserve analyses, we also believe that as a result of the nature of the reinsurance business and the fact that the reinsurance business is in run-off, there exists a greater likelihood that reserves may develop adversely in this segment.
See “Critical Accounting Estimates - Unpaid Losses and Loss Adjustment Expenses” beginning on page 51 for additional information. In addition, see “Cautionary Statements” on page 57 and “Item 1A - Risk Factors” for a discussion of factors that may adversely impact our losses and LAE in the future.
At December 31, 2006 and 2005, we had amounts receivable from our reinsurers and retrocessionaires totaling $1,040.0 million and $1,094.7 million, respectively. As of December 31, 2006 and 2005, $42.8 million, or 4% for 2006, and $54.8 million, or 5% for 2005, of these amounts were due to us on losses we have already paid. The remainder of the reinsurance receivables related to unpaid claims.
At December 31, 2006, we had reinsurance receivables due from the following unaffiliated reinsurers in excess of 5% of our shareholders’ equity:
In February 2006, A.M. Best downgraded the rating of PXRE Reinsurance Company (“PXRE”) to “B+” from “A-,” and in April 2006, PXRE’s rating was further downgraded to “B” and subsequently withdrawn shortly thereafter. Our collateral from PXRE is in the form of an investment portfolio that is held in trust for our benefit, and we believe that the investment securities, together with the interest earned thereon, will be sufficient to pay all billings that we submit.
At December 31, 2006, our reinsurance and retrocessional protection for major lines of business that we write was as follows:
Represents the amount of loss protection above our level of loss retention.
The PMA Insurance Group retains an aggregate $14.1 million deductible on the first layer of its workers’ compensation reinsurance, which is $750,000 excess of $250,000. Effective January 1, 2007, the aggregate deductible decreased to $13.8 million.
Certain portions of The PMA Insurance Group’s workers’ compensation reinsurance include coverage for terrorist acts. In 2006, our per occurrence reinsurance coverage for $5 million excess of $1 million included coverage for certified terrorist acts, except for certified nuclear, biological, chemical and radiological (“NBCR”) events, for one limit. Our 2006 coverage for terrorist acts on additional layers included, for one limit, one half of losses between $6 million and $10 million, all losses between $10 million and $50 million, and one half of losses above $50 million to $70 million, subject to our TRIEA retention, except for NBCR events. For NBCR events, our 2006 coverage included, for one limit, one half of losses for $24 million excess of our $2 million retention. Effective January 1, 2007, our reinsurance coverage for terrorist acts, except for NBCR events, was modified to cover $104 million excess of $1 million for one limit, subject to our TRIEA retention.
In 2004, we purchased reinsurance covering potential adverse loss development of the loss and LAE reserves of the Run-off Operations. Upon entering into the agreement, we ceded $100 million in carried loss and LAE reserves and paid $146.5 million in cash. During 2004, we incurred $6.0 million in ceded premiums for this agreement. During the first quarter of 2005, we ceded $30 million in losses and LAE under this agreement. See Note 4 to our Consolidated Financial Statements for additional information about prior year loss reserve development at the Run-off Operations recorded in 2005. Because the coverage is retroactive, we deferred the initial benefit of this cession, which is being amortized over the estimated settlement period of the losses using the interest method. Accordingly, we have a deferred gain on retroactive reinsurance of $25.4 million at December 31, 2006, which is included in accounts payable, accrued expenses and other liabilities on the Balance Sheet. Amortization of the deferred gain reduced loss and loss adjustment expenses by $1.7 million in 2006 and $2.8 million in 2005. As of December 31, 2006, we also had $25.8 million included in other assets for other receivables due under the contract, such as interest credited on prepaid amounts. Our net assets recorded on a statutory basis for this contract exceeded the consolidated GAAP net assets by $7.5 million at December 31, 2006.
At December 31, 2006, the Run-off Operations had $75 million of available coverage under this agreement for future adverse loss development. Any future cession of losses may require us to cede additional premiums of up to $28.3 million on a pro rata basis, at the following contractually determined levels:
Due to the unpredictable nature of terrorism and the deductible that The PMA Insurance Group must retain under TRIEA, if future terrorist attacks occur, they may result in losses that could have a material adverse effect on our financial condition, results of operations and liquidity. For additional information regarding the underwriting criteria of our operating segments, see “Item 1 - Business - The PMA Insurance Group, Underwriting.”
Operating cash flows were negative in 2006, 2005 and 2004, primarily due to the run-off of our reinsurance business, including the commutation and novation of certain reinsurance and retrocessional contracts of the Run-off Operations and the purchase of a reinsurance agreement covering potential adverse development at the Run-off Operations. See Notes 4 and 5 to the Consolidated Financial Statements for additional information regarding commutations and novations by the Run-off Operations and the reinsurance agreement covering potential adverse loss development, respectively. To a lesser extent, the impact of The PMA Insurance Group’s B++ financial strength rating between November 2003 and November 2004 also negatively impacted operating cash flows for 2004.
financial flexibility of PMA Capital. We monitor the expected payout of the liabilities associated with the Run-off Operations and generally adjust the duration of our invested assets to match the timing of expected payouts.
In its Order approving the transfer of the Pooled Companies from PMACIC to PMA Capital Corporation, the Pennsylvania Insurance Department prohibited PMACIC from declaring or paying any dividends, return of capital or other types of distributions to PMA Capital Corporation in 2004 and 2005. Under the terms of the Order, PMACIC was permitted to request an “extraordinary” dividend, as defined under Pennsylvania law, in 2006 provided that immediately after giving effect to the dividend or return of capital, PMACIC’s risk-based capital equaled or exceeded 225% of Authorized Control Level Capital, as defined by the National Association of Insurance Commissioners. In 2006, the Pennsylvania Insurance Department approved our request for an “extraordinary” dividend in the amount of $73.5 million from PMACIC. We used the proceeds to reduce our debt obligations and to maintain liquidity at the holding company. In 2007, PMACIC may declare and pay ordinary dividends without the prior approval of the Pennsylvania Insurance Department and is permitted to request an “extraordinary” dividend. Such “extraordinary” dividend must be approved by the Pennsylvania Insurance Department prior to payment. As of December 31, 2006, the statutory surplus of PMACIC was $121.6 million, which included $1.5 million of unassigned surplus, and its risk based capital ratio was 506% of Authorized Control Level Capital.
Our unpaid losses and LAE do not have contractual maturity dates and the exact timing of payments cannot be predicted with certainty. However, based on historical payment patterns, we have included an estimate, gross of discount of $186.2 million, of when we expect our unpaid losses and LAE (without the benefit of reinsurance recoveries) to be paid. We maintain an investment portfolio with varying maturities that we believe will provide adequate cash for the payment of claims.
In 2006, we repurchased $28.7 million principal amount of our 6.50% Convertible Debt. All of the open market purchases were made by PMA Capital Corporation, except for $3.3 million, which was made by one of our consolidated operating companies. We paid $32.3 million for these bond purchases, exclusive of accrued interest.
In 2006, we retired $2.6 million principal amount of our 8.50% Senior Notes through open market purchases. We paid $2.6 million for these bond purchases, exclusive of accrued interest. We have the right to call our 8.50% Senior Notes beginning in June 2008.
In October 2006, we entered into an interest rate swap that we have designated as a cash flow hedge to manage interest costs and cash flows associated with the variable interest rates on a portion of our junior subordinated debt. There was no consideration paid or received for this swap. The swap will effectively convert $7.5 million of the junior subordinated debt to fixed rate debt with an interest rate of 9.23%.
consideration paid or received for these swaps. The swaps will effectively convert $15.0 million of the junior subordinated debt to fixed rate debt with an interest rate of 9.52%.
In December 2005, we entered into interest rate swaps that we have designated as cash flow hedges to manage interest costs and cash flows associated with the variable interest rates on a portion of our junior subordinated debt and our Floating Rate Surplus Notes due 2035 (“Surplus Notes”). There was no consideration paid or received for these swaps. The swaps will effectively convert $20.0 million of the junior subordinated debt and $10.0 million of Surplus Notes to fixed rate debt with interest rates of 9.17% and 9.56%, respectively.
In September 2005, we issued, through one of our insurance subsidiaries, $10.0 million principal amount of Surplus Notes. The Surplus Notes may be redeemed in whole or in part on or after November 2, 2010. The Surplus Notes bear interest at an annual rate equal to the three-month London InterBank Offered Rate (“LIBOR”) plus 4.5%. At December 31, 2006, the interest rate on the Surplus Notes was 9.87%. All payments of interest and principal on these notes are subject to the prior approval of the Pennsylvania Insurance Department. We used the net proceeds of $9.7 million to purchase, in the open market, $9.2 million principal amount of our 6.50% Convertible Debt.
On November 15, 2004, we exchanged $84.1 million aggregate principal amount of 6.50% Convertible Debt for $84.1 million aggregate principal amount of 4.25% Convertible Debt. We did not receive any proceeds as a result of the exchange offer. The exchange allowed us to extend the first put date associated with our convertible debt from September 2006 to June 2009. Additionally, in November 2004, we received net proceeds of $15.2 million from the issuance of $15 million aggregate principal amount of 6.50% Convertible Debt in a private placement to a limited number of qualified institutional buyers.
In 2004, the Run-off Operations paid a $1 million fee to shorten the term of our Philadelphia office lease from fifteen years to seven years and reduce the leased space by approximately 75% effective October 1, 2004. This reduced our contractual obligations under the lease by $661,000 annually from 2005 through 2008, $870,000 in 2009 and $14.6 million thereafter. In addition to the reduced contractual obligations, we estimate that this change will also result in reduced related expenses of approximately $830,000 annually.
Under the terms of the sale of one of our insurance subsidiaries, PMA Insurance Cayman, Ltd. (renamed Trabaja Reinsurance Company), to London Life and Casualty Reinsurance Corporation in 1998, we have agreed to indemnify the buyer, up to a maximum of $15.0 million, if the actual claim payments in the aggregate exceed the estimated payments upon which the loss reserves of the former subsidiary were established. If the actual claim payments in the aggregate are less than the estimated payments upon which the loss reserves have been established, we will participate in such favorable loss reserve development. Trabaja Reinsurance Company is our largest reinsurer. As of December 31, 2006, we are not aware of any significant changes from our original estimate. See Note 5 to the Consolidated Financial Statements for additional information.
Our investment objectives are to (i) seek competitive after-tax income and total returns, (ii) maintain high investment grade asset quality and high marketability, (iii) maintain maturity distribution commensurate with our business objectives, (iv) provide portfolio flexibility for changing business and investment climates and (v) provide liquidity to meet operating objectives. Our investment strategy includes setting guidelines for asset quality standards, allocating assets among investment types and issuers, and other relevant criteria for our portfolio. In addition, invested asset cash flows, which includes both current interest income received and investment maturities, are structured to consider projected liability cash flows of loss reserve payouts using actuarial models. Property and casualty claim demands are somewhat unpredictable in nature and require liquidity from the underlying invested assets, which are structured to emphasize current investment income while maintaining appropriate portfolio quality and diversity. Liquidity requirements are met primarily through operating cash flows and maintaining a portfolio with maturities that reflect expected cash flow requirements.
Mortgage-backed and other asset-backed securities in the table above include collateralized mortgage obligations (“CMOs”) of $311.9 million and $200.7 million carried at fair value as of December 31, 2006 and 2005. CMO holdings are mostly AAA rated and concentrated in tranches with limited prepayment, extension and default risk, such as planned amortization class bonds.
The net unrealized loss on our investments at December 31, 2006 was $9.4 million, or 1.0% of the amortized cost basis. The net unrealized loss included gross unrealized gains of $4.3 million and gross unrealized losses of $13.7 million. For all but two securities, which were carried at a fair value of $17.2 million at December 31, 2006, we determine the market value of fixed income securities using prices obtained in the public markets. For these two securities, whose fair values are not reliably determined from these public market sources, we utilize the services of our outside professional investment asset managers to determine the fair value. The asset managers determine the fair value of the securities by using a discounted present value of the estimated future cash flows (interest and principal repayment).
We review the securities in our fixed income portfolio on a periodic basis to specifically identify individual securities for any meaningful decline in fair value below amortized cost. Our analysis addresses all securities whose fair value is significantly below amortized cost at the time of the analysis, with additional emphasis placed on securities whose fair value has been below amortized cost for an extended period of time. As part of our periodic review process, we utilize the expertise of our outside professional asset managers who provide us with an updated assessment of each issuer’s current credit situation based on recent issuer activities, such as quarterly earnings announcements or other pertinent financial news for the company, recent developments in a particular industry, economic outlook for a particular industry and rating agency actions. For structured securities, we analyze the quality of the underlying collateral of the security. We do not believe that there are credit related risks associated with our U.S. Treasury and agency securities.
At December 31, 2006, of the 215 securities that have been in an unrealized loss position for more than 12 months, 214 securities have an unrealized loss of less than $1 million each and less than 15% of each security’s amortized cost. These 214 securities have a total fair value of 97% of the amortized cost basis at December 31, 2006, and the average unrealized loss per security is approximately $24,000. There is only one security out of the 215 with an unrealized loss in excess of $1 million at December 31, 2006, and it has a fair value of $16.5 million and a par value and cost of $20.0 million. This security, which matures in 2011, is a structured security backed by a U.S. Treasury Strip, and is rated AAA. We have both the ability and intent to hold this security until it matures.
The contractual maturity of securities in an unrealized loss position at December 31, 2006 was as follows:
We had pre-tax net realized investment losses of $985,000 in 2006, compared to investment gains of $2.1 million in 2005 and $6.5 million in 2004. During 2006, we had gross realized investment gains and losses of $6.0 million and $7.4 million, respectively, on sales from our invested asset portfolio. The gross realized gains and losses resulted primarily from the repositioning of invested assets out of lower yielding sectors, such as corporate bonds, and into higher yielding sectors, such as structured securities, and reducing our overall risk in the portfolio by improving credit quality and shortening duration. Also included in 2006 net realized investment losses were realized gains of $466,000 related to the decrease in the fair value of the derivative component of our 6.50% Convertible Debt and realized losses of $104,000 related to the mandatory redemption and open market purchases of our 6.50% Convertible Debt.
Results for 2005 included gross realized gains and losses of $9.6 million and $4.6 million, respectively, from investment sales. Also included in 2005 net realized investment gains were realized losses of $3.7 million related to the increase in the fair value of the derivative component of our 6.50% Convertible Debt and gains of $650,000 on foreign exchange and $205,000 related to open market purchases of our 6.50% Convertible Debt. Gross realized investment losses in 2005 reflected sales reducing our per issuer exposure and general duration management trades and impairment losses of $1.0 million on fixed income securities.
Effective January 1, 2006, we adopted FASB Statement No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123R”), using the modified-prospective transition method. SFAS 123R requires all share-based payments to employees, including grants of employee stock options, be recognized as compensation expense in the income statement at fair value. Under the modified-prospective transition method, we recognized expense over the remaining required service period for stock options granted prior to January 1, 2006 for the portion of those grants for which the requisite service had not yet been rendered. No adjustment was made to prior period amounts nor was any expense recorded for options granted prior to January 1, 2006 for which the requisite service had been rendered by that date. As a result of adopting SFAS 123R, we expensed $602,000 related to stock options for the year ended December 31, 2006.
In September 2006, the FASB issued Statement of Financial Accounting Standards No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans” (“SFAS 158”). SFAS 158 requires that an employer recognize the overfunded or underfunded status of each defined benefit postretirement plan as an asset or liability in the statement of financial position. Changes in the funded status during any given period of time shall be recognized as a change in comprehensive income. The statement has no impact on the recognition of benefit costs. Our 2006 adoption of this statement resulted in a $13.5 million decrease in Other assets, a $15.2 million decrease in Accounts payable, accrued expenses and other liabilities, and a $1.1 million increase in Shareholders’ equity.
At December 31, 2006, we estimated that under all insurance policies and reinsurance contracts issued by our insurance businesses, our liability for all events that occurred as of December 31, 2006 is $1,634.9 million. This amount includes estimated losses from claims plus estimated expenses to settle claims. Our estimate also includes estimated amounts for losses occurring on or prior to December 31, 2006 whether or not these claims have been reported to us.
Within the workers’ compensation line of business, we review medical and indemnity costs separately. We undertake this review because we believe that the medical cost component of workers’ compensation claims has a different development pattern than the indemnity payments, and also because we believe that certain assumptions within the medical cost component, such as the rate of medical cost inflation, can lead to more volatility as compared to the indemnity component. At December 31, 2006, our medical loss reserves were approximately 46% of the workers’ compensation loss reserves, with the balance being indemnity costs. We also review the workers’ compensation line of business by state for some of our larger states. We undertake this review because workers’ compensation benefits vary by state and this can cause loss development patterns to vary by state.
We believe that the major factors that can cause actual results to vary from our estimates on our reinsurance business are changes in the experience and case reserving methodologies of our various ceding companies. This would affect the claims being reported to us, which, in turn, would affect our estimate of the frequency and severity of claims for the Run-off Operations. The long-tail nature of a significant portion of this business (in many cases, significant periods of time, ranging up to several years or more, may elapse between the occurrence of an insured loss, the reporting of the loss to us and our payment of that loss) is also a major factor that could impact reserve development.
Any changes to our range of loss reserve estimates, as discussed above, would also affect our assumptions regarding ceded reserves. To the extent that changes in our range of estimates resulted in a change to our carried reserves and the amount of reinsurance receivable against such carried reserves, the net result of these changes would directly affect our pre-tax income.
For additional factors that could impact our reserve estimates please see the risk factor entitled “Reserves are estimates and do not and cannot represent an exact measure of liability. If our actual losses from insureds exceed our loss reserves, our financial results would be adversely affected” on page 19 of this Report on Form 10-K.
The components of our (favorable) unfavorable development of reserves for losses and LAE for prior accident years by business segment, excluding accretion of discount, were as follows:
During 2006, the Run-off Operations recorded $5.3 million in favorable development, largely due to commutations of structured reinsurance treaties with some of our ceding companies. The Run-off Operations does not typically record favorable prior year loss development on commutations unless the treaties are structured reinsurance, where IBNR reserves are directly attributable to a treaty.
During 2004, the favorable prior year loss development at the Run-off Operations related primarily to reinsurance contracts that were novated or commuted. This favorable prior year loss development was substantially offset by a reduction in net premiums earned or increased acquisition expenses.
Based on our evaluation of reinsurance receivables at December 31, 2006, we have established an allowance for amounts that we have concluded are uncollectible at the balance sheet date. In evaluating collectibility, we considered historical payment performance of our reinsurers, the fact that our reinsurers are current on their obligations to our insurance subsidiaries, and any known disputes or collection issues as of the balance sheet date. To these factors, we applied our informed judgment in ascertaining the appropriate level of allowance for uncollectible amounts. At December 31, 2006, approximately $65.7 million of uncollateralized reinsurance receivables, including $38.1 million due for ceded IBNR, are due from reinsurers who have ratings that declined to below “Adequate,” defined as B++ or below by A.M. Best, or who were under regulatory supervision or in liquidation.
For additional information about reinsurance receivables, see Note 5 to the Consolidated Financial Statements as well as “Reinsurance” beginning on page 40.
The valuation allowance of $60.5 million reserves against $52 million of gross deferred tax assets related to the NOL carryforward and the $8.5 million projected deferred tax asset related to the AMT credit carryforward because we believe it is more likely than not that this portion of the benefit will not be realized. We will continue to periodically assess the realizability of our net deferred tax asset. If our estimates of future income were to be revised downward and we determined that it was then more likely than not that we would not be able to realize the value of our net deferred tax asset, then this could have a material adverse effect on our results of operations and financial condition. For additional information, see Note 12 to our Consolidated Financial Statements.
adverse property and casualty loss development for events that we insured in prior years, including unforeseen increases in medical costs and changing judicial interpretations of available coverage for certain insured losses;
our ability to have sufficient cash at the holding company to meet our debt service and other obligations, including any restrictions such as those imposed by the Pennsylvania Insurance Department on receiving dividends from our insurance subsidiaries in an amount sufficient to meet such obligations;
the outcome of any litigation against us, including the outcome of the purported class action lawsuits;
Consolidated Statements of Comprehensive Income (Loss) for the years ended December 31, 2006, 2005
Premiums receivable (net of valuation allowance: 2006 - $9,563; 2005 - $8,342)
Reinsurance receivables (net of valuation allowance: 2006 - $12,891; 2005 - $12,552)
B. Investments - All fixed maturities are classified as available-for-sale and, accordingly, are carried at fair value. Changes in fair value of fixed maturities classified as available-for-sale, net of income tax effects, are reflected in accumulated other comprehensive income (loss). All short-term, highly liquid investments, which have original maturities of one year or less from acquisition date, are treated as short-term investments and are carried at amortized cost, which approximates fair value.
C. Premiums - Premiums, including estimates of premiums resulting from audits of insureds’ records are earned principally on a pro rata basis over the terms of the policies. Any changes occurring or reported to the Company after the policy term are recorded as earned premiums in the period in which the adjustment is made. With respect to policies that provide for premium adjustments, such as experience-rated or exposure-based adjustments, such premium adjustments may be made subsequent to the end of the policy’s coverage period and will be recorded as earned premiums in the period in which the adjustment is made. Premiums applicable to the unexpired terms of policies in force are reported as unearned premiums. The estimated premiums receivable on experience-rated or exposure-based policies are reported as a component of premiums receivable. For reinsurance premiums assumed, management must estimate the subject premiums associated with the treaties in order to determine the level of written and earned premiums for a reporting period. Such estimates are based on information from brokers and ceding companies, which can be subject to change as new information becomes available.
E. Reinsurance - In the ordinary course of business, PMA Capital’s reinsurance and insurance subsidiaries assume and cede premiums with other insurance companies and are members of various insurance pools and associations. The Company’s insurance and reinsurance subsidiaries cede business in order to limit the maximum net loss and limit the accumulation of many smaller losses from a catastrophic event. The insurance and reinsurance subsidiaries remain primarily liable to their clients in the event their reinsurers are unable to meet their financial obligations. Reinsurance receivables include claims paid by the Company and estimates of unpaid losses and LAE that are subject to reimbursement under reinsurance and retrocessional contracts. The method for determining the reinsurance receivable for unpaid losses and LAE involves reviewing actuarial estimates of unpaid losses and LAE to determine the Company’s ability to cede unpaid losses and LAE under its existing reinsurance contracts. This method is continually reviewed and updated and any adjustments resulting there from are reflected in earnings in the period identified. Under certain of the Company’s reinsurance and retrocessional contracts, additional premium and interest may be required if predetermined loss and LAE thresholds are exceeded.
In February 2006, the FASB issued Statement of Financial Accounting Standards No. 155, “Accounting for Certain Hybrid Financial Instruments - an Amendment of FASB Statements No. 133 and 140” (“SFAS 155”). SFAS 155 is intended to simplify the accounting for certain hybrid financial instruments by permitting fair value remeasurement for any hybrid instrument that contains an embedded derivative that previously would have required bifurcation. The statement is effective for all financial instruments acquired, issued or subject to a remeasurement event in fiscal years that begin after September 15, 2006. The Company does not expect that the adoption of SFAS 155 will have a material impact on its consolidated financial statements.
In September 2006, the FASB issued Statement of Financial Accounting Standards No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans” (“SFAS 158”), which the Company was required to adopt in 2006. See Note 13 for the impact of this adoption.
The amortized cost and fair value of fixed maturities at December 31, 2006, by contractual maturity, were as follows:
On December 31, 2006, the Company had securities with a total amortized cost and fair value of $51.7 million on deposit with various governmental authorities, as required by law. In addition, the Company had securities with a total amortized
During 2005, the Run-off Operations recorded unfavorable prior year loss development of $28.8 million, which included a $30 million charge taken in the first quarter. In the first quarter of 2005, company actuaries identified higher than expected claim frequency and severity on policies covering contractors’ liability for construction defects from accident years 1998 to 2001 written by the Company’s former excess and surplus lines operation and an increase in reported losses and continued volatility in pro rata professional liability reinsurance business written from accident years 1997 to 2001. See Note 5 for information regarding applicable reinsurance coverage.
Unpaid losses and LAE for the Company’s workers’ compensation claims, net of reinsurance, at December 31, 2006 and 2005 were $410.7 million and $428.9 million, net of discount of $39.9 million and $40.4 million, respectively. The discount rate used was approximately 5% at December 31, 2006 and 2005.
companies that utilized the Run-off Operations as a retrocessionaire as a result of this decision. The Company does not believe that this decision will have a material impact on its financial condition or results of operations.
At December 31, 2006, 2005 and 2004, gross reserves for asbestos-related losses were $23.3 million, $26.9 million and $27.9 million, respectively ($10.6 million, $13.2 million and $14.0 million, net of reinsurance, respectively). Of the net asbestos reserves, approximately $6.6 million, $10.2 million and $10.3 million related to IBNR losses at December 31, 2006, 2005 and 2004, respectively.
Estimating reserves for asbestos and environmental exposures continues to be difficult because of several factors, including: (i) evolving methodologies for the estimation of the liabilities; (ii) lack of reliable historical claim data; (iii) uncertainties with respect to insurance and reinsurance coverage related to these obligations; (iv) changing judicial interpretations; and (v) changing government standards. Management believes that its reserves for asbestos and environmental claims have been appropriately established based upon known facts, existing case law and generally accepted actuarial methodologies. However, the potential exists for changes in federal and state standards for clean-up and liability and changing interpretations by courts resulting from the resolution of coverage issues. Coverage issues in cases in which the Company is a party include disputes concerning proof of insurance coverage, questions of allocation of liability and damages among the insured and participating insurers, assertions that asbestos claims are not products or completed operations claims subject to an aggregate limit and contentions that more than a single occurrence exists for purposes of determining the available coverage. Therefore, the Company’s ultimate exposure for these claims may vary significantly from the amounts currently recorded, resulting in potential future adjustments that could be material to the Company’s financial condition, results of operations and liquidity.
In 2004, the Company purchased reinsurance covering potential adverse loss development of the loss and LAE reserves of the Run-off Operations. Upon entering into the agreement, the Company ceded $100 million in carried loss and LAE reserves and paid $146.5 million in cash. During 2004, the Company incurred $6.0 million in ceded premiums for this agreement. During the first quarter of 2005, the Run-off Operations ceded $30 million in losses and LAE under this agreement. See Note for additional information about prior year loss reserve development at the Run-off Operations recorded in 2005. Because the coverage is retroactive, the Run-off Operations deferred the initial benefit of this cession, which is being amortized over the estimated settlement period of the losses using the interest method. Accordingly, the Company has a deferred gain on retroactive reinsurance of $25.4 million at December 31, 2006, which is included in accounts payable, accrued expenses and other liabilities on the Balance Sheet. Amortization of the deferred gain reduced loss and loss adjustment expenses by $1.7 million in and $2.8 million in 2005. As of December 31, 2006, the Company also had $25.8 million included in other assets for other receivables due under the contract, such as interest credited on prepaid amounts. The Company’s net assets recorded on a statutory basis for this contract exceeded the consolidated GAAP net assets by $7.5 million at December 31, 2006.
At December 31, 2006, the Company had reinsurance receivables due from the following unaffiliated reinsurers in excess of 5% of shareholders’ equity:
Includes Swiss Reinsurance America Corporation ($140.9 million), GE Reinsurance Corporation ($16.8 million) and other affiliated entities ($5.4 million).
Includes Munich Reinsurance America, Inc ($29.3 million) and American Alternative Insurance Company ($100,000).
The Company performs credit reviews of its reinsurers focusing on, among other things, financial capacity, stability, trends and commitment to the reinsurance business. Reinsurers failing to meet the Company’s standards are excluded from the Company’s reinsurance programs. In addition, the Company requires collateral, typically assets in trust, letters of credit or funds withheld, to support balances due from certain reinsurers, generally those not authorized to transact business in the applicable jurisdictions. At December 31, 2006 and 2005, the Company’s reinsurance receivables of $1,040.0 million and $1,094.7 million were supported by $425.6 million and $444.2 million of collateral. Of the uncollateralized reinsurance receivables as of December 31, 2006, approximately 89% was recoverable from reinsurers rated “A-” or better by A.M. Best.
The PMA Insurance Group has recorded reinsurance receivables of $13.9 million at December 31, 2006, related to certain umbrella policies covering years prior to 1977. The reinsurer has disputed the extent of coverage under these policies. The parties have commenced arbitration to resolve this dispute. The ultimate resolution of this dispute cannot be determined at this time. An unfavorable resolution of the dispute could have a material adverse effect on the Company’s financial condition and results of operations.
The Company’s largest reinsurer is Trabaja Reinsurance Company (“Trabaja”). Reinsurance receivables from Trabaja were $185.0 million at December 31, 2006, of which 97% were collateralized.
In 2002, the Company supplemented its in-force reinsurance programs for The PMA Insurance Group and its former reinsurance business with retroactive reinsurance contracts with Trabaja that provide coverage for adverse loss development on certain lines of business for accident years prior to 2002. These contracts provide coverage of up to $125 million in losses in return for $55 million of funding, which included $50 million of assets and $5 million in ceded
premiums. Under the terms of the contracts, losses and LAE of the Run-off Operations ceded to Trabaja for accident years 1996 through 2001 are recoverable as they are incurred by the Company. Any future cession of losses under these contracts may require the Company to cede additional premiums ranging from 40% to 50% of ceded losses depending on the level of such losses.
During 2006, the Company repurchased $28.7 million principal amount of its 6.50% Convertible Debt through open market purchases. The Company paid $32.3 million for these bond purchases, exclusive of accrued interest. As the derivative component of the bonds was already reflected in the debt balance, the purchase activity did not result in any significant realized gain or loss.
In 2006, the Company retired $2.6 million principal amount of its 8.50% Monthly Income Senior Notes due 2018 (“8.50% Senior Notes”) through open market purchases. The Company paid $2.6 million for these bond purchases, exclusive of accrued interest. The Company has the right to call its 8.50% Senior Notes beginning in June 2008.
In June 2006, the Company entered into interest rate swaps that it has designated as cash flow hedges to manage interest costs and cash flows associated with the variable interest rates on a portion of its junior subordinated debt. There was no consideration paid or received for these swaps. The swaps will effectively convert $15.0 million of the junior subordinated debt to fixed rate debt with an interest rate of 9.52%.
In 2005, the Company made open market purchases of $25.7 million principal amount of its 6.50% Convertible Debt. The debt purchases were financed through proceeds from the Surplus Notes and the direct purchase of a portion of these bonds at the Run-off Operations. The Company paid $27.9 million for these bond purchases, exclusive of accrued interest.
The 6.50% Convertible Debt is secured equally and ratably with the Company’s $54.9 million 8.50% Senior Notes by a first lien on 20% of the capital stock of the Company’s principal operating subsidiaries. The 6.50% Convertible Debt may be converted at any time, at the holder’s option, at $16.368 per share for $18.4 million principal amount and at $15.891 per share for $941,000 principal amount. The indenture governing the 6.50% Convertible Debt contains restrictive covenants with respect to limitations on the Company’s ability to incur indebtedness, enter into transactions with affiliates or engage in a merger or sale of all or substantially all of the Company’s assets.
The put premium and conversion features of the 6.50% Convertible Debt constitute a derivative which requires bifurcation. Any change in the fair value of the derivative component of the 6.50% Convertible Debt is recognized in net realized investment gains (losses). The Company recorded realized investment gains of $466,000 in 2006 resulting from decreases in the fair value of the derivative component of the 6.50% Convertible Debt, and recorded realized investment losses of $3.7 million and $3.8 million in 2005 and 2004, respectively, for increases in the fair value of the derivative component of the 6.50% Convertible Debt.
The junior subordinated debt matures in 2033 and is redeemable, in whole or in part, in 2008 at the stated liquidation amount plus accrued and unpaid interest. The interest rates on the junior subordinated debt equal the three-month LIBOR plus 4.10%, 4.20% and 4.05%, and interest on this debt is payable on a quarterly basis. At December 31, 2006, the weighted average interest rate on the junior subordinated securities was 9.49%.
The Company leases certain facilities, office equipment and automobiles under non-cancelable operating leases. Future minimum net operating lease obligations as of December 31, 2006 are as follows:
(1) Net of sublease rentals of $1.6 million in 2007, 2008, 2009 and 2010, $1.7 million in 2011 and $4.5 million thereafter.
The Company and certain of its directors and key executive officers are defendants in several purported class action lawsuits that were filed in 2003 in the United States District Court for the Eastern District of Pennsylvania by alleged purchasers of the Company’s Class A Common Stock, 4.25% Convertible Debt and 8.50% Senior Notes. On June 28, 2004, the District Court issued an order consolidating the cases under the caption In Re PMA Capital Corporation Securities Litigation (civil action no. 03-6121) and appointing Sheet Metal Workers Local 9 Pension Trust, Alaska Laborers Employers Retirement Fund and Communications Workers of America for Employees’ Pension and Death Benefits as lead plaintiffs. On September 20, 2004, the plaintiffs filed an amended and consolidated complaint on behalf of an alleged class of purchasers of the Company’s securities between May 5, 1999 and February 11, 2004. The complaint alleges, among other things, that the defendants violated Section 10(b) of the Exchange Act and Rule 10b-5 thereunder by making materially false and misleading public statements and material omissions during the class period regarding the Company’s underwriting performance, loss reserves and related internal controls. The complaint alleges, among other things, that the defendants violated Sections 11, 12(a) (2) and of the Securities Act by making materially false and misleading statements in registration statements and prospectuses about the Company’s financial results, underwriting performance, loss reserves and related internal controls. The complaint seeks unspecified compensatory damages, the right to rescind the purchases of securities in the public offerings, interest, and plaintiffs’ reasonable costs and expenses, including attorneys’ fees and expert fees. The Company intends to vigorously defend against the claims asserted in this consolidated action. By Order dated July 27, 2005, the District Court partially granted the Company’s previously filed
Prior to 2004, the Company’s Board of Directors suspended dividends on the Company’s Class A Common Stock.
In 2000, the Company’s Board of Directors adopted a shareholder rights plan that will expire on May 22, 2010. The rights automatically attached to each share of Class A Common Stock. Generally, the rights become exercisable after the acquisition of 15% or more of the Company’s Class A Common Stock and permit rights-holders to purchase the Company’s Class A Common Stock or that of an acquirer at a substantial discount. The Company may redeem the rights for $0.001 per right at any time prior to an acquisition.
On January 1, 2006, the Company adopted SFAS 123R, “Share-Based Payment,” using the modified-prospective transition method. SFAS 123R requires all share-based payments to employees, including grants of employee stock options, be recognized as compensation expense in the income statement at fair value. Under the modified-prospective transition method, the Company recognized expense over the remaining required service period for stock options granted prior to January 1, 2006 for the portion of those grants for which the requisite service had not yet been rendered. No adjustment was made to prior period amounts nor was any expense recorded for options granted prior to January 1, 2006 for which the requisite service had been rendered by that date. The Company recognized stock-based compensation expense of $2.4 million, including $602,000 related to stock options, for the year ended December 31, 2006.
The Company previously accounted for stock-based compensation using the intrinsic value method. Accordingly, compensation cost for stock options was measured as the excess, if any, of the quoted market price of the Company’s Class A Common Stock at grant date or other measurement date over the amount an employee must pay to acquire the Class A Common Stock. In 2005 and 2004, the Company expensed $24,000 and ($172,000), respectively, for stock option compensation costs. Stock option compensation in 2004 was impacted by the cancellation of unvested stock options. The following table illustrates the effect on net income (loss) if the fair value based method had been applied:
Information regarding the Company’s stock option plans for the year ended December 31, 2006 was as follows:
All options granted in 2005 and 2004 were granted with an exercise price that equaled or exceeded the market value of the Class A Common Stock on the grant date (“out-of-the-money”). The weighted average fair values of options granted in 2005 and 2004 were $3.62 per share and $3.43 per share, respectively. The Company did not grant any options in 2006.
Stock options outstanding and options exercisable at December 31, 2006 were as follows:
Upon vesting of a restricted stock award, employees may remit cash or shares of Class A Common Stock to satisfy their tax obligations relating to the award. During 2006 and 2005, employees remitted 8,831 and 54,694 shares, respectively, to the Company to satisfy their payment of withholding taxes for vested awards.
In March 2006, the Compensation Committee approved the 2006 Officer Long Term Incentive Plan, a long-term incentive plan pursuant to which stock may be awarded to all officers in 2009 if the after tax return on equity (“ROE”) in 2008 is within a specified range. Award amounts are calculated as a percentage of the participants’ base salaries. The 2006 Officer Long Term Incentive Plan links compensation to performance under the Company’s three-year strategic plan and recognizes the long-term nature of improvement in ROE and the value ROE growth creates for shareholders. The Company recognized expense of $500,000 related to this plan during the year ended December 31, 2006.
Diluted shares for 2006, 2005 and 2004 do not assume the effect of conversion of the Company’s Convertible Debt into 2.8 million, 5.8 million and 6.1 million shares of Class A Common Stock, respectively, because it was anti-dilutive. The dilutive effect of the Convertible Debt for 2004 represents the impact of the put premium feature on the 6.50% Convertible Debt. See Note 6 for additional information.
As of December 31, 2006 and December 31, 2005, the carrying amounts for the Company’s financial instruments approximated their estimated fair value. The Company measures the fair value of fixed maturities, the Convertible Debt and the Senior Notes based upon quoted market prices or by obtaining quotes from dealers. Certain financial instruments, specifically amounts relating to insurance and reinsurance contracts, are excluded from this disclosure.
The Company also maintains non-qualified unfunded supplemental defined benefit pension plans (the “Non-qualified Pension Plans”) which, prior to January 1, 2006, covered certain key employees. The projected benefit obligation and accumulated benefit obligation for the Non-qualified Pension Plans were $7.4 million and $7.4 million, respectively, as of December 31, 2006.
The decline in Qualified Pension Plan asset performance prior to 2004, combined with historically low interest rates (which are the key assumption in estimating plan liabilities) caused the Company to record a $24.0 million increase in its accrued Qualified Pension Plan liability and record a $15.6 million non-cash charge to equity. The Company further increased its pension liability by $1.2 million in 2004 and $5.1 million in 2005 and recorded non-cash charges to equity of $806,000 and $3.3 million, respectively. These charges did not impact earnings or cash flow, and could reverse in future periods if either interest rates increase or market performance and plan asset returns improve. In 2006, the Company reversed $5.7 million of its pension liability and increased equity by $3.7 million due primarily to the increase in interest rates and higher than expected return on plan assets.
The projected benefit obligation, accumulated benefit obligation and fair value of plan assets for the Qualified Pension Plan were $83.5 million, $83.5 million and $72.7 million, respectively, at December 31, 2006, and $84.2 million, $84.2 million and $67.7 million, respectively, at December 31, 2005.
The asset allocation for the Company’s Qualified Pension Plan at the end of 2006 and 2005, and the target allocation for 2007, by asset category, are as follows:
B. Defined Contribution Savings Plan - The Company also maintains defined contribution savings plans covering substantially all employees. These plans include a voluntary employee contribution component, in which the Company matches employee contributions, up to 5% of compensation and, effective January 1, 2006, an aged-based company contribution. Contributions expensed under these plans in 2006, 2005 and 2004 were $5.2 million, $2.4 million and $2.6 million, respectively.
(1) Corporate and Other includes the effects of eliminating transactions between the various insurance segments.
These consolidated financial statements vary in certain respects from financial statements prepared using statutory accounting practices (“SAP”) that are prescribed or permitted by the Pennsylvania Insurance Department. Prescribed SAP includes state laws, regulations and general administrative rules, as well as a variety of NAIC publications. Permitted SAP encompasses all accounting practices that are not prescribed. The Codification of Statutory Accounting Principles (“Codification”) guidance is the NAIC’s primary guidance on statutory accounting. The principal differences between GAAP and SAP are in the treatment of acquisition expenses, reinsurance, deferred income taxes, fixed assets and investments.
In May 2006, PMA Capital Insurance Company paid an extraordinary dividend in the amount of $73.5 million to its parent, PMA Capital Corporation.
The Company’s statutory financial statements are presented on the basis of accounting practices prescribed or permitted by the Pennsylvania Insurance Department. Although the Pennsylvania Insurance Department has adopted Codification as the basis of its statutory accounting practices, it has retained the prescribed practice of non-tabular discounting of unpaid losses and LAE for workers’ compensation, which was not permitted under Codification. This prescribed accounting practice increased statutory capital and surplus of The Pooled Companies by $101,000 at December 31, 2004 over what it would have been had the prescribed practice not been allowed. As of December 31, 2005, the Company no longer utilizes non-tabular discounting for its net unpaid losses and LAE for workers’ compensation.
We have audited the accompanying consolidated balance sheets of PMA Capital Corporation and subsidiaries (the Company) as of December 31, 2006 and 2005, and the related consolidated statements of operations, cash flows, shareholders’ equity and comprehensive income (loss) for the years then ended. 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. The 2004 consolidated financial statements were audited by other auditors whose report, dated March 16, 2005, expressed an unqualified opinion on those statements.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 12, 2007 expressed an unqualified opinion on management’s assessment of internal control over financial reporting and an unqualified opinion on the effectiveness of internal control over financial reporting.
We have audited management’s assessment, included in the accompanying Management’s Report on Internal Controls over Financial Reporting, that PMA Capital Corporation and subsidiaries (the Company) maintained effective internal control over financial reporting as of December 31, 2006 based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements and financial statement schedules of the Company as of and for the years ended December 31, 2006 and 2005, and our reports dated March 12, 2007 expressed an unqualified opinion on those financial statements and financial statement schedules.
In our opinion, such consolidated financial statements present fairly, in all material respects, the results of operations and cash flows of PMA Capital Corporation and subsidiaries for the year ended December 31, 2004, in conformity with accounting principles generally accepted in the United States of America.