Management intends to identify forward-looking statements when using the words “believe”, “expect”, “anticipate”, “estimate”, “project” or similar expressions. Undue reliance should not be placed on these forward-looking statements.
The Company, a 60 percent owned subsidiary of Employers Mutual Casualty Company (Employers Mutual), is an insurance holding company with operations in property and casualty insurance and reinsurance.
Effective January 1, 2009, EMC Reinsurance Company began writing German assumed reinsurance business on a direct basis (outside the quota share agreement) as a result of regulatory changes in Germany.
Effective January 1, 2010, the terms of the quota share agreement were revised to increase the retention, or cap, on losses assumed per event from $2,000,000 to $3,000,000. The cost of this protection (10.5 percent of premiums written) remains unchanged.
Insurance pricing has historically been cyclical in nature. Periods of excess capital and increased competition encourage price reductions and liberal underwriting practices (referred to as a soft market) as insurance companies compete for market share, while attempting to cover the inevitable underwriting losses from these actions with investment income. A prolonged soft market generally leads to a reduction in the adequacy of capital in the insurance industry. To cure this condition, underwriting practices are tightened, premium pricing increases and competition subsides as companies strive to strengthen their balance sheets (referred to as a hard market). The insurance industry is currently in the fifth year of a soft market; however, premium rates began to show some signs of stabilization during 2009. Management anticipates that overall industry pricing will remain relatively stable in 2010.
The Company has historically reported catastrophe and storm losses net of development experienced on prior accident years’ catastrophe and storm losses. This has not had a material impact on the reported amounts of catastrophe and storm losses because development associated with prior accident years’ catastrophe and storm losses has historically been relatively small. During 2009, however, the Company experienced a larger amount of favorable development related to the record amount of catastrophe and storm losses incurred in 2008. As a result, the Company has changed its reporting of catastrophe and storm losses to include only current accident year events. Any material amount of development experienced on prior accident years’ catastrophe and storm loss reserves is now reported separately. This change in reporting does not have any impact on the Company’s results of operations; it only affects the reported amounts of catastrophe and storm losses.
Care should be exercised when attempting to analyze the financial impact of the reported development amounts because, as noted above, the overall expectation is that, more often than not, favorable development will occur as the prior accident year reserves run off.
During the past two years the Company has experienced above average levels of weather related losses. These losses were not the result of high concentrations of exposures in the affected areas, but rather reflect unusually active and severe weather patterns in the Midwest, where the Company writes the majority of its insurance business. Although the active Midwest weather patterns have resulted in increased loss frequency and severity during this period, management does not believe that this activity represents a permanent change in Midwest storm exposures.
The Company’s consolidated financial statements are prepared on the basis of U.S. generally accepted accounting principles (also known as “GAAP”). The Company also prepares financial statements for each of its insurance subsidiaries based on statutory accounting principles that are filed with insurance regulatory authorities in the states where they do business. Statutory accounting principles are designed to address the concerns of state regulators and stress the measurement of the insurer’s ability to satisfy its obligations to its policyholders and creditors.
Premiums Written Assumed From Affiliates and Premiums Assumed Written 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 business assumed by the reinsurance subsidiary through the quota share agreement and, beginning January 1, 2009, the German-based 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 written premiums ceded to reinsurers, as a measure of the underlying growth of the Company’s insurance business from period to period.
GAAP Combined Ratio. The combined ratio (expressed as a percentage) is the sum of the loss and settlement expense ratio and the acquisition expense ratio, and measures a company’s overall underwriting profit. If the combined ratio is at or above 100, an insurance company cannot be profitable without investment income (and may not be profitable if investment income is insufficient). Management uses the GAAP combined ratio in evaluating the Company’s overall underwriting profitability and as a measure for comparison of the Company’s profitability relative to the profitability of its competitors who prepare GAAP-basis financial statements.
To provide consistency in the reserving process, the Company utilizes established claims management processes and an automated claims system. Claims personnel conduct random case loss reserve reviews to verify the accuracy of the reserve estimates and adherence to the reserving guidelines. In addition, the Company has specific line-of-business management controls for case loss reserves. For example, all workers’ compensation claim files are reviewed by management before declining benefits, and all casualty case loss reserves are reviewed every 60 days for reserve adequacy.
At December 31, 2009, IBNR loss reserves accounted for $73,755,000, or 18.0 percent, of the property and casualty insurance segment’s total loss and settlement expense reserves, compared to $80,463,000, or 18.8 percent, at December 31, 2008. IBNR loss reserves are, by nature, less precise than case loss reserves. A five percent change in IBNR loss reserves at December 31, 2009 would equate to $2,397,000, net of tax, which represents 5.3 percent of the net income reported for 2009 and 0.7 percent of stockholders’ equity.
Following is a summary of the carried loss and settlement expense reserves for the property and casualty insurance segment at December 31, 2009 and 2008.
A third assumption is that individual case loss reserve adequacy is consistent over time. The following table displays the impact on the Company’s results of operations, for the latest ten accident years, of a five percent variance in individual case loss reserve adequacy from the level anticipated in the incurred loss projection factors. In other words, future loss payments under this scenario would be expected to vary from actuarial reserve estimates by these amounts. This variance in expected loss payments could occur in one year or over multiple years. A change in individual case loss reserve adequacy 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. A variance 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. A five percent variance in individual case loss reserve adequacy is considered reasonably likely based on the range of actuarial indications developed during the analysis of the property and casualty insurance segment’s carried reserves.
For the HORAD component, Employers Mutual records the case and IBNR loss reserves reported by the ceding companies. Since many ceding companies in the HORAD book of business do not report IBNR loss reserves, Employers Mutual establishes a bulk IBNR loss reserve, which is based on an actuarial reserve analysis, to cover the lag in reporting. For MRB, Employers Mutual records the case and IBNR loss reserves reported to it by the management of the pool, along with a relatively small IBNR loss reserve to cover a one month reporting lag. To verify the adequacy of the reported reserves, an actuarial evaluation of MRB’s reserves is performed at each year-end.
Assumed reinsurance losses tend to be reported later than direct losses. This lag is reflected in loss projection factors for assumed reinsurance that tend to be higher than for direct business. The result is that assumed reinsurance IBNR loss reserves as a percentage of total reserves tend to be higher than for direct loss reserves. IBNR loss reserves totaled $88,795,000 and $86,780,000 at December 31, 2009 and 2008, respectively, and accounted for approximately 61 percent and 60 percent, respectively, of the reinsurance segment’s total loss and settlement expense reserves. IBNR loss reserves are, by nature, less precise than case loss reserves. A five percent change in IBNR loss reserves at December 31, 2009 would equate to $2,886,000 net of tax, which represents 6.4 percent of the net income reported for 2009 and 0.8 percent of stockholders’ equity.
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 900 asbestos bodily injury lawsuits, some of which involve multiple plaintiffs. Five former policyholders and one current policyholder dominate the pool participants’ asbestos claims. 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 routinely dismissed from asbestos litigation with nominal or no payment (i.e., small contractors, insulators, electrical welding suppliers, furnace manufacturers, and gasket and building supply companies).
The pool participants are defending approximately 67 claims as a result of lawsuits alleging “silica” exposure in Texas and Mississippi jurisdictions, 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 Company’s environmental claims are defined as 1) claims for bodily injury, personal injury, property damage, loss of use of property, diminution of property value, etc., allegedly due to contamination of air, and/or contamination of surface soil or surface water, and/or contamination of ground water, aquifers, wells, etc.; or 2) any/all claims for remediation or clean-up of hazardous waste sites by the United States Environmental Protection Agency, or similar state and local environmental or government agencies, usually presented in conjunction with Federal or local clean up statutes (i.e., CERCLA, RCRA, etc.).
The Company’s current exposures to environmental claims include losses involving petroleum haulers, lead contamination, and soil and groundwater contamination in the State of Indiana. Claims from petroleum haulers are generally caused by overturned commercial vehicles and overfills at commercial and residential properties. Exposures for accident year losses preceding the 1980s include municipality exposures for closed landfills, small commercial businesses involved with disposing waste at landfills, leaking underground storage tanks and contamination from dry cleaning operations. As of December 31, 2009, all Methyl Tertiary Butyl Ether (“MTBE”) claims related to the pool participants’ policyholders have been dismissed.
At December 31, 2009, the Company carried asbestos and environmental reserves for direct insurance and assumed reinsurance business totaling $6,527,000, which represents 1.2 percent of total loss and settlement expense reserves. The asbestos and environmental reserves include $2,149,000 of case loss reserves, $3,895,000 of IBNR loss reserves and $483,000 of bulk settlement expense reserves. Ceded reinsurance on these reserves totaled $307,000.
Following is a summary of loss and settlement expense reserves and payments associated with asbestos, environmental, products liability and casualty excess reinsurance exposures for 2009, 2008 and 2007:
The Company does not determine a range of estimates for all components of the loss and settlement expense reserve at the time those reserves are established. At each quarter-end, however, an actuarially determined range of estimates is developed for the major components of the loss and settlement expense reserve. All reserves are reviewed, except for the involuntary workers’ compensation pools, for which reliance is placed on a reserve opinion received from the National Council on Compensation Insurance certifying the reasonableness of those reserves. Shown below are the actuarially determined ranges of reserve estimates as of December 31, 2009 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 if the reserves were moved to the high end-point or low end-point of the ranges.
A small number of the Company’s securities are not priced by the independent pricing service. One is an equity security that is reported as a Level 3 fair value measurement at December 31, 2009, since no reliable observable inputs are used in its valuation. This equity security continues to be reported at the fair value obtained from the Securities Valuation Office (SVO) of the National Association of Insurance Commissioners (NAIC). The SVO establishes a per share price for this security based on an annual review of that company’s financial statements. This review is typically performed during the second quarter, and resulted in a fair value for the shares held by the Company of $2,000 at December 31, 2009 and $4,000 at December 31, 2008. The remaining two securities not priced by the Company’s independent pricing service are fixed maturity securities. The two fixed maturity securities are classified as Level 2 fair value measurements and are carried at aggregate fair values of $7,722,000 at December 31, 2009 and $7,163,000 at December 31, 2008. The fair values for these two fixed maturity securities were obtained from the Company’s investment custodian using independent pricing services which utilize similar pricing techniques as the Company’s independent pricing service.
The Company regularly monitors its investments which have a fair value that is less than the carrying value for indications of “other-than-temporary” impairment. Several factors are used to determine whether the carrying value of an individual security has been “other-than-temporarily” impaired. Such factors include, but are not limited to (1) the security’s value and performance in the context of the overall markets, (2) length of time and extent the security’s fair value has been below carrying value, (3) key corporate events, and (4) for equity securities, the ability and intent to hold the security until recovery to its cost basis. Prior to April 1, 2009, the Company’s ability and intent to hold fixed maturity securities in an unrealized loss position until recovery was also considered in the determination of “other-than-temporary” impairments.
The expected long-term rate of return on plan assets is developed considering actual historical results, current and expected market conditions, the mix of plan assets and investment strategy. The expected long-term rate of return on plan assets produced by this analysis and used in the pension valuations at December 31, 2009, 2008 and 2007 was 7.50 percent. The expected long-term rate of return on plan assets used in the postretirement benefit valuations at December 31, 2009, 2008 and 2007 was 6.00 percent. The actual rate of return earned on plan assets during 2009, which reflects some recovery from the financial crisis, was approximately 18 percent for the pension plan and 10 percent for the postretirement benefit plans. The expected long-term rate of return assumption is subject to the general movement of the economy, but is generally less volatile than the discount rate assumption. A decrease in the expected long-term rate of return assumption increases future expenses, whereas an increase in the assumption reduces future expenses. A 0.25 percentage point change in the 2009 expected long-term rate of return assumption would change the Company’s net periodic pension and postretirement benefit costs for 2010 by $160,000. For detailed information regarding the current allocation of assets within the pension and postretirement benefit plans, see note 12 of Notes to Consolidated Financial Statements under Part II, Item 8 of this Form 10-K.
Premiums earned decreased 1.4 percent to $384,011,000 in 2009 from $389,318,000 in 2008. This decrease is primarily attributed to a moderate, but steady, decline in overall premium rate levels during the previous two years as a result of competitive market conditions associated with the current soft market. Premium rates stabilized during 2009, but did not improve to the extent anticipated one year ago due to the lagging effects of the weak economy, the very mild 2009 hurricane season, and a general strengthening in the capital base of the industry. The pool participants were able to achieve some increases in rates, though those increases were generally small and targeted to specific local markets and individual accounts. Pricing in the reinsurance marketplace improved with the January 1 renewals, but declined somewhat as the year progressed. Rates seem to be firming already for personal lines in many territories, and management anticipates that rates will begin to firm for commercial lines toward the latter half of 2010. Management expects to continue to implement rate increases in the low to mid-single digits as warranted.
Premiums earned for the reinsurance segment increased 3.0 percent to $75,932,000 in 2009 from $73,720,000 in 2008. This increase is primarily associated with a moderate increase in reinsurance premium rate levels and the addition of a few new accounts. However, this premium growth was partially offset by a decrease in reinstatement premium income, a decline in business assumed from the MRB pool, and a decrease in the amount of earned but not reported (EBNR) premium recognized. Due to a loss of capital in the reinsurance industry in 2008 as a result of the economic crisis, reinsurance premium rate levels firmed somewhat in the first part of 2009 and the reinsurance segment was able to obtain moderate rate increases on most of its renewals (including the January 1 renewals). However, due to the mild hurricane season and a recovery in reinsurance company capital levels during 2009, premium rate levels subsided in the second half of the year. Premium rate levels for the January 1, 2010 renewal season were generally flat, with some moderate declines in premium rates on certain accounts.
Losses and settlement expenses decreased 15.5 percent to $248,749,000 in 2009 from $294,265,000 in 2008, while the loss and settlement expense ratio decreased to 64.8 percent in 2009 from 75.6 percent in 2008. Storm losses, while higher than average due to active Midwest weather patterns, were significantly lower than the record amount experienced in 2008. Catastrophe and storm losses accounted for 8.2 percentage points of the combined ratio for the year ended December 31, 2009, which is higher than the 8-year average of 6.5 percentage points for the period 2000 to 2007, but significantly lower than the record 13.5 percentage points experienced in 2008. Other factors contributing to the improvement in the loss and settlement expense ratio were a decline in large losses, an increase in the amount of favorable development experienced on prior years’ reserves, and strong underwriting performance in the reinsurance segment. Current actuarial analysis indicates that the level of reserve adequacy at December 31, 2009 is consistent with other recent evaluations. From management’s perspective, this measure is more relevant to an understanding of the Company’s results of operation than the composition of the underwriting results between the current and prior accident years.
The loss and settlement expense ratio for the reinsurance segment decreased to 65.4 percent in 2009 from 83.7 percent in 2008. Factors contributing to the reinsurance segment’s improvement include moderate rate increases, good results from the MRB pool, an increase in the amount of favorable development experienced on prior accident years’ reserves due to a reduction in bulk IBNR reserves and the winding down of the MAERP Reinsurance Association (formerly known as Mutual Atomic Energy Reinsurance Pool), and a decline in catastrophe and storm losses from the large amount reported in 2008 (including $2,000,000 of losses associated with Hurricane Ike).
Acquisition and other expenses increased 6.8 percent to $136,100,000 in 2009 from $127,385,000 in 2008. The acquisition expense ratio increased to 35.4 percent in 2009 from 32.7 percent in 2008. These increases are attributed to the property and casualty insurance segment and reflect increases in net periodic pension benefit cost, executive bonuses and contingent salaries, and policyholder dividends. These increases were partially offset by a decline in the acquisition expense ratio in the reinsurance segment, resulting primarily from declines in commission and contingent commission expense.
For the reinsurance segment, the acquisition expense ratio decreased to 22.0 percent in 2009 from 23.8 percent in 2008. This decline is primarily associated with decreases in commission expense (driven largely by fluctuations in the estimate of commission expense relative to the associated estimate of earned but not reported premiums) and contingent commission expense (reflecting a decline from the relatively high amount reported in 2008).
The Company reported a net realized investment gain of $17,922,000 in 2009 compared to a net realized investment loss of $24,456,000 in 2008. The 2009 amount reflects a $22,474,000 realized gain recognized on the disposal of the Company’s holdings of Verisk common stock, and $10,108,000 of “other-than-temporary” investment impairment losses recognized on 34 equity securities and three fixed maturity securities. The impairment losses on the three fixed maturity securities totaled $2,657,000, and is attributed to a bankruptcy filing made by Great Lakes Chemical Corporation, now known as Chemtura Corporation ($2,220,000), a planned disposal of US Freightways Corporation securities ($350,000) and the determination of a credit loss (all contractual cash flows are not expected to be collected) on a residential mortgage-backed security ($87,000). Included in the 2008 loss amount is $16,017,000 of “other-than-temporary” investment impairment losses recognized on 38 equity securities as a result of the severe and prolonged turmoil in the financial markets, and $14,904,000 of losses recognized on the perpetual preferred stocks of Freddie Mac and Fannie Mae when these companies were placed under conservatorship by the U.S. government.
The total rate of return on the Company’s equity portfolio during 2009 was 21.80 percent, compared to 26.46 percent for the S&P 500. The current annualized yield on the bond portfolio was 5.27 percent and the effective duration was 6.12 years, which was up from 5.57 years at December 31, 2008.
The Company reported a net loss of $1,705,000 ($0.13 per share) in 2008 compared to net income of $42,478,000 ($3.09 per share) in 2007. The net loss for 2008 was primarily attributed to two factors: a record amount of catastrophe and storm losses and a record amount of “other-than-temporary” investment impairment losses generated by the severe and prolonged turmoil in the financial markets. Other factors contributing to the net loss for 2008 included an expected decline in the amount of favorable development experienced on prior years’ reserves, and a moderate, but steady, decline in overall premium rate levels.
Premiums earned decreased 1.0 percent to $389,318,000 in 2008 from $393,059,000 in 2007. This decrease was primarily attributed to a moderate, but steady, decline in overall premium rate levels during the prior three years as a result of competitive market conditions associated with the current soft market. Premium rates showed some signs of stabilization during the fourth quarter as the insurance industry began responding to the significant decline in capital that occurred during 2008 as a result of the financial crisis and high level of catastrophe and storm losses.
Premiums earned for the reinsurance segment increased 2.1 percent to $73,720,000 in 2008 from $72,223,000 in 2007. This increase was primarily attributed to the HORAD book of business and reflected an increase in both the estimate of earned but not reported (EBNR) premiums and accrued reinstatement premiums. Under the terms of the quota share agreement, the reinsurance segment receives reinstatement premium income that is collected by Employers Mutual from the ceding companies when coverage is reinstated after a loss event; however, the cap on losses assumed per event contained in the quota share agreement is automatically reinstated without cost to the reinsurance subsidiary. The increases in premium income in the HORAD book of business were largely offset by a decline in the amount of business assumed from the MRB pool. Both the MRB and HORAD books of business suffered from the loss of a few accounts, increased retentions by some of the ceding companies and lower premium rates driven by increased rate competition. This was evident during the January and July renewal seasons as the reinsurance segment experienced an overall decline in the average rate on-line for its accounts. There was some additional minor deterioration in rates during the July renewal period, but increased terms on those accounts with recent loss experience kept overall rate adequacy at a fairly consistent level with that achieved on the January renewals.
Losses and settlement expenses increased 18.7 percent to $294,265,000 in 2008 from $247,839,000 in 2007. The loss and settlement expense ratio increased to 75.6 percent in 2008 from 63.1 percent in 2007. The large increase in the loss and settlement expense ratio was primarily attributed to a record $50,774,000 of catastrophe and storm losses in 2008, compared to $21,514,000 in 2007. Catastrophe and storm losses added 13.0 percentage points to the loss and settlement expense ratio in 2008, compared to 5.5 percentage points in 2007. The moderate, but steady, decline in premium rate levels experienced over the prior several years combined with an expected decline in the amount of favorable development experienced on prior years’ reserves also contributed to the increase in the loss and settlement expense ratio. Current actuarial analysis indicated that reserve adequacy remained at a high level, and actually improved somewhat during 2008.
The loss and settlement expense ratio for the reinsurance segment increased to 83.7 percent in 2008 from 66.9 percent in 2007. This increase reflected an increase in the amount of reported large losses, an increase in catastrophe and storm losses (including $2,000,000 of losses associated with Hurricane Ike), and an increase in reported crop losses. An increase in the amount of favorable development experienced on prior years’ reserves helped to limit the increase in the loss and settlement expense ratio.
The total rate of return on the Company’s equity portfolio during 2008 was negative 37.4 percent, compared to negative 37.0 percent for the S&P 500. The current annualized yield on the bond portfolio and cash was 5.6 percent and the effective duration was 5.57 years, which was up from 3.75 years at December 31, 2007.
The Company reported an income tax benefit of $8,585,000 in 2008, compared to income tax expense of $16,441,000 in 2007. The relatively high ratio of income tax benefit to pretax loss for 2008 reflects the fact that a significant amount of the Company’s investment income was received in the form of tax-exempt interest income.
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 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, 2009, the Company’s insurance subsidiaries had total adjusted statutory capital of $327,244,000, which was well in excess of the minimum RBC requirement of $56,862,000.
The Company’s total cash and invested assets at December 31, 2009 and 2008 are summarized as follows:
As of December 31, 2009, the Company had no material commitments for capital expenditures.
The Company has no direct exposure to sub-prime residential lending, and holds no sub-prime residential collateralized debt obligations or sub-prime collateralized mortgage obligations. The Company does have indirect exposure to sub-prime residential lending markets as it has significant holdings of government agency securities, prime and Alt-A collateralized mortgage obligations, as well as fixed maturity and equity security holdings in both the banking and financial services sectors. While these holdings do not include companies engaged in originating residential lending as their primary business, they do include companies that may be indirectly engaged in this type of lending.
During the second quarter of 2008, management evaluated and implemented a new investment strategy targeting high-quality residential mortgage-backed securities. This investment strategy, which is being administered by Harris Investment Management, Inc., was designed to take advantage of the liquidity-induced market dislocation that existed in the securitized residential mortgage marketplace, and targeted AAA rated residential mortgage-backed securities (no securities backed by subprime mortgages were purchased). The investments were diversified with respect to key risk factors (such as vintage, originator and geography).
All non-investment grade fixed maturity securities held at December 31, 2009 (American Airlines, Weyerhaeuser Company and eight residential mortgage-backed securities) had an aggregate unrealized loss of $593,000. The Company does not purchase non-investment grade securities. Any non-investment grade securities held by the Company are the result of rating downgrades that occurred subsequent to their purchase. The eight residential mortgage-backed securities that are new to this list in 2009 were the only securities on this list with unrealized losses at December 31, 2009. These securities were part of the 2008 investment strategy that targeted high-quality residential mortgage-backed securities.
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. Estimated guaranty fund assessments of $1,236,000 and $1,506,000 and related premium tax offsets of $692,000 and $936,000 have been accrued as of December 31, 2009 and 2008, 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 a worker with a pre-existing disability. Estimated second-injury fund assessments of $1,709,000 and $1,576,000 have been accrued as of December 31, 2009 and 2008, 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.
Interest rate risk (inclusive of credit spreads) includes the price sensitivity of a fixed maturity security to changes in interest rates, and the affect on future earnings from short-term investments and maturing long-term investments given a change in interest rates. The following table illustrates the sensitivity of the Company’s fixed maturity securities available-for-sale to hypothetical changes in market rates and prices.
The Company monitors interest rate risk through the 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 at December 31, 2009 was 6.12 years.
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, 2009.
As of December 31, 2009, the Company held approximately $202,040,000 of municipal securities that are enhanced by financial guaranty insurers, which represents approximately 22.5 percent of the Company’s total fixed maturity portfolio. Municipal securities insurance guarantees the payment of principal and interest if the issuer defaults. The credit rating of insurance enhanced municipal securities is usually based on the credit rating of the insurer. These securities have an average rating of “AA”. Approximately $41,217,000 of the securities have been pre-refunded, which means that funds have been set aside in escrow to satisfy the future interest and principal obligations of the security. A summary of the financial guaranty insurers backing the Company’s insurance enhanced municipal securities, including the pre-refunded bonds that are escrowed, is as follows.
The Company has no insurance enhanced asset-backed securities. As of December 31, 2009, the Company had no direct investment in the entities that provided financial guarantees to any security held by the Company.
Prepayment risk refers to changes in prepayment patterns that can shorten or lengthen the expected timing of principal repayments and thus the average life and the effective yield of a security. Such risk exists primarily within the portfolio of mortgage-backed securities. Prepayment risk is monitored regularly through the analysis of interest rate simulations. At December 31, 2009, the effective duration of the mortgage-backed securities is 3.9 years with an average life of 4.0 years and a yield to maturity of 6.2 percent. At December 31, 2008, the effective duration of the mortgage-backed securities was 6.7 years, with an average life of 5.3 years and a yield to maturity of 5.7 percent.
In May 2009, the FASB updated its guidance related to the Subsequent Events Topic 855 of the FASB ASC (issued as SFAS No. 165, “Subsequent Events”), which sets forth the period after the balance sheet date during which management shall evaluate events or transactions for potential recognition or disclosure, the circumstances under which an entity shall recognize events or transactions occurring after the balance sheet date, and disclosures to make about events or transactions that occur after the balance sheet date. This pronouncement was effective for interim and annual reporting periods ending after June 15, 2009. In February 2010, the FASB updated its guidance related to the Subsequent Events Topic 855, which removed the requirement to disclose the date through which subsequent events were evaluated for Securities and Exchange Commission filers. This pronouncement was effective immediately. Adoption of this pronouncement had no effect on the consolidated financial position or operating results of the Company.
In April 2009, the FASB updated its guidance related to the Investments-Debt and Equity Securities Topic 310 of the FASB ASC (issued as Staff Position (FSP) FAS 115-2 and FAS 124-2, “Recognition and Presentation of Other-Than-Temporary Impairments”). This pronouncement established guidance for evaluating “other-than-temporary” impairments for fixed maturity securities, and required changes to the financial statement presentation and disclosure of fixed maturity and equity security “other-than-temporary” impairments. Included is a requirement that the evaluation of an impaired fixed maturity security include an assessment of whether the entity has the intent to sell the security and if it is more likely than not to be required to sell the security before recovery of its amortized cost basis. In addition, if the present value of cash flows expected to be collected is less than the amortized cost of the security, a credit loss is deemed to exist and the security is considered “other-than-temporarily” impaired. The portion of the impairment related to a credit loss is recognized through earnings and the impairment related to other factors is recognized through “other comprehensive income”. This pronouncement was effective for interim and annual reporting periods ending after June 15, 2009. A cumulative effect adjustment from retained earnings to “accumulated other comprehensive income” was required for previously “other-than-temporarily” impaired fixed maturity securities still owned that had a non-credit component of the loss as of the date of adoption. The Company adopted this pronouncement in the second quarter of 2009. For further discussion of this statement, see Note 1 of the Consolidated Financial Statements.
Management assessed the effectiveness of the Company’s internal control over financial reporting based on criteria established in “Internal Control - Integrated Framework,” issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based on this assessment, management believes that, as of December 31, 2009, the Company maintained effective internal control over financial reporting.
We have audited EMC Insurance Group Inc. and Subsidiaries’ internal control over financial reporting as of December 31, 2009, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). EMC Insurance Group Inc. and Subsidiaries’ management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.
In our opinion, EMC Insurance Group Inc. and Subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 31, 2009, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets as of December 31, 2009 and 2008, and the related statements of income, comprehensive income, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2009 of EMC Insurance Group Inc. and Subsidiaries and our report dated March 15, 2010 expressed an unqualified opinion thereon.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of EMC Insurance Group Inc. and Subsidiaries at December 31, 2009 and 2008, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2009, in conformity with U.S. generally accepted accounting principles.
As discussed in Note 1 to the consolidated financial statements, in response to new accounting standards, the Company changed its methods of accounting for other-than-temporary impairments effective April 1, 2009 and for the accounting for its pension and other post-retirement benefits effective January 1, 2008.
EMC Insurance Group Inc., a 60 percent owned subsidiary of Employers Mutual Casualty Company (Employers Mutual), is an insurance holding company with operations in property and casualty insurance and reinsurance. Both commercial and personal lines of insurance are written, with a focus on medium-sized commercial accounts. Approximately 38 percent of the premiums written are in Iowa and contiguous states. The term “Company” is used interchangeably to describe EMC Insurance Group Inc. (Parent Company only) and EMC Insurance Group Inc. and its subsidiaries.
The Company’s subsidiaries include EMCASCO Insurance Company, Illinois EMCASCO Insurance Company, Dakota Fire Insurance Company, EMC Reinsurance Company and EMC Underwriters, LLC.
Premiums and discounts on fixed maturity securities are amortized over the life of the security as an adjustment to yield using the effective interest method. 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. Included in investments at December 31, 2009 and 2008 are securities on deposit with various regulatory authorities as required by law amounting to $11,725,251 and $11,692,234, respectively.
The Company regularly monitors its investments that have a fair value that is less than the carrying value for indications of “other-than-temporary” impairment. Several factors are used to determine whether the carrying value of an individual security has been “other-than-temporarily” impaired. Such factors include, but are not limited to (1) the security’s value and performance in the context of the overall markets, (2) length of time and extent the security’s fair value has been below carrying value, (3) key corporate events, and (4) for equity securities, the ability and intent to hold the security until recovery to its cost basis. Prior to April 1, 2009, the Company’s ability and intent to hold fixed maturity securities in an unrealized loss position until recovery was also considered in the determination of “other-than-temporary” impairments.
The Company participates in a securities lending program administered by Mellon Bank, N.A. whereby certain fixed maturity securities from the investment portfolio are loaned to other institutions for short periods of time. The Company receives a fee for each security loaned out under this program and requires initial collateral equal to 102 percent of the fair value of the loaned securities. The collateral is primarily cash, but other forms of collateral are occasionally accepted, including letters of credit or U.S. Treasury securities. The cash collateral is invested in a Delaware business trust that is managed by Mellon Bank. In this trust, cash collateral funds of the Company are pooled with cash collateral funds of other security lenders administered by Mellon Bank, and these funds are invested in securities with high credit quality standards, maturity restrictions, and liquidity levels consistent with the short-term nature of securities lending transactions. The acceptable investments include time deposits, commercial paper, floating rate notes, asset-backed floating rate notes, and repurchase agreements. The earnings from this trust are used, in part, to pay the fee the Company receives for each security loaned under the program. The Company has a slight risk of a minor loss associated with the collateral pool if the aggregate fair value of the collateral pool were to decline below the aggregate liability represented by the collateral, assuming all securities loaned and backed by the collateral pool were returned. The securities on loan to others are segregated from the other invested assets on the Company’s balance sheet. In accordance with relevant accounting literature, the collateral held by the Company is accounted for as a secured borrowing and is recorded as an asset on the Company’s balance sheet, with a corresponding liability reflecting the Company’s obligation to return this collateral upon the return of the loaned securities. During the fourth quarter of 2009, management decided to discontinue its participation in the securities lending program and as a result, began to unwind the program.
Effective January 1, 2008, the Company adopted the measurement date provision of the Compensation-Retirement Benefits Topic 715 of the FASB ASC. This provision was a part of the originally issued Statement of Financial Accounting Standards (SFAS) No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans.” This pronouncement included a requirement, which was effective for fiscal years ending after December 15, 2008, to measure the plans’ assets and obligations as of the end of the employer’s fiscal year. This pronouncement provided two approaches to measure the adjustment from a previously reported non-fiscal year-end measurement date to a fiscal year-end measurement date, both of which required the adjustment be recorded to beginning retained earnings and “accumulated other comprehensive income”, as applicable. The Company elected to apply the approach under which the Company’s previous November 1, 2007 measurement date was used to obtain the adjustment for the two month transition period. As a result, on January 1, 2008, the Company recorded a $205,751 decrease to retained earnings and a $46,057 decrease to “accumulated other comprehensive income” to record the net periodic cost associated with the two month transition period.
The Company’s basic and diluted net income per share is computed by dividing net income by the weighted average number of common shares outstanding during each period. As previously noted, the Company receives the current fair value for all shares issued under Employers Mutual’s stock plans. As a result, the Company had no potential common shares outstanding during 2009, 2008 and 2007 that would have been dilutive to the calculation of net income per share.
In May 2009, the FASB updated its guidance related to the Subsequent Events Topic 855 of the FASB ASC (issued as SFAS No. 165, “Subsequent Events”), which sets forth the period after the balance sheet date during which management shall evaluate events or transactions for potential recognition or disclosure, the circumstances under which an entity shall recognize events or transactions occurring after the balance sheet date, and disclosures to make about events or transactions that occur after the balance sheet date. This pronouncement was effective for interim and annual reporting periods ending after June 15, 2009. In February 2010, the FASB updated its guidance related to the Subsequent Events Topic 855 of the FASB, which removed the requirement to disclose the date through which subsequent events were evaluated for Securities and Exchange Commission filers. This pronouncement was effective immediately. Adoption of this pronouncement had no effect on the consolidated financial position or operating results of the Company.
The Fair Value Measurements and Disclosures Topic 820 of the FASB ASC has undergone substantial changes in recent years, including the issuance of several pronouncements predating the Codification. In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements,” which defined fair value, established a framework for measuring fair value, and expanded disclosures about fair value measurements. These requirements were effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The Company adopted this pronouncement effective January 1, 2008, which resulted in additional disclosures, but no impact on the Company’s consolidated financial position or operating results. In October 2008, the FASB issued FSP FAS 157-3, “Determining the Fair Value of a Financial Asset When the Market For That Asset Is Not Active,” which was followed in April 2009 by FSP FAS 157-4, “Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly.” Both of these pronouncements were intended to clarify the determination of fair value in markets that are not, at the measurement date, providing fair values representative of orderly transactions. Adoption of these pronouncements had no effect on the consolidated financial position or operating results of the Company.
The Company’s reinsurance subsidiary assumes a 100 percent quota share portion of Employers Mutual’s assumed reinsurance business, exclusive of certain reinsurance contracts. This includes all premiums and related losses, settlement expenses, and other underwriting and administrative expense of this business, subject to a maximum loss of $2,000,000 per event, with the cost of this protection treated as a reduction to the assumed premiums written. The reinsurance subsidiary does not directly reinsure any of the insurance business written by Employers Mutual or the other pool participants; however, the reinsurance subsidiary assumes reinsurance business from the Mutual Reinsurance Bureau (MRB) pool and this pool provides a small amount of reinsurance protection to the EMC Insurance Companies. As a result, the reinsurance subsidiary’s assumed exposures include a small portion of the EMC Insurance Companies’ direct business, after ceded reinsurance protections purchased by the MRB pool are applied. In addition, the reinsurance subsidiary does not reinsure any “involuntary” facility or pool business that Employers Mutual assumes pursuant to state law. Operations of the quota share agreement give rise to inter-company balances with Employers Mutual, which are settled on a quarterly basis. The investment and income tax activities of the reinsurance subsidiary are not subject to the quota share agreement.
As a result of regulatory changes in Germany, Employers Mutual ceased being an approved reinsurer in Germany beginning January 1, 2009. To avoid the loss of this assumed reinsurance business, the Company’s reinsurance subsidiary began writing this business on a direct basis (outside the quota share agreement) effective January 1, 2009. Since this business is written outside the quota share agreement, it is not subject to the $2,000,000 cap on losses per event. Management has determined that this business has a low risk of generating losses above $2,000,000 per event and has therefore elected to not purchase stand-alone reinsurance coverage for these risks. Premium income on this business amounted to $3,694,943 in 2009.
The reinsurance subsidiary assumes all foreign currency exchange gain/loss associated with contracts incepting on January 1, 2006 and thereafter that are subject to the quota share agreement, as well as the German business written directly. The net foreign currency exchange gain (loss) assumed by the reinsurance subsidiary was $29,238 in 2009, $256,606 in 2008 and ($512,281) in 2007.
Effective January 1, 2010, the terms of the quota share agreement were revised to increase the retention, or cap, on losses assumed per event from $2,000,000 to $3,000,000. The cost for this protection (10.5 percent of premiums written) remains unchanged.
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 $2,597,523, $2,643,930 and $2,314,211 in 2009, 2008 and 2007, respectively. Costs allocated to the Company through the operation of the pooling agreement amounted to $72,480,519, $63,887,041 and $66,646,772 in 2009, 2008 and 2007, respectively.
“Direct” represents policies issued by the property and casualty insurance subsidiaries.
“Assumed from nonaffiliates” for the property and casualty insurance subsidiaries represents the aggregate pool participation percentage of involuntary business assumed by the pool participants pursuant to state law. For the reinsurance subsidiary, this represents the reinsurance business assumed through the quota share agreement, and, starting January 1, 2009, German-based reinsurance business assumed outside the quota share agreement.
“Assumed from affiliates” for the property and casualty insurance subsidiaries represents the aggregate pool participation percentage of all the pool members’ direct business. Losses and settlement expenses incurred also includes claim-related services provided by Employers Mutual that is allocated to the property and casualty insurance subsidiaries and the reinsurance subsidiary.
“Ceded to nonaffiliates” for the property and casualty insurance subsidiaries represents the aggregate pool participation percentage of ceded reinsurance agreements that provide protection to the pool and each of its participants. This line also includes a limited amount of reinsurance business that is assumed under the quota share agreement and ceded on a 100 percent basis to other insurance companies in connection with “fronting” activities conducted by Employers Mutual.
For the reinsurance segment, the December 31, 2008 estimate of loss and settlement expense reserves for accident years 2007 and prior decreased $13,743,764 from the estimate at December 31, 2007. This decrease represented 9.7 percent of the December 31, 2007 gross carried reserves and is largely attributed to the 2005, 2006 and 2007 accident years in the HORAD book of business.
At present, the pool participants are defending approximately 900 asbestos bodily injury lawsuits, some of which involve multiple plaintiffs. Five former policyholders and one current policyholder dominate the pool participants’ asbestos claims. Most of the defenses 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. During 2003, the pool participants were presented with several hundred plaintiff lawsuits (primarily multi-plaintiff lawsuits) filed against three former policyholders representing approximately 66,500 claimants related to exposure to asbestos or products containing asbestos. These claims are based upon nonspecific asbestos exposure and nonspecific injuries. As a result, management did not establish a significant amount of case loss reserves associated with these claims. During the period 2006 through 2009, several of the multi-plaintiff lawsuits (including the vast majority of those associated with one former policyholder) were dismissed. During 2009, approximately 3,000 additional claims against one former policyholder were reported to the pool participants. As of December 31, 2009, approximately 5,500 of the claims remain open. During 2006, the pool participants received notice that another former policyholder was a named defendant in approximately 33,000 claims nationwide. As of December 31, 2009, approximately 27,000 of these claims remain open.
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 2009, 2008 and 2007.
The NAIC utilizes a risk-based capital model to help state regulators assess the capital adequacy of insurance companies and identify insurers that are in, or are perceived as approaching, financial difficulty. This model establishes minimum capital needs based on the risks applicable to the operations of the individual insurer. The risk-based capital requirements for property and casualty insurance companies measure three major areas of risk: asset risk, credit risk and underwriting risk. Companies having less statutory surplus than required by the risk-based capital requirements are subject to varying degrees of regulatory scrutiny and intervention, depending on the severity of the inadequacy. At December 31, 2009, the Company’s insurance subsidiaries had total adjusted statutory capital of $327,244,159, which is well in excess of the minimum risk-based capital requirement of $56,862,112.
The following table displays the net premiums earned of the property and casualty insurance segment and the reinsurance segment for the three years ended December 31, 2009, by line of insurance.
The fair value of the surplus notes is estimated using discounted cash flow analysis based on the Company’s current incremental borrowing rate for similar debt obligations.
Prices or valuation techniques that require significant unobservable inputs. The unobservable inputs may reflect the Company’s own judgements about the assumptions that market participants would use.
A small number of the Company’s securities are not priced by the independent pricing service. One is an equity security that is reported as a Level 3 fair value measurement at December 31, 2009, since no reliable observable inputs are used in its valuation. This equity security continues to be reported at the fair value obtained from the Securities Valuation Office (SVO) of the National Association of Insurance Commissioners (NAIC). The SVO establishes a per share price for this security based on an annual review of that company’s financial statements. This review is typically performed during the second quarter, and resulted in a fair value for the shares held by the Company of $2,014 at December 31, 2009 and $3,641 at December 31, 2008. The remaining two securities not priced by the Company’s independent pricing service are fixed maturity securities. These two fixed maturity securities are classified as Level 2 fair value measurements and are carried at aggregate fair values of $7,722,288 at December 31, 2009 and $7,162,662 at December 31, 2008. The fair values for these two fixed maturity securities were obtained from the Company’s investment custodian using independent pricing services which utilize similar pricing techniques as the Company’s independent pricing service.
The Company’s fixed maturity and equity securities available-for-sale, as well as short-term investments, are measured at fair value on a recurring basis. No assets or liabilities are currently measured at fair value on a non-recurring basis. Presented in the table below are the Company’s assets that are measured at fair value on a recurring basis, as of December 31, 2009 and 2008.
The following table sets forth the estimated fair value and gross unrealized losses associated with investment securities that were in an unrealized loss position as of December 31, 2009 and 2008, listed by length of time the securities were in an unrealized loss position.
Unrealized losses on fixed maturity securities totaled $8,686,782 (includes $161,303 related to the non-credit component of an “other-than-temporary” impairment of a residential mortgage-backed security) at December 31, 2009 and were primarily associated with three different sectors: municipal, U.S. government-sponsored agencies, and asset-backed securities. The primary factor contributing to these unrealized losses was an increase in interest rates in the second half of 2009. In addition, certain municipal and asset-backed securities experienced a widening of risk premium spread over U.S. Treasuries. All but seven of these securities (those seven being residential mortgage-backed securities) are considered investment grade by credit rating agencies. Because management does not intend to sell these securities, does not believe it will be required to sell these securities before recovery, and believes it will collect the amounts due on these securities, it was determined that these securities were not “other-than-temporarily” impaired at December 31, 2009.
All of the Company’s preferred stock holdings are perpetual preferred stocks. The Company evaluates perpetual preferred stocks for “other-than-temporary” impairment similar to fixed maturity securities since they have debt-like characteristics such as periodic cash flows in the form of dividends and call features, are rated by rating agencies and are priced like other long-term callable fixed maturity securities. There was no evidence of any credit deterioration in the issuers of the preferred stocks and the Company does not intend to sell these securities before recovery, nor does it believe it will be required to sell these securities before recovery; therefore, it was determined that the securities were not “other-than-temporarily” impaired at December 31, 2009.
The unrealized losses on common stocks at December 31, 2009 are not concentrated in a particular sector or an individual security. The Company believes the unrealized losses on common stocks are primarily due to general fluctuations in the equity markets. Because the Company has the ability and intent to hold these securities for a reasonable amount of time to allow for recovery, it was determined that the securities were not “other-than-temporarily” impaired at December 31, 2009.
The actual income tax expense (benefit) for the years ended December 31, 2009, 2008 and 2007 differed from the “expected” income tax expense (benefit) for those years (computed by applying the United States federal corporate tax rate of 35 percent to income (loss) before income tax expense (benefit)) as follows:
Comprehensive income tax expense (benefit) included in the consolidated financial statements for the years ended December 31, 2009, 2008 and 2007 is as follows:
The Company had no provision for uncertain tax positions at December 31, 2009 or 2008. The Company did not recognize any interest or other penalties related to U.S. federal or state income taxes during 2009, 2008 or 2007. It is the Company’s accounting policy to reflect income tax penalties as other expense, and interest as interest expense.
Employers Mutual has various employee benefit plans, including a defined benefit retirement plan (pension) and a supplemental retirement plan. Employers Mutual also has two postretirement benefit plans that provide retiree healthcare and life insurance coverage.
Employers Mutual’s pension plan covers substantially all of its employees. The plan is funded by employer contributions and provides benefits under two different formulas, depending on an employee’s age and date of service. Benefits generally vest after three years of service or the attainment of 55 years of age. It is Employers Mutual’s funding policy to make contributions that meet minimum regulatory funding requirements plus additional amounts as determined by management.
Employers Mutual’s supplemental retirement plan provides retirement benefits for a select group of management and highly-compensated employees. This plan enables select employees to receive retirement benefits without the limit on compensation imposed on qualified defined benefit pension plans by the Internal Revenue Service (IRS) and to recognize compensation that has been deferred in the determination of retirement benefits. The plan is unfunded and benefits generally vest after three years of service.
Employers Mutual maintains a Voluntary Employee Beneficiary Association (VEBA) trust which accumulates funds for the payment of postretirement health care and life insurance benefits. Contributions to the VEBA trust are used to fund the projected postretirement benefit obligation, as well as pay current year benefits.
The following table sets forth the funded status of Employers Mutual’s pension and postretirement benefit plans as of December 31, 2009 and 2008, based upon measurement dates of December 31, 2009 and 2008, respectively. The 2009 projected benefit obligation for the postretirement benefit plans includes a significant actuarial loss, which is attributed to actual participant contributions being less than expected and several assumption changes. Effective January 1, 2008, the Company adopted the measurement date provision of FASB ASC Topic 715 and elected to apply the approach under which the Company’s previous November 1, 2007 measurement date was used to obtain the adjustment for the two month transition period. As a result, the 2008 balances reflect fourteen months of activity.
The following table sets forth the projected benefit obligation, accumulated benefit obligation and fair value of plan assets of Employers Mutual’s defined benefit and supplemental retirement plans.
The components of net periodic benefit cost for Employers Mutual’s pension and postretirement benefit plans is as follows:
Following is a description of the valuation methodologies used for the assets classes of Employers Mutual’s VEBA trust that is used to fund the postretirement benefit plans.
Mutual Funds: Valued at the net asset value of shares held by the Plan 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.
Presented in the table below is a reconciliation of the assets measured at fair value using significant unobservable inputs (Level 3) for the year ended December 31, 2009.
Pooled Separate Accounts: Each of the Prudential Retirement Insurance and Annuity Company (Prudential) funds held by the Plan is a pooled or commingled investment vehicle, each with many investors. The Plan asset is represented by a “unit of account” and a per unit value, much like a mutual fund, whose value is the result of the accumulated values of the underlying investments. As the sponsor of a fund, Prudential specifies the source(s) used for the underlying investment asset prices and the protocol used to value each fund. These underlying investments are valued in the following ways:
U.S. Stock Funds - these are funds filled with domestic equities. Securities in these funds are priced using the closing price from the applicable exchange.
International Stock Funds - are comprised of international equities. Securities are priced using the closing price from the appropriate local stock exchange(s). Prudential also uses Interactive Data’s Fair Value Evaluation Service, which seeks to update prices in the event there are material market movements between local stock exchange closing time and portfolio valuation time.
Principal Money Market Separate Account: Invests mainly in short-term securities such as commercial paper. Valued by an independent pricing service.
Principal Bond and Mortgage Separate Account: Invests mainly in fixed securities such as asset backed securities, residential mortgage-backed securities, commercial mortgage-backed securities and corporate bonds. Securities are priced by Interactive Data using inputs such as benchmark yields, reported trades, broker/dealer quotes, and issuer spreads. Interactive Data also monitors market indices and industry and economic events.
Employers Mutual plans to contribute approximately $25,000,000 to the pension plan and $2,750,000 to the VEBA trust in 2010.
The Company participates in other retirement plans sponsored by Employers Mutual, including its 401(k) Plan and Board and Executive Non-Qualified Excess Plan. The Company’s share of expenses for these plans amounted to $1,293,676, $1,085,173 and $1,262,512 in 2009, 2008 and 2007, respectively.
The Company recognized compensation expense from these plans of $282,528 ($237,605 net of tax), $232,318 ($226,624 net of tax) and $200,941 (gross and net of tax) in 2009, 2008 and 2007, respectively.
The expected term of the options granted in 2009 was estimated using historical data that was adjusted to remove the effect of option exercises prior to the normal vesting period due to the retirement of the option holder. The expected term of options granted to individuals who are, or will be, eligible to retire prior to the completion of the normal vesting period has been adjusted to reflect the potential accelerated vesting period. This produced a weighted-average expected term of 2.6 years.
The expected volatility in the price of the underlying shares for the 2009 option grant was computed by using the historical average high and low monthly prices of the Company’s common stock for a period covering 6.3 years, which approximates the average term of the options and produced an expected volatility of 22.7 percent. The expected volatility of options granted to individuals who are, or will be, eligible to retire prior to the completion of the normal vesting period was computed by using the historical average high and low daily, weekly, or monthly prices for the period approximating the expected term of those options. This produced expected volatility ranging from 23.4 percent to 43.8 percent.
At December 31, 2009, the Company’s portion of the unrecognized compensation cost associated with option awards issued under Employers Mutual’s stock option plans that are not currently vested was $247,634, with a 1.5 year weighted-average period over which the compensation expense is expected to be recognized. A summary of non-vested option activity under Employers Mutual’s stock option plans for 2009, 2008 and 2007 is as follows:
The Company’s portion of the total intrinsic value of options exercised under Employers Mutual’s stock option plans was $51,461, $310,210 and $176,344 in 2009, 2008 and 2007, respectively. Under the terms of the pooling and quota share agreements, these amounts were paid to Employers Mutual. The Company received the full fair value for all shares issued under these plans. The Company’s portion of the total fair value of options that vested in 2009, 2008 and 2007 was $282,528, $232,318 and $200,941, respectively. Additional information relating to options outstanding and options vested (exercisable) at December 31, 2009 is as follows:
A total of 500,000 shares of the Company’s common stock have been reserved for issuance under the Employers Mutual Casualty Company 1993 Employee Stock Purchase Plan. Any eligible employee who is employed by Employers Mutual on the first day of the month immediately preceding any option period is eligible to participate in the plan. Participants pay 85 percent of the fair market value of the stock on the date of purchase. The plan is administered by the Board of Employers Mutual and the Board has the right to amend or terminate the plan at any time; however, no such amendment or termination shall adversely affect the rights and privileges of participants with unexercised options. This plan was replaced by a new plan during 2008 and the 217,862 shares that were unused as of December 31, 2008 were de-registered in 2009.
On March 10, 2008, the Company’s Board of Directors authorized a $15,000,000 stock repurchase program. On October 31, 2008, the Company’s Board of Directors announced an extension of the stock repurchase program, authorizing an additional $10,000,000. This program became effective immediately and does not have an expiration date. 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. Common stock purchased under this program is being retired by the Company. As of December 31, 2009, 736,133 shares of common stock had been repurchased at a cost of $17,851,898.
During the second quarter of 2005, Employers Mutual initiated a $15,000,000 stock purchase program under which Employers Mutual will 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 active. 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. During 2007, Employers Mutual purchased 65,501 shares of the Company’s common stock under this program at an average cost of $24.02 per share. No purchases were made during 2009 and 2008. As of December 31, 2009, $4,490,561 remained available under this plan for additional purchases.
One of the Company’s property and casualty insurance subsidiaries leases office facilities in Bismarck, North Dakota with lease terms expiring in 2014. Employers Mutual has entered into various leases for branch and service office facilities with lease terms expiring through 2021. All lease costs are included as expenses under the pooling agreement, after allocation of a portion of these expenses to the subsidiaries that do not participate in the pooling agreement. The following table reflects the lease commitments of the Company as of December 31, 2009.
We have audited the consolidated financial statements of EMC Insurance Group Inc. and Subsidiaries as of December 31, 2009 and 2008, and for each of the three years in the period ended December 31, 2009, and have issued our report thereon dated March 15, 2010 (included elsewhere in this Annual Report on Form 10-K). Our audits also include the financial statement schedules listed in Item 15(a)2 of this Annual Report on Form 10-K. These schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion based on our audits.