Rent expense is allocated to the Company's property and casualty insurance segment through the pooling agreement and to the Company's reinsurance segment through the quota share agreement. A small amount of rent expense is allocated to the Company's insurance agency based on the space utilized by that operation.
Property and casualty insurance operations are conducted through three subsidiaries and represent the most significant segment of the Company’s business, totaling 77 percent of consolidated premiums earned in 2018. The Company’s three property and casualty insurance subsidiaries and two subsidiaries of Employers Mutual (Union Insurance Company of Providence and EMC Property & Casualty Company) are parties to a pooling agreement with Employers Mutual. Under the terms of the pooling agreement, each company cedes to Employers Mutual all of its insurance business, and assumes from Employers Mutual an amount equal to its participation in the pool. All premiums, losses, settlement expenses, and other underwriting and administrative expenses, excluding the voluntary reinsurance business assumed by Employers Mutual from nonaffiliated insurance companies, are prorated among the parties on the basis of participation in the pool. Employers Mutual negotiates reinsurance agreements that provide protection to the pool and each of its participants, including protection against losses arising from catastrophic events. The aggregate participation of the Company’s property and casualty insurance subsidiaries in the pool is 30 percent.
Operations of the pool and the inter-company reinsurance program give rise to inter-company balances with Employers Mutual, which are generally settled during the subsequent month. The investment and income tax activities of the pool participants are not subject to the pooling agreement. The pooling agreement provides that Employers Mutual will make up any shortfall or difference resulting from an error in its systems and/or computation processes that would otherwise result in the required restatement of the pool participants’ financial statements.
The reinsurance subsidiary purchases additional reinsurance protection in peak exposure territories from external parties in which coverage is triggered when losses experienced by the insurance industry from a catastrophic event exceed a specified threshold. Any reinsurance recoveries received from external parties reduces the amount of losses ceded to Employers Mutual under the inter-company reinsurance program. The net cost of this external reinsurance protection was approximately $6.0 million, $5.6 million and $3.5 million in 2018, 2017 and 2016, respectively. During 2018, the reinsurance subsidiary recovered $5.2 million from external parties. No recoveries were made from external parties in 2017 or 2016.
The Company closely monitors the activities of state legislatures, the United States Congress and federal and state agencies through its membership in various organizations. In particular, our trade organizations are working to monitor and shape the activities of the Federal Insurance Office as it continues to evolve and exercise its authority, and to promote accident avoidance and accident prevention technology.
EMC currently has core legacy insurance systems that are built around the traditional insurance model in a pre-digital aged architecture. The systems operate within several functional silos, which makes it difficult to share data and create a unified customer experience. During 2018, management undertook a digital transformation project that will guide the design, build and deployment of a new "EMC Digital Business Platform". This digital platform will consist of new core insurance systems, such as policy, rating, billing, claims, agent portal, customer portal, and an agency distribution management system. These new systems, together with some enhanced systems, will replace the company's current legacy systems. EMC will also adopt cloud technology, and integrate and configure vendor purchased systems. Previously, all core systems were built in-house. This project will take several years to complete, and will require a significant amount of resources.
Premium rate level increases have slowed over the past several years due to increased competition resulting from excess capital in the insurance industry. During this time, management has worked diligently with the sixteen branch offices to stress the importance of achieving modest, but consistent, commercial lines rate level increases whenever possible. These efforts have been successful, as the Company has been able to achieve modest rate level increases during the past five years. Premium rate levels for most commercial lines of business are projected to increase moderately on an industry-wide basis in 2019, and management currently expects the Company's overall rate level to remain steady or increase slightly in 2019. Management will continue to work with the branch offices to ensure that all opportunities for additional rate level increases are pursued.
The Company, like most of the insurance industry, continues to experience high levels of claims frequency and severity in the commercial auto line of business. The commercial auto line of business represents approximately 28 percent of the property and casualty insurance segment's commercial business; therefore, improving profitability is a top priority for management. Management continues to devote a significant amount of resources to the intensive, multi-year Accelerate Commercial Auto Profitability project that was implemented in 2016, which has a goal of returning this line of business to profitability. There are indications that the action plans developed by each of the eight teams charged with returning this line of business to profitability are beginning to take effect.
Premiums Written Assumed From Affiliates and Premiums Written Assumed From Nonaffiliates. For the property and casualty insurance segment, premiums written assumed from affiliates and nonaffiliates reflects the property and casualty insurance subsidiaries’ aggregate 30 percent participation interest in 1) the total direct premiums written by all the participants in the pooling arrangement, and 2) the involuntary business assumed by the pool participants pursuant to state law, respectively. For the reinsurance segment, premiums written assumed from nonaffiliates reflects the reinsurance business assumed through the quota share agreement (including “fronting” activities initiated by Employers Mutual) and reinsurance business assumed outside the quota share agreement. See note 3 of Notes to Consolidated Financial Statements. Management uses premiums written assumed from affiliates and nonaffiliates, which excludes the impact of premiums written ceded to reinsurers, as a measure of the underlying growth of the Company’s insurance business from period to period.
Net Premiums Written. Net premiums written is calculated by summing direct premiums written, premiums written assumed from affiliates and nonaffiliates, and then subtracting from that result premiums written ceded to affiliates and nonaffiliates. For the property and casualty insurance segment, premiums written ceded to nonaffiliates is the portion of the direct and assumed premiums written that is transferred to 1) reinsurers in accordance with the terms of the underlying reinsurance contracts, based upon the risks they accept, and 2) state organizations on a mandatory basis in connection with various workers' compensation and assigned risk programs. For the reinsurance segment, premiums written ceded to nonaffiliates reflects reinsurance business that is ceded to other insurance companies in connection with 1) “fronting” activities initiated by Employers Mutual, and 2) amounts ceded to purchase additional reinsurance protection in peak exposure territories. Premiums written ceded to affiliates includes both the cession of the Company’s property and casualty insurance subsidiaries’ direct business to Employers Mutual under the terms of the pooling agreement, and premiums ceded by the Company’s subsidiaries to Employers Mutual under the terms of the inter-company reinsurance programs with Employers Mutual. See note 3 of Notes to Consolidated Financial Statements. Management uses net premiums written to measure the amount of business retained after cessions to reinsurers.
Estimated ultimate loss and allocated settlement expense amounts for most claims are established by accident year and line of business using standard actuarial techniques. At each reporting date, the amounts to be carried for incurred but not reported (IBNR) loss reserves and allocated settlement expense reserves are determined by subtracting the amounts incurred to date (paid amounts plus case loss reserves carried for reported claims) from the estimated ultimate amounts. Under this methodology, changes in the incurred amounts result in corresponding adjustments to the reserve amounts.
Internal actuarial evaluations of the prior quarter’s overall loss reserve levels are performed each quarter for all direct lines of business. There is a certain amount of random variation in loss and allocated settlement expense development patterns, which results in some uncertainty regarding the estimated ultimate projections, particularly for longer-tail lines such as workers’ compensation, other liability and commercial auto liability. Therefore, the reasonableness of the actuarial projections is regularly monitored through an examination of the assumptions underlying those projections.
Following is a summary of the carried loss and settlement expense reserves for the reinsurance segment at December 31, 2018 and 2017.
The reinsurance book of business is comprised of two major components. The first is HORAD, which includes the reinsurance business assumed by the reinsurance subsidiary through the quota share agreement and the business written directly by the reinsurance subsidiary outside of the quota share agreement. The second is Mutual Re, which is a voluntary reinsurance pool in which Employers Mutual participates with four other unaffiliated insurers.
At December 31, 2018, the carried reserves for HORAD and Mutual Re combined were in the upper third of the range of actuarial reserve indications. This selection reflects the fact that there are inherent uncertainties involved in establishing reserves for assumed reinsurance business. Such uncertainties include the fact that a reinsurance company generally has less knowledge than the ceding company about the underlying book of business and the ceding company’s reserving practices. Because of these uncertainties, there is a risk that the reinsurance segment’s reserves for losses and settlement expenses could prove to be inadequate, with a consequential adverse impact on the Company’s future earnings and stockholders’ equity.
Carried reserves established in addition to those reported by the ceding companies totaled approximately $94.6 million at December 31, 2018. Since many ceding companies in the HORAD book of business do not report IBNR loss reserves, Employers Mutual establishes a bulk IBNR loss reserve to cover the lag in reporting. For the few ceding companies that do report IBNR loss reserves, Employers Mutual carries them as reported. These reported IBNR loss reserves are subtracted from the total IBNR loss reserve calculated by Employers Mutual’s actuaries, with the difference carried as bulk IBNR loss reserves. Except for a negative bulk IBNR loss reserve established by Employers Mutual's actuaries, and a small IBNR loss reserve generally established to cover a one-month lag in reporting, the Mutual Re IBNR loss reserve is established by the management of Mutual Re. Employers Mutual rarely records additional case loss reserves.
As previously noted, the assumptions implicit in the methodologies utilized to establish reserves for the reinsurance segment are stability in the mix of business, consistent claims processing procedures, immaterial impact of loss cost trends on development patterns, consistent case loss reserving practices and appropriate Bornhuetter-Ferguson expected loss ratio selections. The tables below display the impact on the Company’s results of operations from (1) a one percent variance in case loss reserve adequacy from the level anticipated in the incurred loss projection factors, (2) a one percent variance in the implicit annual claims inflation rate, (3) a one percent variance in IBNR losses as a percentage of reported incurred losses (due, for example, to changes in mix of business or claims processing procedures) and (4) a one percent variance in the expected loss ratios used with the Bornhuetter-Ferguson method. In other words, under each scenario, future loss and settlement expense payments would be expected to vary from actuarial reserve estimates by the amounts shown below. These variances in future loss and settlement expense payments could occur in one year or over multiple years. Variances in future loss and settlement payments would also affect the Company’s financial position in that the Company’s equity would be impacted by an amount equivalent to the change in net income. Variances of this type would typically be recognized in loss and settlement expense reserves and, accordingly, would not have a material effect on liquidity because the claims have not been paid. Such variances are considered reasonably likely based on the range of actuarial indications developed during the analysis of the reinsurance segment’s carried reserves.
Toxic tort claims include those where the claimant seeks compensation for harm allegedly caused by exposure to a toxic substance or a substance that increases the risk of contracting a serious disease, such as cancer. Typically, the injury is caused by latent effects of direct or indirect exposure to a substance or combination of substances through absorption, contact, ingestion, inhalation, implantation or injection. Examples of toxic tort claims include injuries arising out of exposure to asbestos, silica, mold, drugs, carbon monoxide, chemicals and lead.
Since 1989, the pool participants have included an asbestos exclusion in liability policies issued for most lines of business. The exclusion prohibits liability coverage for “bodily injury”, “personal injury” or “property damage” (including any associated clean-up obligations) arising out of the installation, existence, removal or disposal of asbestos or any substance containing asbestos fibers. Therefore, the pool participants’ current asbestos exposures are primarily limited to commercial policies issued prior to 1989. At present, the pool participants are defending approximately 1,737 asbestos bodily injury lawsuits, some of which involve multiple plaintiffs. Claims activity associated with seven policyholders dominates the pool participants’ asbestos claims, representing an aggregate 1,727 lawsuits. Most of the lawsuits are subject to express reservation of rights based upon the lack of an injury within the applicable policy periods, because many asbestos lawsuits do not specifically allege dates of asbestos exposure or dates of injury. The pool participants’ policyholders named as defendants in these asbestos lawsuits are typically peripheral defendants who have little or no exposure and are often dismissed from asbestos litigation with nominal or no payment (i.e., small contractors, supply companies, and a furnace manufacturer).
The pool participants are defending approximately 40 lawsuits alleging “silica” exposure in Mississippi and Louisiana, some of which involve multiple plaintiffs. The plaintiffs allege employment exposure to “airborne respirable silica dust,” causing “serious and permanent lung injuries” (i.e., silicosis). Silicosis injuries are identified in the upper lobes of the lungs, while asbestos injuries are localized in the lower lobes.
The plaintiffs in the silicosis lawsuits are sandblasters, gravel and concrete workers, ceramic workers and road construction workers. All of these lawsuits are subject to express reservation of rights based upon the lack of an injury within the applicable policy periods because many silica lawsuits, like asbestos lawsuits, do not specifically allege dates of exposure or dates of injury. The pool participants’ policyholder (a sand and gravel hauler) that has been named as defendant in these silica lawsuits has had little or no exposure, and is routinely dismissed from silica litigation with nominal or no payment.
Since 2004, the pool participants have included a “pneumoconiosis dust” exclusion to their commercial lines liability policies in most jurisdictions where such action was warranted. This exclusion precludes liability coverage due to “mixed dust” pneumoconiosis, pleural plaques, pleural effusion, mesothelioma, lung cancer, emphysema, bronchitis, tuberculosis or pleural thickening, or other pneumoconiosis-related ailments such as arthritis, cancer (other than lung), lupus, heart, kidney or gallbladder disease. “Mixed dust” includes dusts composed of asbestos, silica, fiberglass, coal, cement, or various other elements. It is anticipated that this mixed dust exclusion will further limit the pool participants’ exposure in silica claims, and may be broad enough to limit exposure in other dust claims.
Examples include, but are not limited to: chemical waste; hazardous waste treatment, storage and/or disposal facilities; industrial waste disposal facilities; landfills; superfund sites; toxic waste spills; and underground storage tanks. Widespread use of pollution exclusions since 1970 in virtually all lines of business, except personal lines, has resulted in limited exposure to environmental claims. Absolute pollution exclusions have been used since the 1980’s; however, the courts in the State of Indiana have ruled that the absolute pollution exclusion is ambiguous.
At December 31, 2018, the Company carried asbestos and environmental reserves for direct insurance and assumed reinsurance business totaling $11.6 million, which represents 1.5 percent of total loss and settlement expense reserves. The asbestos and environmental reserves include $5.0 million of case loss reserves, $3.3 million of IBNR loss reserves and $3.4 million of bulk settlement expense reserves. Ceded reinsurance on these reserves totaled $513,000. Asbestos settlement expense reserves were strengthened by $1.5 million in 2018.
Following is a summary of loss and settlement expense reserves and payments associated with asbestos, environmental, products liability and casualty excess reinsurance exposures for 2018, 2017 and 2016:
During each quarter, an actuarially determined range of estimates is developed for the major components of the loss and settlement expense reserves as of the preceding quarter-end. All reserves are reviewed with the exception of reserves for involuntary workers’ compensation pools, which are set by the National Council on Compensation Insurance (NCCI) and are assumed to be adequate (the impact of potential variability of this segment on overall reserve adequacy is considered immaterial). Shown below are the actuarially determined ranges of reserve estimates as of December 31, 2018 along with the statutory-basis carried reserves, which are displayed net of ceded reinsurance. The GAAP-basis loss and settlement expense reserves contained in the Company’s financial statements are reported gross of ceded reinsurance, and contain a small number of adjustments from the statutory-basis amounts presented here. The last two columns display the estimated after-tax impact on earnings, calculated using the federal corporate tax rate of 21 percent, if the reserves were moved to the high end-point or low end-point of the ranges.
Essentially all securities in the Company’s investment portfolios have transparent pricing. All equity securities (with three exceptions) are traded on national exchanges with observable prices. Fixed maturity securities are typically high quality, liquid issues with daily pricing from the Company’s independent pricing source. Prices are validated through a variety of techniques. When performing these validations, the Company uses graduated tolerance levels for determining exceptions. Equity securities and U.S. treasury and government-sponsored agency fixed maturity securities have the highest transparency in pricing, and therefore have the smallest tolerance levels for variance. These are followed by (in order of decreasing transparency/increasing tolerance levels) municipal, corporate, high-yield and finally mortgage-backed fixed maturity securities. The validations performed include:
Acquisition costs, consisting of commissions, premium taxes, and salary and benefit expenses (beginning in 2018, only the service cost component of the net periodic pension and postretirement benefit income/expense is included) of employees directly involved in the underwriting of insurance policies that are successfully issued, are deferred and amortized to expense as premium revenue is recognized. Deferred policy acquisition costs and related amortization are calculated separately for the property and casualty insurance segment and the reinsurance segment. The methodology followed in computing deferred policy acquisition costs limits the amount of such deferred costs to the estimated realizable value. In determining estimated realizable value, the computation gives effect to the premium to be earned, related investment income, anticipated losses and settlement expenses, anticipated policyholder dividends, and certain other costs expected to be incurred to administer the insurance policies as the premium is earned. The anticipated losses and settlement expenses are based on the segment’s projected loss and settlement expense ratios for the next twelve months, which include provisions for anticipated catastrophe and storm losses based on historical results adjusted for recent trends. Utilizing these projections, deferred policy acquisition costs for the property and casualty insurance segment and the reinsurance segment were not subject to limitation at December 31, 2018. Based on an analysis performed by management, the actuarial projections of the expected loss and settlement expense ratios for the next twelve months would have needed to increase 19.2 percentage points in the property and casualty insurance segment and 6.3 percentage points in the reinsurance segment before deferred policy acquisition costs would have been subject to limitation. Such increases in the expected loss and settlement expense ratios would likely be driven by many factors, including higher provisions for anticipated catastrophe and storm losses.
The discount rate utilized in the valuations is based on an analysis of the total rate of return that could be generated by a hypothetical portfolio of high-quality bonds created to generate cash flows that match the plans’ expected benefit payments. No callable bonds are used in this analysis and the discount rate produced by this analysis is compared to interest rates of applicable published indices for reasonableness. The discount rates used in the pension benefit obligation valuations at December 31, 2018, 2017 and 2016 were 4.24 percent, 3.60 percent and 4.07 percent, respectively. The discount rates used in the postretirement benefit obligation valuations at December 31, 2018, 2017 and 2016 were 4.27 percent, 3.63 percent and 4.21 percent, respectively. The discount rates used in the pension and postretirement benefit obligation valuations are also used in the calculation of the net periodic benefit costs for the subsequent year. A 0.25 percentage point decrease in the discount rates used in the 2018 valuations would increase the Company’s net periodic pension and postretirement benefit costs for 2019 by approximately $255,000. Conversely, a 0.25 percentage point increase in the 2018 discount rates would decrease the Company’s net periodic pension and postretirement benefit costs for 2019 by approximately $243,000.
Premiums earned increased 6.3 percent to $645.2 million in 2018 from $607.2 million in 2017. Rate levels for both segments continue to be constrained by a high level of competition, especially for quality accounts with good loss experience; however, there were some indications of moderate rate level improvement during the year. Average rate level increases were slightly positive in the property and casualty insurance segment, with variances by line of business. The lines of business experiencing the greatest profitability challenges in the property and casualty insurance segment, namely commercial auto and personal lines, received larger (mid-single digit) rate increases. During the January 1, 2018 reinsurance renewal season, moderate price increases were achieved on most of the reinsurance segment's property per risk and catastrophe programs. The reinsurance industry is placing greater emphasis on wildfire exposures following a second consecutive year of significant losses from this peril. As a result, programs with wildfire losses received the largest rate level increases during the January 1, 2019 reinsurance renewal season, while other programs renewed flat, or down slightly.
Premiums earned for the reinsurance segment increased 11.1 percent to $149.7 million in 2018 from $134.8 million in 2017. This increase is primarily attributed to increases in participation and higher estimated premiums achieved on existing multi-line contracts and a specialty casualty contract, and the addition of some new excess of loss business. These increases were partially offset by a continued decline in premiums reported by Mutual Re due to its withdrawal from non-standard automobile business. Underwriting capacity tightened somewhat during the January 1, 2019 renewal season. As a result, reinsurance rate levels were mixed, with increases on programs that sustained losses from wildfires and other catastrophe losses, while rate levels remained stable on programs not affected by 2017 and 2018 catastrophic events.
Losses and settlement expenses increased 8.3 percent to $457.2 million in 2018 from $422.0 million in 2017, and the loss and settlement expense ratio increased to 70.9 percent in 2018 from 69.5 percent in 2017. The increase in the loss and settlement expense ratio is primarily attributed to a high level of non-catastrophe losses experienced in the property and casualty insurance segment during the first half of the year. Catastrophe and storm losses were unusually high in both years due to active weather patterns in the Midwest, increased hurricane activity and the California wildfires. The inter-company reinsurance programs continue to perform as expected, and have helped to reduce the volatility of the Company's quarterly earnings. The actuarial analysis of the Company’s carried reserves at December 31, 2018 indicates that they are in the upper third of the range of reasonable reserves.
The loss and settlement expense ratio for the property and casualty insurance segment increased to 67.2 percent in 2018 from 64.1 percent in 2017. The underlying loss and settlement expense ratio, which excludes the impact of catastrophe and storm losses and development on prior years' reserves, increased 1.7 percentage points to 62.8 percent in 2018 from 61.1 percent in 2017. This increase is primarily attributed to the workers' compensation line of business, and reflects an adjustment made to the first quarter ultimate loss and settlement expense ratio during the second quarter. This was deemed necessary after it became apparent that the ultimate loss and settlement expense ratio established for the first quarter needed to be revised due to unanticipated increases in both the frequency and severity of first quarter reported losses as claims emerged during the second quarter. Although loss frequency and severity assumptions returned to more normal levels during the second half of the year, there is less premium to cover projected losses due to the mandatory rate level decreases that have been implemented during the past several years. Management is beginning to see improvement in some of the metrics used to evaluate the performance of the commercial auto line of business; however, it continued to under-perform expectations due to adverse development experienced on prior years' reserves, posting a loss and settlement expense ratio of 82.7 percent in 2018 compared to 85.4 percent in 2017.
The TCJA was signed into law on December 22, 2017. Among other provisions, the TCJA lowered the federal corporate tax rate from 35 percent to 21 percent effective January 1, 2018. Companies were required to calculate deferred income taxes using tax rates expected to be in effect when tax timing differences reverse, which, as of December 22, was 21 percent rather than the previous 35 percent. The Company was in a net deferred tax liability position on the date of enactment, which meant that the reduction in the tax rate resulted in a lower deferred tax liability. In accordance with GAAP, this reduction in the deferred tax liability, which was reflected as a deferred income tax benefit, was recognized in net income in the fourth quarter.
Premiums earned, losses and settlement expenses incurred, and the corresponding loss and settlement expense ratios, by line of business for each segment and on a consolidated basis, for the two years ended December 31, 2017 were as follows:
Premiums earned for the property and casualty insurance segment increased 3.5 percent to $472.4 million in 2017 from $456.5 million in 2016. This increase was primarily attributed to new business in both commercial and personal lines of business, growth in insured exposures and an increase in retained policies in the commercial lines of business. New business premium (representing 15 percent of the pool participants’ direct premiums written) was approximately 15 percent higher than in 2016. Commercial lines new business continued to be in the desired range of growth, and accounted for most of the increase in total new business premium. Personal lines new business premium was up significantly, but was measured against a relatively small amount of new business premium in 2016. While management continued to seek growth in most territories, it was particularly focused on achieving growth outside of the core Midwest market, which would help diversify the pool participants' book of business geographically, while staying consistent with the industry and line of business mix of the existing book of business. Renewal business premium increased approximately five percent during 2017. After factoring in the continued implementation of some mandatory rate reductions on workers' compensation business in a few states, the overall rate change on renewal business was positive, but less than one percent. Rates were expected to continue to be mixed in 2018, with the largest rate increases expected in the commercial auto line of business. Rate decreases were expected in the workers' compensation and general liability lines of business, and rates on most other lines of business were expected to be flat or increase slightly. The overall policy retention rate remained strong during 2017 at 85.8 percent (commercial lines at 86.9 percent and personal lines at 83.7 percent). These retention rates approximated those reported at the end of 2016.
Losses and settlement expenses increased 9.1 percent to $422.0 million in 2017 from $386.9 million in 2016, and the loss and settlement expense ratio increased to 69.5 percent in 2017 from 65.3 percent in 2016. Higher catastrophe and storm losses in the reinsurance segment (including a record amount during the third quarter of 2017), along with a decline in favorable development on prior years' reserves, were the primary drivers of the increase in the ratio. These increases were partially offset by an improvement in the property and casualty insurance segment's underlying loss and settlement expense ratio. Fourth quarter catastrophe and storm losses in the reinsurance segment, which primarily resulted from the California wildfires, were mitigated by the inter-company reinsurance program with Employers Mutual. Since the retention amount under the annual aggregate treaty was filled during the third quarter, the reinsurance segment only retained 20 percent of the fourth quarter wildfire losses. The inter-company reinsurance programs implemented in 2016 performed as expected, and reduced the volatility of the Company's quarterly earnings. The actuarial analysis of the Company’s carried reserves at December 31, 2017 indicated that they were in the upper third of the range of reasonable reserves.
The loss and settlement expense ratio for the reinsurance segment increased to 88.3 percent in 2017 from 68.1 percent in 2016. The large increase was primarily due to a significant increase in catastrophe and storm losses, which accounted for 22.4 percentage points of the loss and settlement expense ratio in 2017 compared to just 9.3 percentage points in 2016. Gross losses from Hurricanes Harvey, Irma and Maria were estimated to be approximately $9.0 million, $7.0 million and $3.5 million, respectively, and the aggregate losses from the California wildfires were estimated at approximately $9.5 million. The reinsurance subsidiary ceded $16.8 million and ($467,000) of catastrophe and storm losses to Employers Mutual under the inter-company reinsurance program in 2017 and 2016, respectively. Taking the loss recoveries and the premiums paid to Employers Mutual into consideration, the inter-company reinsurance program reduced the reinsurance segment's loss and settlement expense ratio by 9.0 percentage points for the year ended December 31, 2017, but increased it by 2.8 percentage points in 2016. The inter-company reinsurance program was renewed for 2018. The only change was a $400,000 increase in the cost of the program.
The acquisition expense ratio for the reinsurance segment decreased to 23.6 percent in 2017 from 24.3 percent in 2016. This decrease reflected a shift in the mix of business towards excess of loss contracts from pro rata contracts, as pro rata contracts typically have higher commission rates. The decrease also reflected declines in salary and benefit expenses (inclusive of bonuses) and contingent commissions.
Net investment income decreased 4.2 percent to $45.5 million in 2017 from $47.5 million in 2016. The decrease primarily reflected a lower book yield in the fixed maturity portfolio and a decline in dividend income. Current interest rate levels remained below the average book yield of the fixed maturity portfolio, and would therefore likely continue to limit future growth in net investment income. The average coupon rate on the fixed maturity portfolio, excluding interest-only securities, declined slightly over the past year, coming in at 3.7 percent at December 31, 2017 compared to 3.8 percent at December 31, 2016 and 3.9 percent at December 31, 2015. The effective duration of the fixed maturity portfolio, excluding interest-only securities, also declined slightly to 5.0 at December 31, 2017 from 5.2 at December 31, 2016. The Company’s equity portfolio produced dividend income of $6.0 million in 2017, compared to $6.9 million in 2016.
The Company reported net realized investment gains of $6.6 million in 2017, compared to $4.1 million in 2016. Included in these amounts were losses of $6.3 million in both 2017 and 2016 from declines in the carrying value of a limited partnership that the Company invested in to help protect the equity portfolio from a sudden and significant decline in value (an equity tail-risk hedging strategy). The Company recognized "other-than-temporary" impairment losses of $1.1 million and $1.3 million during 2017 and 2016, respectively. With the exception of a $209,000 impairment loss recorded in 2016 on a new investment that conveys investment tax credits (included in other long-term investments), these impairment losses were recognized on securities held in the Company's equity portfolio.
Liquidity is a measure of a company’s ability to generate sufficient cash flows to meet cash obligations. The Company had positive cash flows from operations of $71.8 million in 2018, $58.9 million in 2017 and $83.4 million in 2016. The Company typically generates substantial positive cash flows from operations because cash from premium payments is generally received in advance of cash payments made to settle claims. These positive cash flows provide the foundation of the Company’s asset/liability management program and are the primary driver of the Company’s liquidity. The Company invests in high quality, liquid securities to match the anticipated payments of losses and settlement expenses of the underlying insurance policies. Because the timing of the losses is uncertain, the majority of the portfolio is maintained in short to intermediate maturity securities that can be easily liquidated or that generate adequate cash flow to meet liabilities.
The Company held $19.3 million and $13.6 million in other long-term investments at December 31, 2018 and 2017, respectively, which primarily consist of holdings in limited partnerships, and privately placed common and non-redeemable convertible preferred stock in start-up technology companies with ties to the insurance industry. The equity method of accounting is used for these investments, with changes in the carrying value recorded as realized investment gains (losses). During 2018 and 2017, the Company invested additional funds of $7.5 million and $5.8 million, respectively, into a limited partnership that is designed to help protect the Company from a sudden and significant decline in the value of its equity portfolio (the 2018 contribution amount includes $2.3 million of gains realized from the program that were reinvested). Also included in other long-term investments are holdings in limited liability companies that convey renewable energy tax credits that are carried at amortized cost. After reductions for the utilization of the tax credits and impairment losses, the carrying values of these investments totaled $2.2 million and $1.5 million at December 31, 2018 and 2017, respectively.
Capital resources consist of stockholders’ equity and debt, representing funds deployed or available to be deployed to support business operations. For the Company’s insurance subsidiaries, capital resources are required to support premium writings. Regulatory guidelines suggest that the ratio of a property and casualty insurer’s annual net premiums written to its statutory surplus should not exceed three to one. All of the Company’s property and casualty insurance subsidiaries were well under this guideline at December 31, 2018.
The Company’s insurance subsidiaries are required to maintain a certain minimum level of surplus on a statutory basis, and are subject to regulations under which the payment of dividends from statutory surplus is restricted and may require prior approval of their domiciliary insurance regulatory authorities. The Company’s insurance subsidiaries are also subject to annual Risk Based Capital (RBC) requirements that may further impact their ability to pay dividends. RBC requirements attempt to measure minimum statutory capital needs based upon the risks in a company’s mix of products and investment portfolio. At December 31, 2018, the Company’s insurance subsidiaries had total adjusted statutory capital of $527.1 million, which is well in excess of the minimum risk-based capital requirement of $101.9 million.
As of December 31, 2018, the Company had no material commitments for capital expenditures.
Employers Mutual collects from agents, policyholders and ceding companies all premiums written associated with the insurance business produced by the pool participants and the assumed reinsurance business ceded to the reinsurance subsidiary. Employers Mutual also collects from its reinsurers all losses and settlement expenses recoverable under the reinsurance contracts protecting the pool participants and the reinsurance subsidiary, as well as the fronting business ceded to the reinsurance subsidiary. Employers Mutual settles with the pool participants (monthly) and the reinsurance subsidiary (quarterly) the premiums written from these insurance policies and the paid losses and settlement expenses recoverable under the external reinsurance contracts, providing full credit for the premiums written and the paid losses and settlement expenses recoverable under the external reinsurance contracts generated during the period (not just the collected portion). Due to this arrangement, and since a significant portion of the premium balances are collected over the course of the underlying coverage periods, Employers Mutual carries a substantial receivable balance for insurance and reinsurance premiums in process of collection and, to a lesser extent, paid losses and settlement expenses recoverable from the external reinsurance companies. Any of these receivable amounts that are ultimately deemed to be uncollectible are charged-off by Employers Mutual and the expense is charged to the reinsurance subsidiary or allocated to the pool members on the basis of pool participation. As a result, the Company has off-balance sheet arrangements with an unconsolidated entity that results in credit-risk exposures (Employers Mutual’s insurance and reinsurance premium receivable balances, and paid loss and settlement expense recoverable amounts) that are not reflected in the Company’s financial statements. The average annual expense for such charge-offs allocated to the Company over the past ten years is $414,000. Based on this historical data, this credit-risk exposure is not considered to be material to the Company’s results of operations or financial position and, accordingly, no loss contingency liability has been recorded.
Following is a schedule of the length of time fixed maturity securities available-for-sale have continuously been in an unrealized loss position as of December 31, 2018.
Following is a schedule of gross realized losses recognized in 2018 on fixed maturity securities available-for-sale. The schedule is aged according to the length of time the underlying securities were in an unrealized loss position.
The participants in the pooling agreement are subject to guaranty fund assessments by states in which they write business. Guaranty fund assessments are used by states to pay policyholder liabilities of insolvent insurers domiciled in those states. Many states allow assessments to be recovered through premium tax offsets. The Company has accrued estimated guaranty fund assessments of $615,000 and $706,000 as of December 31, 2018 and 2017, respectively. Premium tax offsets of $809,000 and $897,000, which are related to prior guarantee fund payments and current assessments, have been accrued as of December 31, 2018 and 2017, respectively. The guaranty fund assessments are expected to be paid over the next two years and the premium tax offsets are expected to be realized within ten years of the payments. The participants in the pooling agreement are also subject to second-injury fund assessments, which are designed to encourage employers to employ workers with pre-existing disabilities. The Company had accrued estimated second-injury fund assessments of $2.4 million and $2.0 million as of December 31, 2018 and 2017, respectively. The second-injury fund assessment accruals are based on projected loss payments. The periods over which the assessments will be paid is not known.
The Company monitors interest rate risk through an analysis of interest rate simulations, and adjusts the average duration of its fixed maturity portfolio by investing in either longer or shorter-term instruments given the results of interest rate simulations and judgments of cash flow needs. The effective duration of the Company’s fixed maturity portfolio, excluding interest-only securities, was 4.9 at December 31, 2018.
Fixed maturity securities held by the Company generally have an investment quality rating of “A” or better by independent rating agencies. The following table shows the composition of the Company’s fixed maturity securities, by rating, as of December 31, 2018.
Ratings for preferred stocks and fixed maturity securities are assigned by nationally recognized statistical rating organizations ("NRSRO"). NRSRO rating processes seek to evaluate the quality of a security by examining the factors that affect returns to investors. NRSRO ratings are based on quantitative and qualitative factors, as well as the economic, social and political environment in which the issuing entity operates. For further discussion of credit risk and related topics (i.e., unrealized losses, assessing "other-than-temporary" impairment losses, and non-investment grade securities held by the Company in its fixed maturity securities available-for-sale portfolio) see the section entitled "Investment Impairments and Considerations” within this Management’s Discussion and Analysis of Financial Condition and Results of Operations.
We have audited the accompanying consolidated balance sheets of EMC Insurance Group Inc. and Subsidiaries (the Company) as of December 31, 2018 and 2017, the related consolidated statements of income, comprehensive income, stockholders' equity and cash flows for each of the three years in the period ended December 31, 2018, and the related notes and financial statement schedules listed in the Index at Item 15(a) (collectively referred to as the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company at December 31, 2018 and 2017, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2018, in conformity with U.S. generally accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the Company’s internal control over financial reporting as of December 31, 2018, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations and the Treadway Commission (2013 framework), and our report dated March 6, 2019 expressed an unqualified opinion thereon.
We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatements of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and the significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion.
The Company writes property and casualty insurance in both commercial and personal lines of insurance, with a focus on medium-sized commercial accounts; however, on October 29, 2018, the Company, Employers Mutual and their subsidiary insurance companies (collectively the "EMC Insurance Companies") announced that they had made a strategic decision to exit personal lines business so that more time and resources can be dedicated to the commercial, reinsurance and life business. Approximately 36 percent of the premiums written are in Iowa and contiguous states. The Company’s reinsurance business is primarily written through a quota share reinsurance agreement with Employers Mutual. A small portion of the assumed reinsurance business is written on a direct basis, outside the quota share reinsurance agreement.
The consolidated financial statements have been prepared on the basis of U.S. generally accepted accounting principles (GAAP), which differ in some respects from those followed in reports to insurance regulatory authorities. All significant inter-company balances and transactions have been eliminated.
In January 2016, the Financial Accounting Standards Board (FASB) updated its guidance related to Financial Instruments-Overall Subtopic 825-10 of the Accounting Standards CodificationTM (Codification or ASC). The objective of this update is to enhance the reporting model for financial instruments to provide financial statement users with more decision-useful information. The major change in reporting from this update is a requirement that equity investments (excluding those accounted for under the equity method of accounting or those that are consolidated) be measured at fair value, with changes in fair value recognized in net income. Equity investments that do not have a readily determinable fair value may be measured at estimated fair value or cost less impairment. All of the Company's common and preferred stock equity investments were already measured at fair value, as they were classified as available-for-sale with changes in fair value recognized in other comprehensive income (excludes those investments that were consolidated and those that were accounted for under the equity method of accounting). The Company adopted this guidance on January 1, 2018, recording a cumulative-effect adjustment that moved $66.2 million from accumulated other comprehensive income to retained earnings, which is the amount of net unrealized investment gains on available-for-sale equity securities as of December 31, 2017, net of deferred income taxes. Management uses the equity method of accounting for a few holdings in privately placed common and non-redeemable convertible preferred stock investments in start-up technology companies with ties to the insurance industry, as well as for an investment company limited partnership in which the Company has a minor ownership interest (these investments are classified as other long-term investments). In connection with the adoption of this new guidance, beginning January 1, 2018, the equity adjustments for these investments are being reported as realized investment gains and losses on other long-term investments, rather than net investment income.
Certain commercial lines of business written by the property and casualty insurance subsidiaries, including workers’ compensation, are eligible for policyholder dividends in accordance with provisions of the underlying insurance policies. Net premiums written subject to policyholder dividends represented approximately 32 percent and 26 percent of the property and casualty insurance subsidiaries’ total net commercial line premiums written in 2018 and 2017, respectively. Policyholder dividends are accrued over the terms of the underlying policy periods.
Ceded reinsurance amounts with nonaffiliated reinsurers relating to reinsurance receivables for unpaid losses and settlement expenses and prepaid reinsurance premiums are reported on the balance sheet on a gross basis. Amounts ceded to Employers Mutual under the affiliated reinsurance pooling agreement and the inter-company reinsurance programs (see note 2) have not been grossed up because the contracts provide that receivables and payables may be offset upon settlement.
Currently, all fixed maturity securities are classified as available-for-sale and are carried at fair value, with unrealized holding gains and losses reported as a component of accumulated other comprehensive income in stockholders’ equity, net of deferred income taxes. Beginning January 1, 2018, equity securities (excluding those accounted for under the equity method of accounting or those that are consolidated) are measured at fair value, with changes in fair value recognized in net income. However, equity investments that do not have a readily determinable fair value are measured at cost less impairment. Prior to 2018, equity securities were classified as available-for-sale and were carried at fair value, with unrealized holding gains and losses reported as a component of accumulated other comprehensive income in stockholders’ equity, net of deferred income taxes.
Short-term investments generally include money market funds, U.S. Treasury bills and commercial paper that are carried at fair value, which approximates cost.
The Company uses independent pricing sources to obtain the estimated fair value of securities. Fair values are based on quoted market prices, where available. In cases where quoted market prices are not available, fair values are based on a variety of valuation techniques depending on the type of investment. The fair values obtained from independent pricing sources are reviewed for reasonableness and any discrepancies are investigated for final valuation (see note 8). The Company uses the practical expedient of net asset value per share to measure fair value of its private equity arrangements (referred to as investment funds) and the pooled separate account investments in Employers Mutual's qualified pension plan (see notes 8 & 12).
Goodwill represents the excess of cost over the fair value of net assets of acquired subsidiaries. Goodwill is not amortized, but is instead subject to impairment if the carrying value of the goodwill exceeds the estimated fair value of net assets. If the carrying amount of the reporting unit (including goodwill) exceeds the computed fair value, an impairment loss is recognized through the income statement equal to the excess amount, but not greater than the balance of the goodwill. Goodwill was not deemed to be impaired in 2018, 2017 or 2016.
On November 20, 2018, the Company announced receipt of a non-binding indicative proposal dated November 15, 2018 from Employers Mutual to purchase all the outstanding common stock of the Company not already owned by Employers Mutual, and the formation of a special committee of the Company's board of directors to consider the proposal. The proposal, which is subject to certain conditions, provides that the shares will be purchased at a price of $30 per share in cash. The special committee has retained its own independent financial and legal advisors to assist it in considering the proposal. There can be no assurance that any definitive agreement will be finalized and executed or that the proposal transaction or any other transaction will be approved or consummated.
The purpose of the pooling agreement is to spread the risk of an exposure insured by any of the pool participants among all the companies participating in the pool. The pooling agreement produces a more uniform and stable underwriting result from year to year for the companies participating in the pool than might be experienced individually. In addition, each company benefits from the capacity of the entire pool, rather than being limited to policy exposures of a size commensurate with its own statutory surplus, and from the wide range of policy forms, lines of insurance written, rate filings and commission plans offered by each of the companies.
The Company’s reinsurance subsidiary is party to a quota share agreement and an inter-company reinsurance program with Employers Mutual. Under the terms of the quota share agreement, the reinsurance subsidiary assumes 100 percent of Employers Mutual’s assumed reinsurance business, subject to certain exceptions. The inter-company reinsurance program in place with Employers Mutual covers both business assumed from Employers Mutual through the quota share agreement, as well as business obtained outside the quota share agreement, and consists of two treaties. The first is a per occurrence catastrophe excess of loss treaty with a retention of $10.0 million, a limit of $10.0 million, 20 percent co-participation, and no reinstatement. The total cost of this treaty was approximately $1.6 million, $1.7 million and $2.0 million in 2018, 2017 and 2016, respectively. The second is an annual aggregate catastrophe excess of loss treaty with a retention of $20.0 million, a limit of $100.0 million, and 20 percent co-participation. The total cost of this treaty was approximately $3.6 million, $3.2 million and $3.2 million in 2018, 2017 and 2016, respectively. Any losses recovered under the per occurrence treaty inure to the benefit of the aggregate treaty, and only catastrophic events with total losses greater than $500,000 are subject to the terms of the aggregate treaty. With the exception of the costs, the terms of the program were the same in all three years presented. Losses and settlement expenses ceded to Employers Mutual under the inter-company reinsurance program totaled $(4.6) million in 2018, $16.8 million in 2017 and $(467,000) in 2016. Much of the negative amount for 2018 is attributed to the reinsurance subsidiary recovering losses under external reinsurance purchased in 2017 to provide additional protection in peak exposure territories (see following paragraph). In accordance with the co-participation provision of the inter-company reinsurance program, the reinsurance subsidiary retained 20 percent of this recovery, with the balance ceded to Employers Mutual.
Premiums earned assumed by the reinsurance subsidiary from Employers Mutual amounted to $149.9 million, $135.7 million and $135.2 million in 2018, 2017 and 2016, respectively. Losses and settlement expenses assumed by the reinsurance subsidiary from Employers Mutual amounted to $116.7 million, $131.1 million and $90.9 million in 2018, 2017 and 2016, respectively. It is customary in the reinsurance business for the assuming company to compensate the ceding company for the acquisition expenses incurred in the generation of the business. Commissions incurred by the reinsurance subsidiary under the quota share agreement with Employers Mutual amounted to $30.0 million, $27.5 million and $27.4 million in 2018, 2017 and 2016, respectively.
The Company does not have any employees of its own. Employers Mutual performs all operations for all of its subsidiaries and affiliate. Such services include data processing, claims, financial, actuarial, legal, auditing, marketing and underwriting. Employers Mutual allocates a portion of the cost of these services to its subsidiaries that do not participate in the pooling agreement based upon a number of criteria, including usage of the services and the number of transactions. The remaining costs are charged to the pooling agreement and each pool participant shares in the total cost in accordance with its pool participation percentage. Costs allocated to the Company by Employers Mutual for services provided to the holding company and its subsidiaries that do not participate in the pooling agreement amounted to $5.9 million, $4.4 million and $4.7 million in 2018, 2017 and 2016, respectively. Costs allocated to the Company through the operation of the pooling agreement amounted to $104.8 million, $97.7 million and $92.3 million in 2018, 2017 and 2016, respectively.
As of December 31, 2018 and 2017, amounts recoverable from nonaffiliated reinsurers (two in 2018 and three in 2017) totaled $16.6 million and $22.7 million respectively, which represents a significant portion of the total prepaid reinsurance premiums and reinsurance receivables for losses and settlement expenses. Included in these balances is the property and casualty insurance subsidiaries’ aggregate pool participation percentage of amounts ceded by Employers Mutual to an organization on a mandatory basis. Credit risk associated with these amounts are minimal, as all companies participating in the organization are responsible for the liabilities of the organization on a pro rata basis.
The effect of reinsurance on premiums written and earned, and losses and settlement expenses incurred, for the three years ended December 31, 2018 is presented below. The classification of the assumed and ceded reinsurance amounts between affiliates and nonaffiliates is based on the participants in the underlying reinsurance agreements, and is intended to provide an understanding of the actual source of the reinsurance activities. This presentation differs from the classifications used in the consolidated financial statements, where all amounts flowing through the pooling and quota share agreements and inter-company reinsurance programs with Employers Mutual are reported as “affiliated” balances.
“Ceded to nonaffiliates” for the property and casualty insurance subsidiaries represents their aggregate 30 percent pool participation percentage of 1) the amounts ceded to nonaffiliated reinsurance companies in accordance with the terms of the reinsurance agreements providing protection to the pool and each of its participants, and 2) the amounts ceded on a mandatory basis to state organizations in connection with various programs. For the reinsurance subsidiary, this line includes 1) reinsurance business that is ceded to other insurance companies in connection with “fronting” activities initiated by Employers Mutual, and 2) amounts ceded in connection with the purchase of additional reinsurance protection in peak exposure territories from external parties.
“Ceded to affiliates” for the property and casualty insurance subsidiaries represents the cession of their direct business to Employers Mutual under the terms of the pooling agreement and amounts ceded to Employers Mutual under the terms of the inter-company reinsurance program. For the reinsurance subsidiary this line represents amounts ceded to Employers Mutual under the terms of the inter-company reinsurance program.
There is an inherent amount of uncertainty involved in the establishment of insurance liabilities. This uncertainty is greatest in the current and more recent accident years because a smaller percentage of the expected ultimate claims have been reported, adjusted and settled compared to more mature accident years. As the carried reserves for these accident years run off, the overall expectation is that, more often than not, favorable development will occur. However, there is also the possibility that the ultimate settlement of liabilities associated with these accident years will show adverse development, and such adverse development could be substantial.
During the third quarter of 2016, management implemented a new reserving methodology for the determination of direct bulk reserves in the property and casualty insurance segment. The new methodology, which is referred to as the accident year ultimate estimate approach, better conforms to industry practices and provides increased transparency of the drivers of the property and casualty insurance segment's performance. In connection with this change in reserving methodology, there was a reallocation of incurred but not reported ("IBNR") loss reserves and allocated settlement expense reserves from prior accident years to the current accident year in multiple lines of business. This change resulted in the movement of approximately $5.6 million of reserves from prior accident years to the current accident year that was reported as favorable development; however, this development was "mechanical in nature", and did not have an impact on earnings because the total amount of carried reserves did not change.
The Company’s insurance subsidiaries are required to file financial statements with state regulatory authorities. The accounting principles used to prepare these statutory financial statements follow prescribed or permitted accounting practices that differ from GAAP. Prescribed statutory accounting principles include state laws, regulations and general administrative rules issued by the state of domicile, as well as a variety of publications and manuals of the National Association of Insurance Commissioners (NAIC). Permitted accounting practices encompass all accounting practices not prescribed, but allowed by the state of domicile. The Company’s insurance subsidiaries had no permitted accounting practices during 2018, 2017 or 2016.
Statutory surplus of the Company’s insurance subsidiaries was $527.1 million and $560.1 million at December 31, 2018 and 2017, respectively. Statutory net income of the Company’s insurance subsidiaries was $10.8 million, $30.1 million and $48.3 million in 2018, 2017 and 2016, respectively.
The following table displays the premiums earned for the property and casualty insurance segment and the reinsurance segment for the three years ended December 31, 2018, by line of insurance.
The estimated fair values of fixed maturity and equity securities is based on quoted market prices, where available. In cases where quoted market prices are not available, fair values are based on a variety of valuation techniques depending on the type of security. During 2018, the Company invested in a few privately placed equity investments. One of these was in the form of preferred units in a limited liability corporation offering weather-related predictive analytics and risk mitigation tools. In accordance with the new guidance related to financial instruments that was adopted January 1, 2018, this investment does not have a readily determinable fair value. Therefore, the Company has elected to measure this investment at the alternative measurement of cost, adjusted for impairments and observable price changes. No impairment losses have been made to this investment. Due to the alternative measurement classification, this investment is excluded from the disclosures in this footnote. The other privately placed equity investment, also in the field of insurance technology, is accounted for under the equity method of accounting, and as such is also excluded from these fair value disclosures. Since 2016, the Company has held another privately placed equity investment in the form of non-redeembable convertible preferred stock issued by a start-up technology company that Employers Mutual works with in its data analytics activities. During 2018, the Company purchased common stock in this entity. The Company accounts for its investment in this entity under the equity method of accounting, and as such it is also excluded from these fair value disclosures.
The fair values of investment company limited partnership investments and similar vehicles (referred to as investment funds) are based on the capital account balances reported by the investment funds subject to their management review and adjustment. These capital account balances reflect the fair value of the investment funds.
Presented in the tables below are the estimated fair values of the Company’s financial instruments as of December 31, 2018 and 2017.
The following tables set forth the estimated fair values and gross unrealized losses associated with investment securities that were in an unrealized loss position recognized in accumulated other comprehensive income as of December 31, 2018 and 2017, listed by length of time the securities were consistently in an unrealized loss position.
The amortized cost and estimated fair values of fixed maturity securities at December 31, 2018, 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.
Gains and losses realized on the disposition of investments are included in net income. The cost of investments sold is determined on the specific identification method using the highest cost basis first. The Company did not have any outstanding cumulative credit losses on fixed maturity securities that have been recognized in earnings from “other-than-temporary” impairments during any of the reported periods. The net realized investment losses recognized on other long-term investments primarily represent changes in the carrying value of a limited partnership that is used solely to support an equity tail-risk hedging strategy, but for 2016 also included an "other-than-temporary" impairment loss of $209,000 on an investment that conveyed investment tax credits.
Pursuant to Staff Accounting Bulletin No. 118 issued by the Securities Exchange Commission, the Company made reasonable estimates of the effects the TCJA had on deferred income tax assets and liabilities at December 31, 2017. For items where the Company could not make a reasonable estimate, primarily loss reserve discounting, the Company used existing accounting guidance and the provisions of the tax laws that were in place prior to the enactment. Subsequently, the Company made its final determination of the effects of the TCJA when the Internal Revenue Service (IRS) issued Revenue Procedure 2019-06, which provides applicable discount factors for both the transition obligation (reserves at January 1, 2018), and reserves at December 31, 2018.
Comprehensive income tax expense (benefit) included in the consolidated financial statements for the years ended December 31, 2018, 2017 and 2016 is as follows. The deferred income tax benefit that resulted from the enactment of the TCJA in 2017 is included in the "operations" line.
Employers Mutual has various employee benefit plans, including a qualified defined benefit pension plan, a non-qualified defined benefit supplemental pension plan, a retiree life insurance benefit and a retiree health reimbursement arrangement (HRA) benefit.
The qualified defined benefit plan covers substantially all of its employees. This plan is funded by employer contributions and provides a benefit under a cash balance formula for most employees; however, benefits are provided to a few long-term employees based on a traditional benefit formula. The cash balance method accumulates funds so that the employee can receive a specified benefit amount at retirement. Benefits accrue with an interest and salary credit each year. On December 18, 2017, Employers Mutual notified its employees that effective January 1, 2019, the salary credit will be based on a combination of age and years of service, rather than just age. This change did not have a material impact on the pension benefit obligation. Benefits generally vest after three years of service or the attainment of 55 years of age and one year of service. It is Employers Mutual’s funding policy to make contributions sufficient to be in compliance with minimum regulatory funding requirements, plus additional amounts as determined by management.
Employers Mutual’s non-qualified defined benefit supplemental retirement plan provides additional retirement benefits for a select group of management. This plan enables select employees to receive retirement benefits without the limit on compensation imposed on qualified defined benefit pension plans by the IRS and to recognize compensation that has been deferred in the non-qualified deferred compensation plan. The plan is unfunded and benefits generally vest after three years of service.
Employers Mutual maintains a Voluntary Employee Beneficiary Association (VEBA) trust that has historically been used to accumulate funds for the payment of postretirement benefits. Given the overfunded position of the postretirement benefit plans, contributions to the VEBA trust are not anticipated for the foreseeable future.
The following tables set forth the amounts recognized in the Company’s financial statements as a result of the property and casualty insurance subsidiaries’ aggregate 30 percent participation in the pooling agreement.
The net periodic postretirement benefit income recognized on Employers Mutual's postretirement benefit plans is due to a plan amendment that was announced in the fourth quarter of 2013. This plan amendment generated a prior service credit that is being amortized into net periodic benefit cost over a period of 10 years.
Mutual Funds: Valued at the net asset value of shares held by the trust at year-end. For purposes of calculating the net asset value, portfolio securities and other assets for which market quotes are readily available are valued at fair value. Fair value is generally determined on the basis of last reported sales prices, or if no sales are reported, based on quotes obtained from a quotation reporting system, established market makers, or independent pricing services.
Global Portfolio Strategies, Inc. reviews the plan’s assets and liabilities in relation to expectations of long-term market performance and liability development to recommend the appropriate asset allocation. The data for the contributions and emerging liabilities is provided from the plan’s actuarial valuation, while the current asset and monthly benefit payment data is provided by the plan record keeper.
Following is a description of the valuation techniques and inputs used for pooled separate accounts, the only major class of assets measured at fair value in Employers Mutual’s qualified pension plan.
Employers Mutual plans to contribute approximately $7.0 million to the pension plan in 2019. No contributions are expected to be made to the VEBA trust in 2019.
On May 26, 2017, the Company registered 150,000 shares of its common stock for use in the EMC Insurance Group Inc. 2017 Non-Employee Director Stock Plan (the "2017 Director Plan"). The 2017 Director Plan provides for the awarding of non-qualified stock options, restricted stock, restricted stock units and other stock-based awards to the Company's non-employee directors. During 2018 and 2017, 2,800 and 2,000 shares of restricted stock were granted to non-employee directors of the Company under this plan. These shares of restricted stock vest over a one year period. Dividends on the unvested restricted stock are accrued and paid to the directors at the time of vesting.
Employers Mutual currently maintains two separate stock plans for the benefit of officers and key employees of Employers Mutual and its subsidiaries. A total of 3,000,000 shares of the Company’s common stock have been reserved for issuance under the 2007 Employers Mutual Casualty Company Stock Incentive Plan (2007 Plan), and a total of 1,000,000 shares have been reserved for issuance under the Employers Mutual Casualty Company 2017 Stock Incentive Plan (2017 Plan).
Both of Employers Mutual's plans permit the issuance of performance shares, performance units, and other stock-based awards, in addition to qualified (incentive) and non-qualified stock options, stock appreciation rights, restricted stock and restricted stock units. Both plans provide for a ten-year time limit for granting awards. No additional grants can be made under the 2007 Plan due to the expiration of the term of the plan. The Senior Executive Compensation Committee of Employers Mutual’s Board of Directors grants the awards and is the administrator of the plans. The Company’s Compensation Committee must consider and approve all awards granted to the Company’s executive officers. Awards granted to directors are approved by the Company's Corporate Governance and Nominating Committee.
During 2016, 2,000 shares of restricted stock were granted to non-employee directors of the Company under the 2007 Plan. These shares of restricted stock vest over a period of three years, or upon a director reaching 75 years of age while an active director. The directors are entitled to receive compensation income (equal to the amount of dividends paid on the Company's common stock) earned on unvested shares of restricted stock.
As discussed above, during 2017 Employers Mutual began issuing restricted stock unit awards to eligible employees. These awards are accounted for as liability-based awards, whereby the liability is remeasured at each reporting date as the average of the high and low trading prices of the Company's common stock on that date. Upon settlement, the Company will receive the full fair value for all shares issued. The Company's share of this liability at December 31, 2018 was $1.2 million. A summary of restricted stock unit awards activity for 2018 and 2017 is as follows:
The Company’s portion of the total intrinsic value of options exercised under Employers Mutual’s stock plans was $339,000, $901,000 and $1.1 million in 2018, 2017 and 2016, respectively. Under the terms of the pooling and quota share agreements, these amounts were paid to Employers Mutual. The Company receives the full fair value, as of the exercise date, for all shares issued in connection with option exercises. Additional information relating to options outstanding and options vested (exercisable) at December 31, 2018 is as follows:
Incentive stock options generally do not generate income tax deductions for the Company. The Company has recorded a deferred income tax benefit for non-qualified stock options and restricted stock awards that have been issued. The Company’s portion of the current income tax deduction realized from exercises of non-qualified stock options was $56,000, $239,000 and $284,000 in 2018, 2017 and 2016, respectively. These actual deductions are generally in excess of the deferred tax benefits recorded in conjunction with the compensation expense (referred to as excess tax benefits), which reduce income tax expense. The income tax benefit that results from disqualifying dispositions of stock purchased through the exercise of incentive stock options is immaterial.
During 2018, shares were purchased under the plan at prices ranging from $20.90 to $24.70. Activity under the plan was as follows:
During 2018, shares were purchased under the plan at prices ranging from $18.95 to $19.99. Activity under the plan was as follows:
The following tables display amounts reclassified out of accumulated other comprehensive income and into net income during the three years ended December 31, 2018.
On November 3, 2011, the Company’s Board of Directors authorized a $15.0 million stock repurchase program. This program does not have an expiration date. The timing and terms of the purchases are determined by management based on board approved parameters and market conditions, and are conducted in accordance with the applicable rules of the Securities and Exchange Commission. Common stock repurchased under this program will be retired by the Company. During 2018, the Company repurchased 25,300 shares of its common stock at an average cost of $25.76. No repurchases were made in 2017, but 17,300 shares were repurchased during 2016 at an average cost of $22.14.
During the second quarter of 2005, Employers Mutual initiated a $15.0 million stock purchase program under which Employers Mutual may purchase shares of the Company’s common stock in the open market. This purchase program does not have an expiration date; however, this program is currently dormant and will remain so while the Company’s repurchase program is in effect. The timing and terms of the purchases are determined by management based on market conditions and are conducted in accordance with the applicable rules of the Securities and Exchange Commission. No purchases were made during 2018, 2017 and 2016. As of December 31, 2018, $4.5 million remained available under this plan for additional purchases.