Our headquarters are located in a four story, 110,000 square foot building that we own in Blue Bell, Pennsylvania. Through various wholly-owned subsidiaries, we rent additional office space for our insurance operations in 15 other locations. All of these facilities are shared by The PMA Insurance Group with PMA Management Corp. and/or PMA Management Corp. of New England, Inc. We also rent additional office space for Midlands at five other locations in Oklahoma, Texas, California, and New York, and for PMA Management Corp. of New England, Inc. at a location in New York. We also lease approximately 63,000 square feet of office space in Yardley, Pennsylvania, which previously housed our excess and surplus lines business and now is subleased to an unaffiliated third party. We believe that such owned and leased properties are suitable and adequate for our current business operations.
The following selected historical financial information for each of the past five fiscal years has been derived from our audited historical financial statements. This information is only a summary and should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our audited consolidated financial statements and notes thereto included elsewhere in this annual report. The results of operations for past periods are not necessarily indicative of the results to be expected for any future period.
In 2009, we reduced the valuation allowance on our deferred tax assets by $20.0 million, which resulted in an income tax benefit.
This Management’s Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements, which involve risks and uncertainties. See “Item 1A - Risk Factors” and the “Cautionary Note Regarding Forward-Looking Statements” on page 60 for an explanation of factors that could cause our actual results to differ materially from those contained in any forward-looking statement.
These items are further described elsewhere in this discussion and in “Item 1 - Business.”
Our Fee-based Business earns revenues and generates cash by providing claims adjusting, managed care and risk control services to customers and by placing insurance business with other third party insurance and reinsurance companies. Revenues for our Fee-based Business were $80.8 million in 2009, compared to $71.6 million in 2008 and $38.1 million in 2007. Payments made at this segment primarily consist of operating expenses, which include employee-related costs to operate the business, managed care vendor expenses and commissions paid to sub-producers. The Fee-based Business segment includes the results of PMA Management Corp., which has been in operation since 1991, Midlands Management Corporation, which we acquired in 2007, and PMA Management Corp. of New England, Inc., which we acquired in 2008. Revenues and income increased in 2008, compared to 2007, primarily as a result of these acquisitions.
In 2007, we began reporting the results of our Run-off Operations as discontinued operations which requires that the balance sheets be presented with the gross assets and liabilities of discontinued operations in separate lines and the statements of operations be presented with the net results from discontinued operations shown after the results from continuing operations. Our Run-off Operations includes our reinsurance and excess and surplus lines businesses, which we
placed into run-off in 2003 and 2002, respectively. In 2009, we sold our Run-off Operations for $100,000. We agreed to contribute $13.1 million to the Run-off Operations and entered into two capital support agreements. Upon the closing of the transaction, we recorded an after-tax charge of $18.3 million, which represented the impact of the capital contribution and the estimated fair value of the capital support, as well as other costs associated with the closing of the sale.
In 2009, we reduced the valuation allowance on our deferred tax assets, which increased both net income and operating income by $20.0 million. This change resulted from the profitable operating results at The PMA Insurance Group and our Fee-based Business over the past several years, our expectation that profitable results will continue going forward, and the removal of the volatility and uncertainty related to the Run-off Operations. Net income also included an after-tax loss of $19.6 million from discontinued operations, which primarily reflected the $18.3 million charge associated with the closing of the sale of our Run-off Operations.
Net income in 2008 included an after-tax loss of $12.8 million from discontinued operations, which resulted from a $13.0 million capital contribution that increased the statutory capital of our Run-off Operations and prior year adverse loss development.
The net loss in 2007 included an after-tax loss of $57.3 million from discontinued operations. The loss from discontinued operations included an after-tax impairment charge of $40.0 million related to the write-down of the net assets of our Run-off Operations to our estimate of the projected proceeds at the sale. The net loss also included an after-tax reserve charge of $14.3 million for prior year adverse loss development at our Run-off Operations.
In addition to providing consolidated net income (loss), we also provide segment operating income (loss) because we believe that it is a meaningful measure of the profit or loss generated by our operating segments. Operating income, which we define as GAAP net income (loss) excluding net realized investment gains (losses) and results from discontinued operations, is the financial performance measure used by our management and Board of Directors to evaluate and assess the results of our businesses. Net realized investment activity is excluded because (i) net realized investment gains and losses are unpredictable and not necessarily indicative of current operating fundamentals or future performance of the business segments and (ii) in many instances, decisions to buy and sell securities are made at the holding company level, and such decisions result in net realized gains and losses that do not relate to the operations of the individual segments. Operating income does not replace net income (loss) as the GAAP measure of our consolidated results of operations.
Consolidated revenues were $531.7 million in 2009, compared to $494.2 million in 2008 and $455.8 million in 2007. The increase in consolidated revenues in 2009, compared to 2008, was primarily due to increases in net premiums earned of $24.6 million and claims service revenues of $10.3 million. The growth in net premiums earned mainly reflected an increase in direct premiums written over the past year, while the increase in claims service revenues resulted from organic growth and our prior year acquisition of PMA Management Corp. of New England, Inc. Organic claims service revenue growth was primarily due to increases in managed care revenues earned from existing clients and new business in 2009. The increase in consolidated revenues in 2008, compared to 2007, primarily reflected an increase in fee-based revenues of $32.7 million and growth in net premiums earned of $12.0 million. Included in the fee-based revenue increase were increases in claims service revenues of $23.3 million and commission income of $9.4 million. The increases in claims service revenues and commission income were primarily due to revenues resulting from our acquisition of Midlands, while the growth in net premiums earned mainly reflected an increase in direct premium production, which was due to increases in renewal premiums and larger account business.
We define direct premium production as direct premiums written, excluding fronting premiums and premium adjustments. The following is a reconciliation of our direct premium production to direct premiums written:
In 2009, pricing on our rate-sensitive workers’ compensation business, which represents approximately 57% of our total workers’ compensation business, decreased by 1%, compared to declines of 6% in 2008 and 4% in 2007. Although our pricing on this business declined for full year 2009, it increased modestly during the second half of the year. For workers’ compensation coverages, the premium charged on fixed-cost policies is primarily based upon the manual rates filed with state insurance departments. In 2009, workers’ compensation manual rates for business in our principal marketing territories decreased by 4%, compared to declines of 7% in 2008 and 4% in 2007. These changes in manual rates generally reflect the effects of average medical and indemnity cost fluctuations in recent years. Manual rate changes are set by state insurance regulatory authorities and directly affect the prices that we can charge for our rate-sensitive workers’ compensation products. To the extent that manual rates decline, our amount of premiums written will continue to be negatively impacted.
In 2008, our pricing on rate-sensitive workers’ compensation business written decreased 22% in New York and 18% in Florida. The pricing reductions in both New York and Florida were mainly driven by manual loss cost changes filed by each respective state’s rating bureau. These two states collectively represented about 16% of our overall rate-sensitive workers’ compensation business written during 2008. Exclusive of business written in New York and Florida, our pricing on rate-sensitive workers’ compensation business decreased 3% in 2008.
Pricing on our rate-sensitive workers’ compensation business in Pennsylvania declined 5% in 2008. In Pennsylvania, we were affected by a 10.2% reduction in loss costs, which was approved by the Pennsylvania Insurance Department and became effective in April 2008. While this resulted in lower filed loss costs in Pennsylvania, we have continued our practice of underwriting our business with a goal of achieving a reasonable level of profitability on each account. We continue to determine our business pricing through schedule charges and credits that we file and use to limit the effect of filed loss cost changes and have not experienced a decrease in premiums equal to the reduction in filed rates. We also believe the nature of our loss-sensitive and alternative market books of business, which represent approximately 40% of our Pennsylvania workers’ compensation business, mitigates the impact of reductions in filed loss costs.
In total, net premiums written decreased 3% in 2009, compared to 2008. The decline in 2009 reflected a decrease in workers’ compensation direct premium production, primarily due to a decrease in new business during 2009. Net premiums written increased 5% in 2008, compared to 2007. The increase in 2008 primarily reflected the increase in direct premium production, which was partially offset by higher return premium adjustments.
Pricing changes coupled with payroll inflation for rate-sensitive workers’ compensation business are slightly above overall estimated loss trends. In addition, our current accident year loss and LAE ratio improved modestly between years as we continued to benefit in 2009 from changes in the type of workers’ compensation products selected by our insureds and from managed care initiatives. We estimated our medical cost inflation to be 6.0% during 2009, compared to our estimate of 6.5% in 2008, and we expect that medical cost inflation will continue to be a significant component of our overall loss experience.
The loss and LAE ratio improved 0.2 points in 2008, compared to 2007. The improved loss and LAE ratio primarily benefited from favorable development in our loss-sensitive business, which resulted in the retrospective premium adjustments recorded in 2008. Although pricing changes coupled with payroll inflation for rate-sensitive workers’
compensation business were below overall estimated loss trends, our 2008 accident year loss and LAE ratio benefited from changes in the type of workers’ compensation products selected by our insureds. We estimated our medical cost inflation to be 6.5% during 2008, compared to our estimate of 7% in 2007. This decline reflected a decrease in utilization as well as our enhanced network and managed care initiatives.
Net investment income was $36.7 million in 2009, compared to $35.4 million in 2008 and $37.9 million in 2007. The increase in 2009, compared to 2008, was due primarily to an increase in average invested assets of 5%, which was partially offset by a lower investment yield of approximately 10 basis points. The decrease in 2008, compared to 2007, was due primarily to a lower investment yield of approximately 40 basis points.
On October 1, 2007, we acquired Midlands, an Oklahoma City-based managing general agent, program administrator and provider of TPA services. Our operating results for 2007 include the operating results of Midlands only from the date of acquisition.
The increase in operating expenses of $30.0 million in 2008, compared to 2007, primarily reflected the inclusion of Midlands’ expenses for full year 2008. Midlands’ operating expenses were $19.6 million higher for full year 2008, compared to the fourth quarter of 2007. The increase in operating expenses for 2008 also reflected an increase in the direct costs associated with the additional claims and managed care services provided to self-insured clients.
At December 31, 2007, we recorded an income tax benefit on the impairment loss, as we believed we would be able to use the loss to offset future operating earnings.
Subsequent to 2007, the loss from discontinued operations, net of tax, reflected decreases in the amount of proceeds we either expected to receive or actually received at the closing of the sale. As there was normal operating activity in 2008 and 2009 that did not impact the sales proceeds, we adjusted the valuation adjustment against the net assets of discontinued operations that we recorded in 2007 to offset this activity.
In 2008, as a result of adverse loss development, we estimated that the cash to be received at closing would be reduced by $7.5 million. We also recorded an $8.5 million after-tax charge in 2008 related to a $13.0 million capital contribution received from the holding company in order to comply with a commitment made to an independent rating agency. The capital contribution, which included $5.0 million of cash and a promissory note of $8.0 million, increased the statutory capital of PMA Capital Insurance Company. We wrote-off the capital contribution as we believed that the additional capital would not result in an increase to the cash expected to be received at the closing of the sale. This write-off was reflected in the discontinued operations’ financial statements as an impairment charge.
The following table represents the reserve levels as of December 31, 2009 for The PMA Insurance Group and the significant lines of business within this segment:
Our unpaid losses and LAE, net of reinsurance, at December 31, 2009 and 2008 were $458.2 million and $432.8 million, respectively, net of discount of $30.2 million and $27.5 million, respectively. Included in unpaid losses and LAE were amounts related to our workers’ compensation claims of $412.5 million and $382.1 million, net of discount of $29.9 million and $27.4 million at December 31, 2009 and 2008, respectively. The discount rate used was approximately 5% at December 31, 2009 and 2008.
We believe that our unpaid losses and LAE are fairly stated at December 31, 2009. However, estimating the ultimate claims liability is necessarily a complex and judgmental process inasmuch as the amounts are based on management’s informed estimates, assumptions and judgments using data currently available. As additional experience and data become available regarding claims payment and reporting patterns, legal, legislative and regulatory developments, judicial theories of liability, the impact of regulatory trends on benefit levels for both medical and indemnity payments, changes in social attitudes and economic conditions, the estimates are revised accordingly. If our ultimate losses, net of reinsurance, prove to differ substantially from the amounts recorded at December 31, 2009, then the related adjustments could have a material adverse impact on our financial condition, results of operations and liquidity.
Periodically, the Pennsylvania Insurance Department, through its Bureau of Financial Examinations, performs financial examinations of insurance companies domiciled in the Commonwealth. In connection with its examination of the Pooled Companies for the five years ended December 31, 2007, the Bureau issued a report questioning the reasonableness of the
Under our reinsurance and retrocessional coverages in place during 2009, 2008 and 2007, we ceded earned premiums totaling $153.2 million, $117.5 million and $117.6 million, and we ceded losses and LAE of $85.4 million, $93.5 million and $102.8 million to reinsurers and retrocessionaires.
In 2007, we purchased reinsurance covering substantially all unpaid losses and LAE related to our integrated disability business. Under the agreement, the reinsurer also handles the servicing and benefit payments related to this business. Upon entering into this agreement, we ceded $25.7 million in carried loss and LAE reserves and paid $22.7 million in cash. As of December 31, 2009, we have recovered $11.1 million of these losses from the reinsurer.
At December 31, 2009, we had reinsurance receivables due from the following unaffiliated reinsurers in excess of 5% of our shareholders’ equity:
In July 2009, we commuted our reinsurance with Houston Casualty Company. This reinsurance covered workers’ compensation business written in 1999 and 2000. As a result of this commutation, we received cash of $43.9 million and reduced our reinsurance receivables. This commutation did not have a material impact on our results of operations, but did improve liquidity by the amount of the cash received.
We perform credit reviews of our reinsurers focusing on, among other things, financial capacity, stability, trends and commitment to the reinsurance business. Reinsurers failing to meet our standards are excluded from our reinsurance programs. In addition, we require collateral, typically assets in trust, letters of credit or funds withheld, to support balances due from certain reinsurers, generally those not authorized to transact business in the applicable jurisdictions. At December 31, 2009 and 2008, our reinsurance receivables were supported by $398.6 million and $367.4 million of collateral, respectively. Of the uncollateralized reinsurance receivables at December 31, 2009, approximately 89% was due from reinsurers rated “A-” or better by A.M. Best and is broken down as follows: “A++” - 3%; “A+” - 16%; “A” - 59% and “A-” - 11%. We believe that our reinsurance receivables, net of the valuation allowance, are fully collectible. The timing of payments and the collectibility of reinsurance receivables have not had a material adverse effect on our liquidity.
For certain low risk classes of business, per risk property limit is $69.3 million.
For one of the fronting arrangements we entered into during 2008, workers’ compensation policies are underwritten solely in California, which is exposed to earthquake peril. Upon inception, we retained a 20% quota share of the first $1.0 million of loss per occurrence on this business and ceded the other 80% to non-affiliated reinsurers. Included, as part of our reinsurance program for this business, is dedicated workers’ compensation catastrophe protection up to a limit of $50.0 million. An additional $55.0 million of coverage in excess of $50.0 million was purchased as part of the reinsurance protection included in the table above.
Although we believe that we have adequate reinsurance to protect against the estimated probable maximum gross loss from a catastrophe, an especially severe catastrophe or series of catastrophes, or a terrorist event, could exceed our reinsurance and/or retrocessional protection and may have a material adverse impact on our financial condition, results of operations and liquidity. In 2009, 2008 and 2007, our loss and LAE ratios were not significantly impacted by catastrophes.
Liquidity is a measure of an entity’s ability to secure sufficient cash to meet its contractual obligations and operating needs. Our insurance operations generate cash by writing insurance policies and collecting premiums. The cash generated is used to pay losses and LAE as well as acquisition and operating expenses. Any excess cash is invested and earns investment income. Our fee-based businesses generate cash by providing services to clients. The cash generated is used to pay operating expenses, including commissions to sub-producers.
We expect that the cash flows generated from the operating activities of The PMA Insurance Group and our Fee-based Business will be positive for the foreseeable future as we anticipate premium and other service revenue collections to exceed losses and LAE payments as well as acquisition and operating expense payments. We intend to invest these positive cash flows and earn investment income, yet maintain an appropriate maturity duration on investments to match the timing of our anticipated obligations. The increase in net cash flows provided by operating activities from continuing operations in 2009, compared to both 2008 and 2007, primarily reflected the commutation of a reinsurance agreement at The PMA Insurance Group, which resulted in cash received of $43.9 million. For additional information regarding the commutation, see “Loss Reserves and Reinsurance - Reinsurance” on page 43 of this MD&A. The positive operating cash flows at our continuing operations in 2007 were reduced by $22.7 million for retroactive reinsurance purchased by The PMA Insurance Group to cover substantially all of the unpaid losses and LAE related to its integrated disability business.
On December 24, 2009, we sold the Run-off Operations for $100,000. In connection with the closing, we agreed to contribute $13.1 million to the Run-off Operations and entered into two capital support agreements. The capital contribution included cash of $3.1 million and a note payable in two equal installments of $5.0 million in June 2010 and June 2011. The capital support agreements may require us to make payments to the Run-off Operations in the event its payments on claims in the excess workers’ compensation and certain excess liability (occurrence) lines of business exceed certain pre-established limits. Such support is limited to an amount not to exceed $45.9 million and any payments with respect to the supported lines of business are not expected to commence until 2018 and may extend to 2052.
At the holding company level, our primary sources of liquidity are dividends and tax payments received from subsidiaries and capital raising activities. We utilize cash to pay debt obligations, including interest costs, taxes to the federal government, corporate expenses and dividends to shareholders. At December 31, 2009, we had $29.5 million of cash and short-term investments at our holding company and non-regulated subsidiaries, which we believe combined with our other capital sources, will continue to provide us with sufficient funds to meet our foreseeable ongoing expenses, interest payments and other obligations. We do not currently pay dividends on our Class A Common Stock.
surplus of one subsidiary is inadequate, the Commissioner could use his or her broad discretionary authority to seek to require us to apply payments received from another subsidiary for the benefit of that insurance subsidiary.
The Pooled Companies did not pay dividends to the holding company in 2009 or 2007, but did pay dividends of $4.0 million to the holding company in 2008. As of December 31, 2009, the Pooled Companies can pay up to $46.1 million in dividends to the holding company during 2010 without the prior approval of the Pennsylvania Insurance Department. In considering their future dividend policy, the Pooled Companies will consider, among other things, applicable regulatory constraints and the impact of paying dividends on their financial strength ratings. The Pooled Companies had statutory surplus of $417.3 million as of December 31, 2009, including $10.0 million relating to surplus notes.
On June 30, 2008, we acquired PMA Management Corp. of New England, Inc. for $7.3 million. The purchase price adjusted for certain closing adjustments and net of cash received on the purchase resulted in a net cash outflow on this transaction of $5.7 million.
See discussion below for the variable interest rates on the junior subordinated debt and the Floating Rate Surplus Notes due 2035 (“Surplus Notes”). The obligations related to the junior subordinated debt and the Surplus Notes have been calculated using the interest rates in effect at December 31, 2009. This calculation includes the impact of interest rate swap agreements.
We entered into two capital support agreements in connection with the closing of the sale on the Run-off Operations. The amount above reflects an estimate, gross of discount of $20.5 million, of what may be paid under these agreements in the event payments on claims in excess workers’ compensation and certain excess liability (occurrence) lines of business exceed certain pre-established limits.
As of December 31, 2009, our total outstanding debt was $143.4 million, compared to $129.4 million at December 31, 2008. The increase in our total outstanding debt in 2009 resulted from notes payable of $14.0 million to our former Run-off Operations. These notes originated from capital contributions made to the Run-off Operations in 2008 and 2009. The 2008 capital contribution for $13.0 million included a cash payment of $5.0 million in December 2008 and a note payable in two equal installments of $4.0 million, the first of which was paid in March 2009 and the other payable in March 2010. The 2009 capital contribution for $13.1 million included a cash payment of $3.1 million in December 2009 and a note payable in two equal installments of $5.0 million, which are payable in June 2010 and June 2011, at an interest rate of 6.0%. We pledged, as collateral, shares of our Class A Common Stock held in treasury to secure the payment of this debt.
During 2008, we retired the remaining $1.3 million principal amount of our 6.50% Senior Secured Convertible Debt due 2022 (“6.50% Convertible Debt”) for which we paid $1.5 million, exclusive of accrued interest. The lien and restrictive covenants associated with this debt were released shortly thereafter. As the derivative component of the debt was already reflected in the debt balance, the purchase activity did not result in any significant realized gain or loss. During 2008, we also retired $410,000 principal amount of our 4.25% Senior Convertible Debt due 2022, $20,000 of which was put to us on September 30, 2008. We paid par for these bond purchases, exclusive of accrued interest.
We have interest rate swaps that we have designated as cash flow hedges to manage interest costs and cash flows associated with the variable interest rates on our Surplus Notes and a portion of our junior subordinated debt. The swaps effectively convert $10.0 million of Surplus Notes and $20.0 million of junior subordinated debt to fixed rate debt with interest rates of 9.93% and 8.29%, respectively. The swap on the $10.0 million of Surplus Notes matures in November 2010, and the swap on the $20.0 million of junior subordinated debt matures in June 2012.
During 2009, 2008 and 2007, we incurred $9.8 million, $10.9 million and $11.7 million of interest expense, and paid interest of $9.7 million, $11.0 million and $11.8 million in each respective year. The reductions in interest expense and interest paid in 2009 and 2008, compared to each immediately preceding year, were due to lower interest rates on our variable rate debt. The decrease in 2008 was also due to a lower average amount of debt outstanding.
Our investment objectives are to (i) seek competitive after-tax income and total returns, (ii) maintain high investment grade asset quality and high marketability, (iii) maintain maturity distribution commensurate with our business objectives, (iv) provide portfolio flexibility for changing business and investment climates and (v) provide liquidity to meet operating objectives. Our investment strategy includes setting guidelines for asset quality standards, allocating assets among investment types and issuers, and other relevant criteria for our portfolio. In addition, invested asset cash flows, which include both current interest income received and investment maturities, are structured to consider projected liability cash flows of loss reserve payouts that are based on actuarial models. Property and casualty claim demands are somewhat unpredictable in nature and require liquidity from the underlying invested assets, which are structured to emphasize current investment income while maintaining appropriate portfolio quality and diversity. Liquidity requirements are met primarily
through operating cash flows and by maintaining a portfolio with maturities that reflect our estimates of future cash flow requirements.
We have structured our investment portfolio to provide an appropriate matching of maturities with anticipated claims payments. The fair values of these investments are subject to fluctuations in interest rates. If we decide or are required in the future to sell securities in a rising interest rate environment, then we would expect to incur losses from such sales. As of December 31, 2009, the duration of our investments that support the insurance reserves was 4.3 years and the duration of our insurance reserves was 3.6 years. The difference in the duration of our investments and our insurance reserves reflects our decision to maintain longer asset duration in order to enhance overall yield, while maintaining a high overall credit quality.
Our investment portfolio is comprised of mostly investment grade fixed maturities and short-term investments, substantially all of which are publicly traded, with no individual equity securities. We believe the portfolio is sufficiently diversified because it does not contain any significant concentrations in single issuers other than U.S. Treasury and agency obligations. Our largest exposure to a single corporate issuer is $18.7 million, or 2% of total invested assets. In addition, we do not have a significant concentration of our investments in any single industry segment other than finance companies, which comprised 14% of invested assets at December 31, 2009. Included in this industry segment are diverse financial institutions, including banks and insurance companies, with no single issuer exceeding 2% of the total investment portfolio. All of our investments as of December 31, 2009 are dollar denominated.
We hold $231.7 million, or 63% of our structured securities, of residential mortgage-backed pools and CMOs issued by either U.S. Government Agencies or U.S. Government Sponsored Enterprises (“GSE”).
The investment portfolio also held securities with a fair value of $25.2 million, or 3% of our investment portfolio, whose credit ratings were enhanced by various financial guaranty insurers. Of the credit enhanced securities, $7.7 million were asset-backed securities with a weighted average life of 1.9 years and whose underlying collateral had an imputed internal rating of A. None of these securities were wrapped asset-backed security collateralized debt obligation exposures.
The net unrealized gain on our investments at December 31, 2009 was $15.1 million, or 2% of the cost or amortized cost basis. The net unrealized gain included gross unrealized gains of $25.3 million and gross unrealized losses of $10.2 million.
For all but eight fixed income securities and two other investments, which were carried at fair values of $3.5 million and $4.5 million at December 31, 2009, respectively, we determined the fair value of fixed income securities and other investments from prices obtained in the public markets. Prices obtained in the public market include quoted prices that are readily and regularly available in an active market, market values generated by external pricing models that vary by asset class and incorporate available trade, bid and other market information, as well as price quotes from other well-established independent market sources. For the ten investments whose prices were not obtained from the public markets, which included six privately placed construction bridge loans, one private placement whose principal is backed and guaranteed at maturity by discounted GSE securities, one corporate bond currently in default with an expected recovery value upon bankruptcy liquidation, and two promissory notes, we generally use discounted cash flow valuation models to approximate fair value.
At December 31, 2009, all but eight of the publicly traded securities in our fixed income portfolio were of investment grade credit quality. The eight below investment grade securities had an aggregate fair value of $9.6 million and a net unrealized gain of $1.3 million. Our fixed income portfolio also included seven securities that were not rated at December 31, 2009. These seven securities had an aggregate fair value of $2.7 million, which equaled their combined amortized cost.
Gross investment income less investment expenses and before interest credited on funds held treaties. Excludes net realized investment gains and losses.
In addition to issuer-specific financial information, general economic data and our projections of discounted cash flows, we also assess whether we have the intent to sell a particular security or whether it is more likely than not we will be required to sell the security before its anticipated recovery. When we determine that we either intend to sell or are no longer more likely than not to hold the security until its anticipated recovery, an other than temporary impairment loss is recognized in the statement of operations for the full amount of the difference between fair value and amortized cost.
In addition, the impairments for 2009 included $931,000 related to write-downs of five privately placed distressed construction bridge loans. The valuation of the distressed loans was determined by estimating anticipated discounted cash flows to be collected from the borrower upon liquidation of the underlying real estate. The fair value of these loans as of December 31, 2009 was $1.6 million.
The remaining impairments recorded in 2009 consisted of three structured securities and one real estate investment trust security. Of these four securities, one security, a non-agency residential mortgage-backed security with alternative A mortgage collateral, incurred an other than temporary credit loss because it was determined the present value of the future cash flows expected to be received over the security’s expected remaining life fell below its amortized cost. The security was subsequently sold in 2009. Our intent is to sell the remaining securities once market conditions allow.
The contractual maturities of fixed maturities available for sale in an unrealized loss position at December 31, 2009 were as follows:
The fair value of the investment portfolio at the discontinued operations at December 31, 2008 was $146.0 million and had an amortized cost of $143.7 million. These amounts included accrued investment income of $543,000 related to trading securities in the portfolio at December 31, 2008. The investment portfolio consisted of 63% in short-term investments at December 31, 2008.
The data generated by application of these various actuarial methods generally reflect various development patterns and trends that assume historical patterns will be predictive of future patterns. Our actuaries analyze the various sets of data generated by these actuarial methods and also consider the impact of legal, legislative and regulatory developments, regulatory trends including state benefit levels, changes in social attitudes and economic conditions in order to develop various sets of assumptions that we believe are reasonable and valid and can be used to assist us in predicting future claim trends. These assumptions are used in conjunction with the various development patterns and trends generated by the actuarial methods described above to produce various reserve estimates. Our actuaries consider these estimates and, utilizing their judgment, select a reasonable range of possible outcomes of the ultimate claims to be paid by us in the future. Because reported claims and paid claims activity can vary significantly between periods, our actuaries do not routinely rely on the same actuarial techniques and assumptions to develop their range of reasonable outcomes; instead, they will use their judgment to understand the effect that paid and reported claim activity has on the various actuarial techniques in a particular accident year, and consider this effect in determining their reasonable range.
Our actuaries separately review the reserves for our workers’ compensation and integrated disability, commercial automobile and commercial multi-peril/general liability lines of business. The PMA Insurance Group’s loss reserves are comprised primarily of reserves for our workers’ compensation and integrated disability business (85% of the segment loss reserves). Commercial multi-peril/general liability reserves comprise 12% of this segment’s carried reserves, with 21% of such commercial multi-peril/general liability reserves being asbestos and environmental reserves (see page 42 of this Report on Form 10-K for more detail regarding asbestos and environmental loss reserves).
Within the workers’ compensation line of business, we review medical and indemnity costs separately. We undertake this review because we believe that the medical cost component of workers’ compensation claims has a different development pattern than the indemnity payments, and also because we believe that certain assumptions within the medical cost component, such as the rate of medical cost inflation, can lead to more volatility as compared to the indemnity component. For example, a one percentage-point change in current year medical inflation would result in about three tenths of a point change in our overall loss and LAE ratio. At December 31, 2009, our medical loss reserves were approximately 52% of the workers’ compensation loss reserves, with the balance being indemnity costs. We also review the workers’ compensation line of business by state for some of our larger states. We undertake this review because workers’ compensation benefits vary by state and this can cause loss development patterns to vary by state.
After our actuaries complete the analyses described above, management reviews the data along with various industry benchmarks, and using its informed judgment, selects its best estimate of the amounts needed to pay all pending and future claims and related expenses, including those not yet reported to us. This best estimate is recorded as a loss and LAE reserve on our balance sheet. Our practice is to establish reserves for unpaid losses and LAE at a level where we believe it is likely that such unpaid losses and LAE could ultimately settle at similar amounts either above or below management’s best estimate. At December 31, 2009, management’s best estimate reflects an estimate of loss and LAE reserves that is approximately the mid-point of our actuaries’ range of loss reserves.
It is important to understand that the process of estimating our ultimate claims liability is necessarily a complex and judgmental process inasmuch as the amounts are based on management’s informed estimates, assumptions and judgments using data currently available. The assumptions we utilize in developing a range of loss reserves are based on the premise that past experience, adjusted for the effects of current developments and anticipated trends, is an appropriate basis for establishing our reserve ranges. As more current and additional experience and data become available regarding the existence and the dollar amounts of claims, claims payment and reporting patterns, legal and legislative developments, judicial theories of liability, the impact of regulatory trends on benefit levels for both medical and indemnity payments, and changes in social attitudes and economic conditions, we revise our actuarially determined range of estimates accordingly. Because of the aforementioned factors, actual results can differ from our current estimates. While all of these factors affect the reserving process and results, we believe that the major factors that can cause actual results to vary from our estimates for The PMA Insurance Group are a change in frequency of reported claims, a change in the severity of claims reported to us, and in particular for workers’ compensation, a change in the rate of medical cost inflation.
December 31, 2009. However, if significant assumptions that are components of our actuarial analysis, such as the frequency and severity of claims or the amount of medical cost inflation, develop differently than we anticipate, then our range of reserve estimates could vary. Based upon our actuarial analysis at December 31, 2009, we believe there is a reasonable probability that the range of reserve estimates for losses and LAE could vary, higher or lower, from our reserves at December 31, 2009 by approximately five percent (5%) at The PMA Insurance Group. Because our carried reserves reflect management’s best estimate and are not determined by a formula that is automatically the direct product of the actuarial methods used to develop our range of reserves, we are unable to quantify in any meaningful way the effect of a change to any one of the significant assumptions underlying our actuarial process on our carried reserves. It is also possible that the amount required to settle all losses and LAE for unpaid claims or our estimates in future periods could exceed or be less than the reasonable range of possible outcomes that we can currently estimate.
At the discontinued operations, the components of our unfavorable development of reserves for losses and LAE for prior accident years by accident year, excluding accretion of discount, were as follows:
During 2007, the discontinued operations recorded unfavorable prior year loss development of $21.6 million, which included a $22.0 million charge taken in the third quarter. Our actuaries observed increased loss development from a limited number of ceding companies on our claims-made general liability business, primarily related to professional liability claims. Specifically, we experienced higher than expected severity on general liability claims-made losses at our discontinued operations during the third quarter causing our actuaries to increase the average expected size of future loss payments on these types of claims. This increase in 2007 loss trends caused management to determine that reserve levels, primarily for accident years 2001 to 2003, needed to be increased by $22.0 million.
All fixed maturities and other investments in our investment portfolio are carried at fair value. For all but eight of our fixed income securities and two of our other investments, we determined the fair value of fixed income securities and other investments from prices obtained in the public markets. Prices obtained in the public market include quoted prices that are readily and regularly available in an active market, market values generated by external pricing models that vary by asset class and incorporate available trade, bid and other market information, as well as price quotes from other well-established independent market sources.
As part of determining the fair value for each specific investment that we hold, we evaluate each issuer’s ability to fully meet their obligation to pay all amounts, both interest and principal, due in the future. Because we have invested in fixed income obligations with an overall average credit quality of AA+, and substantially all of our investments are currently meeting their obligations with respect to scheduled interest income and principal payments, we believe that we will fully realize the value of our investments. However, future general economic conditions and/or specific company performance issues may cause a particular issuer, or group of issuers in the same industry segment, to become unable to meet their obligation to pay principal and interest as it comes due. If such events were to occur, then we would evaluate our ability to fully recover the recorded value of our investment. Ultimately, we may have to write down an investment to its then determined net realizable value and reflect that write-down in earnings in the period such determination is made.
For additional information about our investments, see Notes 2-B, 3 and 4 to the Consolidated Financial Statements as well as “Investments” beginning on page 48.
We follow the customary insurance industry practice of reinsuring with other insurance and reinsurance companies a portion of the risks under the policies written by our insurance subsidiaries. Our reinsurance receivables total $827.5 million at December 31, 2009. We have estimated that $4.7 million of our reinsurance receivables will be uncollectible, and we have provided a valuation allowance for that amount.
We record deferred tax assets and liabilities to the extent of the tax effect of differences between the financial statement carrying values and tax bases of assets and liabilities. The recoverability of deferred tax assets is evaluated based upon management’s estimates of the future profitability of our taxable entities based on current forecasts. We establish a valuation allowance for deferred tax assets where it appears more likely than not that we will not be able to recover the deferred tax asset. At December 31, 2009, PMA Capital has a net deferred tax asset of $139.8 million, resulting from $208.9 million of gross deferred tax assets reduced by a deferred tax asset valuation allowance of $40.5 million and by $28.6 million of deferred tax liabilities. In establishing the appropriate value of this asset, management must make judgments about our ability to utilize the net tax benefit from the reversal of temporary differences and the utilization of operating loss carryforwards that expire mainly from 2021 through 2029.
As a result of the acquisitions of the fee-based businesses which we made in 2007 and 2008, we have recorded intangible assets of $29.8 million at December 31, 2009, which includes identifiable intangible assets of $11.5 million and goodwill of $18.3 million. The identifiable intangible assets consist of $7.2 million for assets with finite lives, such as non-contractual customer relationships, and $4.3 million for assets with indefinite lives, which include certain licenses and a trade name. Goodwill represents the excess of the purchase price over the fair value of the net identifiable assets acquired.
Goodwill and indefinite-lived intangible assets will remain on the balance sheet and will be tested for impairment on an annual basis, or when there is a reason to suspect that their values may have been diminished or impaired. Other intangible assets that are not deemed to have an indefinite useful life will be amortized over their estimated useful lives. Annual impairment testing was performed during the second quarter of 2009 on the intangible assets that relate to the acquisitions of Midlands and PMA Management Corp. of New England, Inc. Based upon this review, these assets were not impaired. For additional information about our intangible assets, see Notes 2-H and 8 to our Consolidated Financial Statements.
This annual report contains forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995 with respect to the Company’s business, financial condition and results of operations and the plans and objectives of its management. Forward-looking statements can generally be identified by use of forward-looking terminology such as “may,” “will,” “plan,” “expect,” “intend,” “anticipate,” “should” and “believe.” These forward-looking statements may include estimates, assumptions or projections and are based on currently available financial, industry, competitive and economic data and our current operating plans. All forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from those expressed or implied by the forward-looking statements.
adequacy of reserves for claim liabilities, including reserves for potential environmental and asbestos claims;
judicial, legislative and regulatory changes that affect the cost of, or demand for, our products or otherwise affect our ability to conduct business, including any action with respect to our industry or business taken by state insurance departments or the federal government;
regulatory actions by state insurance departments affecting the operation of our business or our financial condition, including actions relating to licensing, examinations, reserving, rate changes, investments, insurance policy terms and conditions and state based assessments;
adverse economic or regulatory developments in the eastern part of the United States, particularly those affecting Pennsylvania, New York and New Jersey;
the impact of future results on the value of recorded goodwill and other intangible assets and the recoverability of our deferred tax asset;
You should not place undue reliance on any forward-looking statements that we make. All forward-looking statements made in this annual report reflect our views on the date of this annual report. Forward-looking statements are not generally required to be publicly revised as circumstances change and we do not intend to update the forward-looking statements in this annual report to reflect circumstances after the date of this report or to reflect the occurrence of unanticipated events.
Consolidated Statements of Cash Flows for the years ended December 31, 2009, 2008 and
Fixed maturities available for sale, at fair value (amortized cost: - $779,154; 2008 - $749,806)
Premiums receivable (net of valuation allowance: 2009 - $7,427; 2008 - $9,011)
The accompanying consolidated financial statements include the accounts of PMA Capital Corporation and its subsidiaries (collectively referred to as “PMA Capital” or the “Company”). PMA Capital Corporation is a holding company whose operating subsidiaries provide insurance and fee-based services. Insurance products are underwritten and marketed under the trade name The PMA Insurance Group. Fee-based services include third party administrator (“TPA”), managing general agent and program administrator services. The Company previously managed the run-off of its reinsurance and excess and surplus lines operations, which have been recorded as discontinued operations.
The PMA Insurance Group - The PMA Insurance Group writes workers’ compensation and other commercial property and casualty lines of insurance, which are marketed primarily in the eastern part of the United States. The PMA Insurance Group primarily consists of the results of the Company’s principal insurance subsidiaries, which are commonly referred to as the “Pooled Companies” because they share results under an intercompany pooling arrangement. Approximately 93% of The PMA Insurance Group’s business for 2009 was produced through independent agents and brokers.
A. Basis of Presentation - The consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). All significant intercompany accounts and transactions have been eliminated in consolidation. The preparation of consolidated financial statements in conformity with GAAP requires management to make certain estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the period. Actual results could differ from those estimates. Certain amounts in the prior year periods have been reclassified to conform to the current year presentation.
In 2007, the Company determined that the results of its Run-off Operations should be reported as discontinued operations which requires that the balance sheets be presented with the gross assets and liabilities of discontinued operations in separate lines and the statements of operations be presented with the net results from discontinued operations shown after the results from continuing operations. See Note 9 for additional information regarding the Company’s discontinued operations.
The balance sheet information presented in these consolidated financial statements and notes thereto is as of December 31 for each respective year. The statements of operations, cash flows, changes in shareholders’ equity and changes in comprehensive income (loss) information are for the year ended December 31 for each respective year.
B. Investments - All fixed maturities in the Company’s investment portfolio are carried at fair value. Changes in fair value of fixed maturities classified as available for sale, net of income tax effects, are reflected in accumulated other comprehensive income (loss). Changes in fair value of fixed maturities classified as trading are reported in realized investment gains (losses). All short-term, highly liquid investments, which have original maturities of one year or less from acquisition date, are treated as short-term investments and are carried at amortized cost, which approximates fair value.
Realized gains and losses, determined by the first-in, first-out method, are reflected in income in the period in which the sale transaction occurs. The Company reviews the securities in its investment portfolio on a periodic basis to specifically
For structured securities, management projects cash flows using loss adjusted cash flows that contemplate current market factors such as prepayment assumptions, expected default assumptions, and the current condition of the guarantor of the security. For structured securities, the discount rate used in the present value calculation is the security’s current effective interest rate. The discount rate used for other fixed income securities is the security’s effective interest rate on the date acquired.
C. Premiums - Premiums, including estimates of premiums resulting from audits of insureds’ records, are earned principally on a pro rata basis over the terms of the policies. Any changes occurring or reported to the Company after the policy term are recorded as earned premiums in the period in which the adjustment is made. With respect to policies that provide for premium adjustments, such as experience or exposure-based adjustments, such premium adjustment may be made subsequent to the end of the policy’s coverage period and will be recorded as earned premium in the period in which the adjustment is made. Premiums applicable to the unexpired terms of policies in force are reported as unearned premiums. The estimated premiums receivable on experience or exposure-based policies are reported as a component of premiums receivable. For reinsurance premiums assumed at the Company’s discontinued operations, management estimated the subject premiums associated with the treaties in order to determine the level of written and earned premiums for a reporting period. Such estimates were based on information from brokers and ceding companies, which were subject to change as new information became available.
F. Income Taxes - The Company records deferred tax assets and liabilities to the extent of the tax effect of differences between the financial statement carrying values and tax bases of assets and liabilities. A valuation allowance is recorded for deferred tax assets where it appears more likely than not that the Company will not be able to recover the deferred tax asset. See Note 7 for additional information.
G. Deferred Acquisition Costs - Costs that directly relate to and vary with the acquisition of new and renewal business are deferred and amortized over the period during which the related premiums are earned. Such direct costs include commissions or brokerage and premium taxes, as well as other policy issuance costs and underwriting expenses. The Company determines whether acquisition costs are recoverable considering future losses and LAE, maintenance costs and anticipated investment income. To the extent that acquisition costs are not recoverable, the deficiency is charged to income in the period identified.
H. Intangible Assets - Identifiable intangible assets consist of non-contractual customer relationships, licenses and a trade name from business acquisitions. Goodwill represents the excess of the purchase price over the fair value of the net identifiable assets acquired. Goodwill and indefinite-lived intangible assets remain on the balance sheet and are tested for impairment on an annual basis, or when there is a reason to suspect that their values may have been diminished or impaired. Other identifiable intangible assets that are not deemed to have an indefinite useful life are amortized over their estimated useful lives. The identifiable intangible assets and goodwill are reported as intangible assets on the balance sheet.
In October 2008, the FASB issued guidance on “Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active.” The purpose of this guidance is to clarify the application of previously issued guidance under “Fair Value Measurements” for a market that is not active. It also allows for the use of management’s internal assumptions about future cash flows with appropriately risk-adjusted discount rates when relevant observable market data does not exist. This guidance does not change the objective of “Fair Value Measurements,” which is the determination of the price that would be received in an orderly transaction that is not a forced liquidation or distressed sale at the measurement date. The
In June 2009, the FASB issued guidance on “Accounting for Transfers of Financial Assets.” This guidance requires additional disclosures about the transfer and derecognition of financial assets and eliminates the concept of qualifying special-purpose entities. This guidance is effective for fiscal years beginning after November 15, 2009. In February 2010, the FASB deferred indefinitely the effective date of this guidance for an investment manager's interests in certain entities having attributes of an investment company. The Company does not expect the adoption of this guidance will have a material impact on its financial condition, results of operations or liquidity.
The Company’s investment portfolio is diversified and does not contain any significant concentrations in single issuers other than U.S. Treasury and agency obligations. In addition, the Company does not have a significant concentration of investments in any single industry segment other than finance companies, which comprised 14% of invested assets at December 31, 2009. Included in this industry segment are diverse financial institutions, including banks and insurance companies, with no single issuer exceeding 2% of the total investment portfolio. The Company does not believe that there are credit related risks associated with its U.S. Treasury and agency securities.
The cost or amortized cost and fair value of the Company’s investment portfolio were as follows:
There were a total of 82 investment securities in an unrealized loss position at December 31, 2009. Of the 82 investment securities, 44 have been in an unrealized loss position for 12 months or more and have an average unrealized loss per security of approximately $168,000. Of these 44 securities, 14 are commercial mortgage-backed securities (“CMBS”) that had a total fair value of $68.9 million, or 94% of their combined amortized cost, and unrealized losses of $4.3 million at December 31, 2009. There are also seven asset-backed securities, whose underlying collateral are non-mortgage classes such as auto loans and credit card receivables, which had a total fair value of $10.7 million and unrealized losses of $1.1 million.
The Company recorded other than temporary impairments of $5.9 million pre-tax in 2009. Of these impairments, $4.4 million related to the write-down of a portion of the Company’s CMBS portfolio that was subsequently sold in 2009 in order to reduce its exposure to this asset sector. These write-downs were measured based on public market prices. The gross realized gains from sales of investments during 2009 primarily were generated in order to minimize the statutory capital charge associated with the reduction of the Company’s CMBS exposure.
The impairment losses for 2008 were related to write-downs of the Company’s investments in three corporate senior debt securities, which were issued by Lehman Brothers Holdings, Inc., and perpetual preferred stock issued by the Federal National Mortgage Association (“Fannie Mae”). The Company’s write-down of the Lehman Brothers senior debt was for $8.2 million and its write-down of the Fannie Mae preferred stock was for $967,000. The impairment loss for 2007 was related to a security issued by a national provider of higher education loans. The write-downs in 2008 and 2007 were measured based on public market prices.
The carrying amount reported for the Senior Notes in the balance sheets as of December 31, 2009 and 2008 was $54.9 million. Based upon the quoted market price, the Company determined the fair value of its Senior Notes to be $51.2 million at December 31, 2009 and $42.0 million at December 31, 2008.
Level 3 - Fair value measures are based on inputs that are unobservable and significant to the overall fair value measurement, and may involve management judgment.
Accounts payable, accrued expenses and other liabilities - Interest rate swap
Fixed maturities available for sale - ending balance as of December
Losses included in earnings for 2009 were reported in net realized investment gains as other than temporary impairments.
At December 31, 2009, the Company held ten Level 3 investments whose prices were not obtained from the public markets. These investments consisted of eight fixed income securities and two other investments. The eight fixed income securities included six privately placed construction bridge loans, one private placement whose principal is backed and guaranteed at maturity by discounted U.S. Government Sponsored Enterprise securities, and one corporate bond currently in default with an expected recovery value upon liquidation. The two other investments were promissory notes. For these investments, whose prices are not obtained from the public markets, the Company generally uses discounted cash flow valuation models to approximate fair value.
Under The PMA Insurance Group’s loss-sensitive plans, the amount of the insured’s premiums is adjusted after the policy period expires based, to a large extent, upon the insured’s actual losses incurred during the policy period. Accordingly, offsetting the effects of the $5.0 million unfavorable prior year loss development in 2009 were additional premiums of $2.0 million, which are due under these loss-sensitive products for the portion of this development that is shared with the insureds. Also, for The PMA Insurance Group’s rent-a-captive business in 2009, dividends to policyholders offset the favorable development. Rent-a-captives are used by customers as an alternative method to manage their loss exposure without establishing and capitalizing their own captive insurance company.
During 2008, The PMA Insurance Group had favorable prior year loss development of $7.8 million. In 2008, the Company’s actuaries noticed lower than expected claims frequency and severity in workers’ compensation business written for accident years 2006 and 2007, primarily from loss-sensitive business. As a result, The PMA Insurance Group reduced loss reserves for prior years. Under policies that are subject to dividend plans, the ultimate amount of the dividend that the insured may receive is based, to a large extent, upon loss experience during the policy period. Accordingly, offsetting the effects of this favorable prior year loss development were premium adjustments of $8.9 million under loss-sensitive plans and increased policyholder dividends of $1.0 million.
Unpaid losses and LAE for the Company’s workers’ compensation claims, net of reinsurance, at December 31, 2009 and 2008 were $412.5 million and $382.1 million, net of discount of $29.9 million and $27.4 million, respectively. The discount rate used was approximately 5% at December 31, 2009 and 2008.
Management believes that its unpaid losses and LAE are fairly stated at December 31, 2009. However, estimating the ultimate claims liability is necessarily a complex and judgmental process inasmuch as the amounts are based on management’s informed estimates, assumptions and judgments using data currently available. As additional experience and data become available regarding claims payment and reporting patterns, legal and legislative developments, judicial theories of liability, the impact of regulatory trends on benefit levels for both medical and indemnity payments, changes in social attitudes and economic conditions, the estimates are revised accordingly. Periodically, the Pennsylvania Insurance Department, through its Bureau of Financial Examinations, performs financial examinations of insurance companies domiciled in the Commonwealth. In connection with its examination of the Pooled Companies for the five years ended December 31, 2007, the Bureau issued a report questioning the reasonableness of the Pooled Companies’ loss and loss adjustment expense reserves, which report was subsequently rejected by the Department. The examiner was directed to reopen the examination and to obtain additional data, documentation and information from the Company relative to its financial condition. The Company believes the Pooled Companies’ estimate of loss and loss adjustment expense reserves is reasonable and has provided the Bureau with several independent analyses and other information that support its position. The Company is continuing to provide additional information to the Bureau and is having discussions to resolve this issue. If the Company is not able to reach a resolution with the Department on this issue, it could have a material adverse effect on the Company’s business, results of operations and financial condition. If the Company’s ultimate losses, net of reinsurance, prove to differ substantially from the amounts recorded at December 31, 2009, then the related adjustments could have a material adverse impact on the Company’s financial condition, results of operations and liquidity.
The Company purchased reinsurance covering substantially all unpaid losses and LAE related to its integrated disability business in 2007. Under the agreement, the reinsurer also handles the servicing and benefit payments related to this business. Upon entering into this agreement, the Company ceded $25.7 million in carried loss and LAE reserves and paid $22.7 million in cash. As of December 31, 2009, the Company has recovered $11.1 million of these losses from the reinsurer.
At December 31, 2009, the Company had reinsurance receivables due from the following unaffiliated reinsurers in excess of 5% of shareholders’ equity:
The Company performs credit reviews of its reinsurers focusing on, among other things, financial capacity, stability, trends and commitment to the reinsurance business. Reinsurers failing to meet the Company’s standards are excluded from the Company’s reinsurance programs. In addition, the Company requires collateral, typically assets in trust, letters of credit or funds withheld, to support balances due from certain reinsurers, generally those not authorized to transact business in the applicable jurisdictions. At December 31, 2009 and 2008, the Company’s reinsurance receivables of $827.5 million and $826.1 million were supported by $398.6 million and $367.4 million of collateral. Of the uncollateralized reinsurance receivables as of December 31, 2009, approximately 89% was recoverable from reinsurers rated “A-” or better by A.M. Best.
In 2002, the Company supplemented its in-force reinsurance programs for The PMA Insurance Group and its former reinsurance business with retroactive reinsurance contracts with Trabaja that provide coverage for adverse loss development on certain lines of business for accident years prior to 2002. These contracts provide coverage of up to $125 million in losses in return for $55 million of funding, which included $50 million of assets and $5 million in ceded premiums. Any future cession of losses under these contracts may require the Company to cede additional premiums ranging from 40% to 50% of ceded losses depending on the level of such losses.
The components of the federal and state income tax expense (benefit) were:
The tax effects of significant temporary differences between the financial statement carrying amounts and tax bases of assets and liabilities that represent the net deferred tax asset were as follows:
Prior to 2007, the Company had established a valuation allowance in the amount of $60.5 million. This was based upon management’s assessment that it was more likely than not that a portion of the gross deferred tax assets related to the NOL
carryforward and all of the deferred tax asset related to the AMT credit carryforward would not be realized. Factors considered by management in its assessment included historical earnings, scheduled reversal of deferred tax liabilities and projections of future earnings.
The valuation allowance of $40.5 million is a reserve against a portion of the gross deferred tax assets related to the NOL carryforward and all of the projected deferred tax asset related to the AMT credit carryforward because it is more likely than not that this portion of the benefit will not be realized. The Company will continue to periodically assess the realizability of its net deferred tax asset.
The Company files income tax returns in the U.S. federal jurisdiction and in various states and foreign jurisdictions. With few exceptions, the Company is no longer subject to U.S. federal, state and local, or non-U.S. income tax examinations by tax authorities for years before 2006. The Company does not anticipate any significant changes to its total unrecognized tax benefits within the next 12 months. The Company will recognize, as applicable, interest and penalties related to unrecognized tax positions as part of income taxes.
Identifiable intangible assets consist of non-contractual customer relationships, which were calculated using a 10% annual attrition rate. The non-contractual customer relationships are being amortized on a straight-line basis over 15 years. The Company recognized $147,000 of expenses related to the amortization of non-contractual customer relationships in 2009 and $73,000 in 2008.
Annual impairment testing was performed during the second quarter of 2009 on the intangible assets that relate to the Company’s acquisitions of Midlands and PMA Management Corp. of New England, Inc. Based upon this review, these assets were not impaired.
On March 28, 2008, the Company entered into a Stock Purchase Agreement to sell its Run-off Operations to Armour Reinsurance Group Limited (“Armour Re”), a Bermuda-based corporation. On December 24, 2009, the Company executed an Amended and Restated Stock Purchase Agreement with Armour Re and sold the Run-off Operations for $100,000. In connection with the closing, the Company contributed $13.1 million to the Run-off Operations and entered into two capital support agreements. The capital contribution included cash of $3.1 million and a note payable in two equal installments of $5.0 million in June 2010 and June 2011. The capital support agreements may require the Company to make payments to the Run-off Operations in the event its payments on claims in the excess workers’ compensation and certain excess liability (occurrence) lines of business exceed certain pre-established limits. Such support is limited to an amount not to exceed $45.9 million and any payments with respect to the supported lines of business are not expected to commence until 2018 and may extend to 2052. Generally Accepted Accounting Principles require guarantees to be recorded at fair value at inception, which the Company estimates is approximately $13 million for the capital support agreements. Upon the closing of the transaction, the Company recorded an after-tax charge of $18.3 million, which represented the impact of the capital contribution and the estimated fair value of the capital support, as well as other costs associated with the closing of the sale.
The following table provides detailed information regarding the after-tax losses from discontinued operations included in the Company’s Consolidated Statements of Operations.
At December 31, 2007, the Company recorded an income tax benefit on the impairment loss, as it believed it would be able to use the loss to offset future operating earnings.
In 2008, as a result of adverse loss development, the Company estimated that the cash to be received at closing would be reduced by $7.5 million. The Company also recorded an $8.5 million after-tax charge in 2008 related to a $13.0 million capital contribution received from PMA Capital Corporation in order to comply with a commitment made to an independent rating agency. The capital contribution, which included $5.0 million of cash and a promissory note of $8.0 million, increased the statutory capital of PMA Capital Insurance Company. The Company wrote-off the capital contribution as it believed that the additional capital would not result in an increase to the cash expected to be received at the closing of the sale. This write-off was reflected in the discontinued operations’ financial statements as an impairment charge.
The condensed balance sheet of the discontinued operations as of December 31, 2008 included assets of $243.7 million, which primarily consisted of $147.4 million of cash and investments and $95.0 million of reinsurance receivables, and liabilities of $271.7 million, which included $247.4 million of unpaid losses and loss adjustment expenses.
At December 31, 2008, the fair value of the investment portfolio at the discontinued operations was $146.0 million and its amortized cost was $143.7 million. These amounts included accrued investment income of $543,000 related to trading securities in the portfolio. The investment portfolio consisted of 63% in short-term investments at December 31, 2008.
The following table provides the fair value measurements of the discontinued operations’ fixed maturities by level within the fair value hierarchy as of December 31, 2008. These assets were measured on a recurring basis.
In February 2007, the FASB issued guidance on “The Fair Value Option for Financial Assets and Financial Liabilities.” The objective of this guidance is to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently. This guidance permits entities to choose, at specified election dates, to measure eligible items at fair value (i.e., the fair value option). Business entities are required to report unrealized gains and losses on items for which the fair value option has been elected in net income.
The Company adopted this guidance because the investment portfolio at the discontinued operations decreased by 50% in the first quarter of 2007, compared to the first quarter of 2006. The Company also considered that, given the unpredictability of cash flows for commutations, combined with the shrinking size of the portfolio, trading activity was expected to increase in 2007. The discontinued operations’ investment portfolio was also reduced significantly during the second quarter of 2007 as a result of a $37.5 million extraordinary dividend payment to PMA Capital Corporation in April 2007.
The balance sheet impact of the Company’s adoption of this guidance on the discontinued operations was as follows:
Because reinsurers rely on their ceding companies to provide them with information regarding incurred losses, it takes longer for reinsurers to find out about reported claims than for primary insurers and those claims are subject to more unforeseen development and uncertainty. See Note 5 for additional information regarding management estimates included in unpaid losses and LAE.
During 2008, the discontinued operations recorded unfavorable prior year loss development of $20.8 million. Based on the reserve reviews performed by the Company’s actuaries in 2008, increased loss development was observed on the discontinued operations’ pro rata general liability reinsurance business, and to a lesser degree, excess of loss reinsurance business. This increase in 2008 loss trends caused management to determine that reserve levels, primarily for accident years 2001 to 2004, needed to be increased by $20.8 million.
During 2007, the discontinued operations recorded unfavorable prior year loss development of $21.6 million, which included a $22.0 million charge taken in the third quarter. In the third quarter of 2007, the Company’s actuaries conducted their periodic comprehensive reserve review. Based on the actuarial work performed, the Company’s actuaries observed increased loss development from a limited number of ceding companies on its claims-made general liability business, primarily related to professional liability claims. This increase in 2007 loss trends caused management to determine that
The discontinued operations’ losses and LAE paid in 2008 and 2007 were both impacted by the commutation of retrocessional reinsurance agreements, which reduced the amounts paid for each period. In 2007, losses and LAE paid were significantly reduced by the commutation of the discontinued operations’ retrocessional contract covering potential adverse loss development, which also resulted in the discontinued operations receiving $171.9 million in cash.
The following table summarizes the effect on the Company’s assets and liabilities of discontinued operations for the commutation of certain reinsurance and retrocessional contracts occurring in 2008. Commutations did not have a material impact on the loss from discontinued operations in 2009, 2008 or 2007.
At December 31, 2008 and 2007, the discontinued operations’ gross reserves for environmental-related losses were $931,000 and $877,000, respectively ($539,000 and $364,000, net of reinsurance, respectively). Of the net environmental reserves, $110,000 and $0 related to IBNR losses at December 31, 2008 and 2007, respectively. All incurred asbestos and environmental losses were for accident years 1986 and prior.
The Company has $14.0 million of notes payable to its former Run-off Operations. These notes originated from capital contributions made by the Company to PMA Capital Insurance Company in 2008 and 2009. The 2008 capital contribution for $13.0 million included a cash payment of $5.0 million in December 2008 and a note payable in two equal installments of $4.0 million, the first of which was paid in March 2009 and the other payable in March 2010. This note was recorded at PMA Capital Corporation in 2008, but eliminated in the Company's consolidated financials until the sale of the Run-off Operations closed. The 2009 capital contribution for $13.1 million included a cash payment of $3.1 million in December 2009 and a note payable in two equal installments of $5.0 million, which are payable in June 2010 and June 2011, at an
interest rate of 6.0%. The Company pledged, as collateral, shares of its Class A Common Stock held in treasury to secure the payment of this debt.
In June 2007, the Company issued $20.6 million of 30-year floating rate junior subordinated securities to a wholly-owned statutory trust subsidiary. The junior subordinated debt matures in 2037 and is redeemable, in whole or in part, any time prior to 2012 at 107.5% of par, or beginning in 2012 at par, plus accrued and unpaid interest. The interest rate on the junior subordinated debt equals the three-month London InterBank Offered Rate (“LIBOR”) plus 3.55%, and interest on this debt is payable on a quarterly basis. The remaining junior subordinated debt of $43.8 million matures in 2033. The weighted average interest rates on this junior subordinated debt equal the three-month LIBOR plus 4.12%, and interest on this debt is also payable on a quarterly basis. At December 31, 2009, the weighted average interest rate on all of the junior subordinated securities was 4.20%.
The put premium and conversion features of the 6.50% Convertible Debt constituted a derivative which required bifurcation. Any change in the fair value of the derivative component of the 6.50% Convertible Debt was recorded in net realized investment gains (losses). In 2007, the Company recognized realized investment losses of $483,000, resulting from changes in the fair value of the derivative component of its 6.50% Convertible Debt.
The Company has interest rate swaps that it has designated as cash flow hedges to manage interest costs and cash flows associated with the variable interest rates on its Floating Rate Surplus Notes due 2035 (“Surplus Notes”) and a portion of its junior subordinated debt. The swaps effectively convert $10.0 million of Surplus Notes and $20.0 million of the junior subordinated debt to fixed rate debt with interest rates of 9.93% and 8.29%, respectively. The swap on the $10.0 million of Surplus Notes matures in November 2010, and the swap on the $20.0 million of junior subordinated debt matures in June 2012.
Pension Benefits - The Company sponsors a qualified non-contributory defined benefit pension plan (the “Qualified Pension Plan”) which, prior to January 1, 2006, covered substantially all employees. After meeting certain requirements under the Qualified Pension Plan, an employee acquired a vested right to future benefits. The benefits payable under the plan are generally determined on the basis of an employee’s length of employment and salary during employment. The Company’s policy is to fund pension costs in accordance with the Employee Retirement Income Security Act of 1974. The Company also maintains non-qualified unfunded supplemental defined benefit pension plans (the “Non-qualified Pension Plans”) which, prior to January 1, 2006, covered certain key employees. The accumulated benefit obligation for the Non-qualified Pension Plans was $7.1 million as of December 31, 2009.
The Company uses a December 31 measurement date for its Plans. For the measurement of other postretirement benefits, an 8% annual rate of increase in the per capita cost of covered health care benefits was assumed for 2009. The rate was assumed to decrease gradually to 5% by 2018 and remain at that level thereafter. A one-percentage point change in assumed health care cost trend rates would have an immaterial impact on the total service and interest cost components of the net periodic benefit cost and the postretirement benefit obligation.
The fair value of the mutual funds included in the Level 1 category is represented by unit shares, which are valued at the net asset value as reported by the fund. The fair value of the common collective trust (“CCT”) included in the Level 2 category is the plan’s proportionate interest in the net assets of the CCT. The net asset value of the CCT is determined based on the fair values of the underlying assets of the CCT. See Note 4 for additional information regarding the Company’s categorization of the fair value of its financial instruments.
B. Defined Contribution Savings Plan - The Company also maintains defined contribution savings plans covering substantially all employees. These plans include a voluntary employee contribution component, in which the Company matches employee contributions, up to 6% of compensation. These plans also include a quarterly aged-based company contribution. Contributions expensed under these plans were $7.3 million in 2009, $6.3 million in 2008 and $5.3 million in 2007.
The Company leases certain facilities, office equipment and automobiles under non-cancelable operating leases. Future minimum net operating lease obligations as of December 31, 2009 are as follows:
In the event a property and casualty insurer operating in a jurisdiction where the Company’s insurance subsidiaries also operate becomes or is declared insolvent, state insurance regulations provide for the assessment of other insurers to fund
See Note 6 for information regarding the terms of the sale of PMA Cayman in 1998.
The Company currently has stock-based compensation plans in place for directors, officers and other key employees of the Company. Pursuant to the terms of these plans, under which 3,738,562 shares of Class A Common Stock are reserved for issuance at December 31, 2009, the Company grants restricted and unrestricted shares of its Class A Common Stock and options to purchase the Company’s Class A Common Stock. Stock-based compensation is granted under terms and conditions determined by the Compensation Committee of the Board of Directors. Stock options have a maximum term of ten years, generally vest over periods ranging between one and four years, and are typically granted with an exercise price at least equal to the market value of the Class A Common Stock on the date of grant. Restricted and unrestricted stock is valued at the market value of the Class A Common Stock on the date of grant and generally vest between one and three years. The Company recognized stock-based compensation expense of $596,000, $2.4 million and $1.8 million for the years ended December 31, 2009, 2008 and 2007, respectively. The stock-based compensation expense included amounts related to stock options of $44,000 in 2007.
Stock options outstanding and exercisable at December 31, 2009 had a weighted average remaining life of 4.0 years and an aggregate intrinsic value of $60,000. The total intrinsic value of stock options exercised was $335,000 in 2008 and $241,000 in 2007. The Company reissued shares from its treasury for options exercised during 2008 and 2007.
Stock options outstanding and options exercisable at December 31, 2009 were as follows:
In 2009, the Company issued 12,500 shares of restricted Class A Common Stock to employees under the Company’s 2007 Omnibus Incentive Compensation Plan and 30,000 shares of restricted Class A Common Stock to its Directors under the 2004 Directors Plan. In 2008, the Company issued 12,500 shares of restricted Class A Common Stock to employees under the Company’s 2007 Omnibus Incentive Compensation Plan and 36,000 shares of restricted Class A Common Stock to its Directors under the 2004 Directors Plan. In 2007, the Company issued 5,000 shares of restricted Class A Common Stock to employees under the Company’s 2007 Omnibus Incentive Compensation Plan, 3,000 shares of restricted Class A Common Stock to employees under the Company’s 2002 Equity Incentive Plan and 48,533 shares of restricted Class A Common Stock to its Directors under the 2004 Directors Plan. The restricted stock vests between one and three years.
Upon vesting of a restricted stock award, employees may remit cash or shares of Class A Common Stock to satisfy their tax obligations relating to the award. During 2009, 2008 and 2007, employees remitted 2,513 shares, 1,241 shares and 31,525 shares, respectively, to the Company to satisfy their payment of withholding taxes for vested awards.
These consolidated financial statements vary in certain respects from financial statements prepared using statutory accounting practices (“SAP”) that are prescribed or permitted by the Pennsylvania Insurance Department. Prescribed SAP includes state laws, regulations and general administrative rules, as well as a variety of publications from the National Association of Insurance Commissioners (“NAIC”). Permitted SAP encompasses all accounting practices that are not prescribed. The Codification of Statutory Accounting Principles guidance is the NAIC’s primary guidance on statutory accounting. The principal differences between GAAP and SAP are in the treatment of acquisition expenses, reinsurance, deferred income taxes, fixed assets and investments.
The Pooled Companies are comprised of Pennsylvania Manufacturers’ Association Insurance Company, Manufacturers Alliance Insurance Company and Pennsylvania Manufacturers Indemnity Company.
Included the impact of adopting Statement of Statutory Accounting Principles No. 10R, “Income Taxes - Revised, A Temporary Replacement of SSAP No. 10.”
We have audited the accompanying consolidated balance sheets of PMA Capital Corporation and subsidiaries (the Company) as of December 31, 2009 and 2008, and the related consolidated statements of operations, cash flows, shareholders’ equity and comprehensive income (loss) for each of the years in the three-year period ended December 31, 2009. The Company’s management is responsible for these consolidated financial statements. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of PMA Capital Corporation and subsidiaries as of December 31, 2009 and 2008, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2009 in conformity with accounting principles generally accepted in the United States of America.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), PMA Capital Corporation 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 (COSO), and our report dated March 16, 2010 expressed an unqualified opinion.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets and the related consolidated statements of operations, cash flows, shareholders’ equity, comprehensive income (loss) and financial statement schedules of PMA Capital Corporation and subsidiaries, and our reports dated March 16, 2010 expressed an unqualified opinion.