The Company's subsidiaries that do not participate in the pooling arrangement (EMC Reinsurance Company and EMC Underwriters, LLC), as well as subsidiaries of Employers Mutual that do not participate in the pooling arrangement, are allocated rent expense based on the square footage occupied by the respective operations. The remaining rent expense is attributed to the
The reinsurance subsidiary pays an annual override commission to Employers Mutual in connection with the $1,500,000 cap on losses assumed per event. The override commission rate is charged at 4.50 percent of written premiums. The reinsurance subsidiary also pays for 100 percent of the outside reinsurance protection Employers Mutual purchases to protect itself from catastrophic losses on the assumed reinsurance business, excluding reinstatement premiums. This cost is recorded as a reduction to the premiums received by the reinsurance subsidiary.
As a result of the planned change in aggregate pool participation, the reinsurance segment will have slightly less impact on the Company's financial results in 2005 and beyond. For example, the reinsurance segment represented approximately 28 percent of total premiums earned in 2004. Had the new 30 percent aggregate pool participation been in effect in 2004, the reinsurance segment would have represented approximately 23 percent of total premiums earned.
The successful completion of the follow-on stock offering will result in the Company surpassing the Securities and Exchange Commission's market value threshold for determination of accelerated filer status when the test is performed at June 30, 2005. As a result, the Company will become subject to accelerated filing deadlines beginning with the December 31, 2005 Annual Report on Form 10-K.
A substantial determinant of an insurance company's underwriting results is its loss and settlement expense reserving. Insurance companies must estimate the amount of losses and settlement expenses that will ultimately be paid to settle claims that have occurred to date (loss and settlement expense reserves). This estimation process is inherently subjective with the possibility of widely varying results, particularly for certain highly volatile types of claims (asbestos, environmental, and various casualty exposures, such as products liability, where the loss amount and the parties responsible are difficult to determine). During a soft market, inadequate premium rates put pressure on insurance companies to under-estimate their loss and settlement expense reserves in order to show a profit. Correspondingly, inadequate reserves play an integral part in bringing about a hard market, because increased profitability from higher premium rate levels can be used to strengthen an insurance company's loss and settlement expense reserves. Despite large reserve strengthening actions taken by the insurance industry during 2003 and 2004, there continues to be concern about the magnitude of potential reserve deficiencies, particularly for asbestos and pollution exposures.
Insurance companies collect cash in the form of insurance premiums and pay out cash in the form of loss and settlement expense payments. Additional cash outflows occur through the payment of acquisition and underwriting costs such as commissions, premium taxes, salaries and general overhead. During the loss settlement period, which varies by line of business and by the circumstances surrounding each claim and may cover several years, insurance companies invest the cash premiums and earn interest and dividend income. This investment income supplements underwriting results and contributes to net earnings. The weakening economy during the period 2000 through 2002 prompted the Federal Reserve Bank to reduce interest rates several times, to the point of historic lows. As a result, called and matured fixed maturity securities have been reissued at much lower interest rates, which has had a negative impact on the insurance industry's investment income. Interest rates generally trended upward in 2004, but are still significantly lower than historic levels.
Determination of the legality and propriety of the compensation arrangements targeted by Attorney General Spitzer will take time to resolve through the investigative and judicial processes. The Company intends to closely monitor these developments and will be diligent in reviewing and assessing its internal practices, as well as its contingent compensation arrangements, with a goal of ensuring that they are in compliance with all legal requirements.
Attorney General Spitzer has also alleged the use of bid-rigging practices by some in the insurance industry. Bid-rigging constitutes a violation of federal and state laws and is strictly prohibited by the Company's Code of Corporate Conduct.
The insurance industry is highly regulated and very competitive, and its operations are impacted by many economic and social factors. In order to be a viable source of insurance protection in today's marketplace, an insurance company must be strongly capitalized, carry a secure rating from A.M. Best Company (which is considered to be the leading insurance rating agency), and offer competitive products and excellent service. Management recognizes that insurance agents and their customers have many options to choose from when selecting an insurance carrier and continually emphasizes the need to meet and exceed their expectations in these areas.
Management has long recognized the importance of adequate capitalization for its insurance subsidiaries and has strived to maintain a strong capital position by investing their assets conservatively and, more importantly, maintaining a consistent level of loss and settlement expense reserve adequacy. Carried reserves are analyzed on a regular basis and adjustments, if necessary, are implemented on a timely basis. This procedure not only assures a consistent level of reserve adequacy, it also minimizes the impact that any required adjustment will have on current operations. This dedication to reserve adequacy was demonstrated during 2003 and again during 2004 as the Company strengthened loss and settlement reserves in the property and casualty insurance segment in response to the findings of regularly-scheduled actuarial evaluations.
In addition to the recent actions taken to improve reserve adequacy, effective March 1, 2005, Richard K. Schulz, a current employee of Employers Mutual, became the senior claims executive officer. Mr. Schulz has been the claims manager at the Chicago branch office for the last five years and has over ten years of prior insurance industry experience. Mr. Schulz will report to William A. Murray, Executive Vice President and Chief Operating Officer.
The participants in the EMC Insurance Companies pooling agreement currently carry an "A-" (Excellent) rating from A.M. Best Company. Management has worked diligently over the last several years to improve profitability through a combination of adequate pricing and focused underwriting practices. Maintaining a consistent level of profitability is a primary goal of management that will assist the Company in its quest to achieve an even higher rating from A.M. Best Company.
Catastrophe and storm losses are unpredictable and can vary significantly from year to year. Management uses modeling software to help identify and estimate its potential loss exposure to a variety of events, both natural and
manmade. Natural events that are modeled include hurricanes, tornados and windstorms, and earthquakes. Modeling activities for manmade events are primarily directed toward identifying concentrations of risk, such as workers' compensation coverage for a business or property that is subject to a terrorist attack or other manmade event. Management purchases reinsurance protection to mitigate the Company's loss potential to these types of exposures.
The Company has completed the majority of the documentation of its work flow and internal controls over financial reporting as required by Section 404 of the Sarbanes-Oxley Act of 2002. Efforts during 2005 will focus on remediation of any identified gaps in existing controls, testing of the documented controls, remediation of any controls that are found to be not working as designed and the establishment of a maintenance process. Management expects to complete its evaluation of the Company's internal controls over financial reporting by mid July, which will allow sufficient time for the Company's independent auditors to perform their analysis and testing procedures and issue their audit report on the Company's internal controls over financial reporting as of December 31, 2005.
Acquisition Expense Ratio. The acquisition expense ratio is the ratio (expressed as a percentage) of net acquisition and other expenses to premiums earned and measures a company's operational efficiency in producing, underwriting and administering its insurance business. For statutory accounting purposes, acquisition and other expenses of an insurance company exclude investment expenses. There is no such industry definition for determining an acquisition expense ratio for GAAP purposes. As a result, management applies the statutory definition to calculate the Company's acquisition expense ratio on a GAAP basis. The net acquisition expense ratio is meaningful in evaluating the Company's financial results, which are net of ceded reinsurance, as reflected in the consolidated financial statements.
Statutory Combined Ratio. The statutory combined ratio is calculated in the same manner as the GAAP combined ratio, but is based on results determined pursuant to statutory accounting rules and regulations. The statutory "trade combined ratio" differs from the statutory combined ratio in that the acquisition expense ratio is based on net premiums written rather than premiums earned. Management uses the statutory trade combined ratio as a measure for comparison of the Company's profitability relative to the profitability of its competitors, all of whom must file statutory-basis financial statements with insurance regulatory authorities.
Ceded reserves are derived by applying the ceded contract terms to the direct reserves. For excess of loss contracts (excluding the catastrophe contract), this is accomplished by applying the ceded contract terms to the case reserves of the ceded claims. For the catastrophe excess of loss contract, ceded reserves are calculated by applying the contract terms to both the aggregate case reserves on claims stemming from catastrophes and the estimate of IBNR reserves developed for each individual catastrophe. For quota share contracts, ceded reserves are calculated as the quota share percentage multiplied by both case and IBNR reserves on the direct business.
Following is a summary of the carried loss and settlement expense reserves for the property and casualty insurance segment at December 31, 2004 and 2003.
December 31, 2004 ----------------------------------------- Settlement Line of Business Case IBNR Expense Total - ---------------- -------- ------- ------- -------- ($ in thousands) Commercial lines: Automobile ..................... $ 31,139 $ 5,798 $ 6,987 $ 43,924 Property ....................... 8,339 2,468 1,816 12,623 Workers compensation ........... 80,615 16,928 13,315 110,858 Liability ...................... 50,561 25,631 34,055 110,247 Bonds .......................... 1,028 731 613 2,372 -------- ------- ------- -------- Total commercial lines ....... 171,682 51,556 56,786 280,024 -------- ------- ------- -------- Personal lines: Automobile ..................... 17,271 2,275 2,339 21,885 Property ....................... 5,019 1,889 1,155 8,063 Total personal lines ......... 22,290 4,164 3,494 29,948 -------- ------- ------- -------- Total property and casualty insurance segment .......... $193,972 $55,720 $60,280 $309,972 ======== ======= ======= ========
December 31, 2003 ----------------------------------------- Settlement Line of Business Case IBNR Expense Total -------- ------- ------- -------- ($ in thousands) Commercial lines: Automobile ..................... $ 27,807 $ 5,784 $ 6,427 $ 40,018 Property ....................... 7,582 2,372 1,690 11,644 Workers compensation ........... 63,275 13,348 10,220 86,843 Liability ...................... 38,241 22,457 25,542 86,240 Other .......................... 889 656 436 1,981 -------- ------- ------- -------- Total commercial lines ....... 137,794 44,617 44,315 226,726 -------- ------- ------- -------- Personal lines: Automobile ..................... 11,968 2,468 2,260 16,696 Property ....................... 4,566 2,174 1,098 7,838 Total personal lines ......... 16,534 4,642 3,358 24,534 -------- ------- ------- -------- Total property and casualty insurance segment .......... $154,328 $49,259 $47,673 $251,260 ======== ======= ======= ========
Internal actuarial evaluations of overall loss reserve levels are performed quarterly for all direct lines of business. There is a certain amount of random variation in loss development patterns, which results in some uncertainty regarding projected ultimate losses, particularly for longer tail lines such as workers' compensation, other liability and commercial auto liability. Therefore, the reasonability of the actuarial projections is regularly monitored through an examination of loss ratio and claims severity trends implied by these projections.
Historically, individual case reserves established by the claims department have been adequate. However, actuarial analyses performed during 2003 indicated that overall case reserves appeared to be somewhat inadequate. This apparent inadequacy was driven by the workers' compensation line of business, where adverse development more than offset the favorable development experienced on all other lines of business combined. Further analysis revealed that recent adverse development experienced in the workers' compensation line of business was arising from both the indemnity and medical portion of the claims. The underlying data indicated that the aggregate liability associated with time away from work was somewhat underestimated and that permanent injury awards were somewhat underestimated and/or not anticipated when the reserves were established. In response to these findings, the Company established a bulk case reserve for the workers' compensation line of business to supplement the individual case reserves. An actuarial evaluation of case reserve adequacy is now performed each quarter, which resulted in additional increases in the bulk case reserve during 2004.
As previously noted, the estimation of settlement expense reserves assumes a consistent claims department philosophy regarding the defense of
lawsuits. If the Company should in the future take a more aggressive defense posture, defense costs would increase and it is likely that carried settlement expense reserves would be deficient. However, such a change in philosophy could be expected to reduce losses, generating some offsetting redundancy in the loss reserves.
After-tax Line of business impact on earnings ---------------- ------------------ ($ in thousands) Personal auto liability ........... $ 149 Commercial auto liability ......... 511 Auto physical damage .............. 15
The property and casualty insurance companies have exposure to environmental and asbestos claims arising primarily from the other liability line of business. This exposure is closely monitored by management, and the Company has established IBNR reserves to cover estimated ultimate losses. Currently, asbestos reserves are based on the results of an independent consultant's ground-up study of the Company's asbestos exposures, which was completed in early 2003. Environmental reserves are established with consideration to the implied three-year survival ratio (ratio of loss reserves to the three-year average of loss payments). Estimation of ultimate liabilities for these exposures is unusually difficult due to unresolved issues such as whether coverage exists, the definition of an occurrence, the determination of ultimate damages and the allocation of such damages to financially responsible parties. Therefore, any estimation of these liabilities is subject to greater than normal variation and uncertainty, and ultimate payments for losses and settlement expenses for these exposures may differ significantly from the carried reserves.
For the HORAD component, Employers Mutual records the case and IBNR reserves reported by the ceding companies. Since many ceding companies in the HORAD book of business do not report IBNR reserves, Employers Mutual establishes a bulk IBNR reserve, which is based on an actuarial reserve analysis, to cover the lag in reporting. For MRB, Employers Mutual records the case and IBNR reserves reported to it by the management of the pool, along with a relatively small IBNR 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.
At December 31, 2004, the carried reserves for HORAD and MRB combined were in the upper quarter of the range of actuarial reserve indications. This conservative selection reflects the fact that there are inherent uncertainties involved in establishing reserves for assumed reinsurance business. Such uncertainties include the fact that a reinsurance company generally has less knowledge than the ceding company about the underlying book of business and the ceding company's reserving practices. Because of these uncertainties, there is a risk that the reinsurance segment's reserves for losses and settlement expenses could prove to be inadequate, with a consequent adverse impact on the Company's future earnings and stockholders' equity.
Carried reserves established in addition to those reported by the ceding companies totaled approximately $47,196,000 at December 31, 2004. Since many ceding companies in the HORAD book of business do not report IBNR reserves, Employers Mutual establishes a bulk IBNR reserve to cover the lag in reporting. For the few ceding companies that do report IBNR reserves, Employers Mutual carries them as reported. These reported IBNR reserves are subtracted from the total IBNR reserve calculated by Employers Mutual's actuaries, with the difference carried as bulk IBNR reserves. Except for a small IBNR reserve established to cover a one-month lag in reporting, the MRB IBNR reserve is established by the management of MRB. Employers Mutual rarely records additional case reserves.
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 reserves as a percentage of total reserves tend to be higher than for direct reserves. IBNR reserves totaled $66,092,000 and $58,427,000 at December 31, 2004 and 2003, respectively, and accounted for approximately 55% and 50% percent, respectively, of the reinsurance segment's total loss reserves. IBNR reserves are, by nature, less precise than case reserves. A five percent change in IBNR reserves at December 31, 2004 would equate to a $3,305,000 change in loss reserves, which would represent 16.3 percent of net income and 0.9 percent of stockholders' equity.
Following is a summary of the carried loss and settlement expense reserves for the reinsurance segment at December 31, 2004 and 2003.
December 31, 2004 ----------------------------------------- Settlement Line of Business Case IBNR Expense Total - ---------------- -------- ------- ------- -------- ($ in thousands) Pro Rata Reinsurance: Property and casualty ........ $ 3,125 $ 2,899 $ 237 $ 6,261 Property ..................... 6,097 7,127 335 13,559 Crop ......................... 1,034 36 54 1,124 Casualty ..................... 2,267 4,418 296 6,981 Marine/Aviation .............. 9,187 7,802 890 17,879 -------- ------- ------- -------- Total pro rata reinsurance 21,710 22,282 1,812 45,804 -------- ------- ------- -------- Excess Reinsurance: Excess per risk reinsurance: Property ..................... 9,961 11,805 475 22,241 Casualty ..................... 16,436 31,050 1,719 49,205 Surety ....................... 1,440 955 60 2,455 -------- ------- ------- -------- Total excess per risk reinsurance .............. 27,837 43,810 2,254 73,901 -------- ------- ------- -------- Total reinsurance segment .. $ 49,547 $66,092 $ 4,066 $119,705 ======== ======= ======= ========
December 31, 2003 ----------------------------------------- Settlement Line of Business Case IBNR Expense Total - ---------------- -------- ------- ------- -------- ($ in thousands) Pro Rata Reinsurance: Property and casualty ........ $ 3,881 $ 2,564 $ 206 $ 6,651 Property ..................... 6,824 9,031 276 16,131 Crop ......................... 683 35 18 736 Casualty ..................... 2,703 4,714 237 7,654 Marine/Aviation .............. 8,273 5,599 1,049 14,921 -------- ------- ------- -------- Total pro rata reinsurance 22,364 21,943 1,786 46,093 -------- ------- ------- -------- Excess Reinsurance: Excess per risk reinsurance: Property ..................... 11,190 10,695 373 22,258 Casualty ..................... 18,959 24,835 1,859 45,653 Surety ....................... 1,690 954 16 2,660 -------- ------- ------- -------- Total excess per risk reinsurance .............. 31,839 36,484 2,248 70,571 -------- ------- ------- -------- Total reinsurance segment .. $ 54,203 $58,427 $ 4,034 $116,664 ======== ======= ======= ========
To ensure the accuracy and completeness of the information received from the ceding companies, the actuarial department carefully reviews the latest four HORAD policy years on a quarterly basis, and all policy years on an annual basis. Any significant departures from historical reporting patterns are brought to the attention of the reinsurance department staff, who check the bookings for accuracy and, if necessary, contact the ceding company or broker for clarification.
The Company has denied coverage to one of the former policyholders, representing approximately 10,000 claims, because of express asbestos exclusion language contained in the policy. Minimal expense payments have been made to date on the lawsuits related to the other two former policyholders and no payments have been made for either defense or indemnity. Four former policyholders and one current policyholder dominate the Company's asbestos claims. To date, actual losses paid have been minimal due to the plaintiffs' failure to identify an asbestos-containing product to which they were exposed that is associated with the Company's policyholders. Defense costs, on the other hand, have typically increased due to the increased number of parties involved in the litigation and the length of time required to obtain a favorable judgment. Whenever possible, the Company has participated in cost sharing agreements with other insurance companies to reduce overall asbestos claim expenses.
The plaintiffs in the silicosis lawsuits are sandblasters, gravel and concrete workers, ceramic workers and road construction workers. All of these defenses are subject to express reservation of rights based upon the lack of an injury within the Company's policy periods because many silica lawsuits, like asbestos lawsuits, do not specifically allege dates of exposure or dates of injury. The Company's policyholders (a refractory product manufacturer, small local concrete and gravel companies and a concrete cutting machine
manufacturer) that have been named as defendants in these silica lawsuits have had little or no exposure and are routinely dismissed from silica litigation with nominal, or no, payment. While the expense of handling these lawsuits is high, it is not proportional based upon the number of plaintiffs, and is mitigated to some extent through cost sharing agreements reached with other insurance companies.
In 2004, the Company developed, filed and attached "pneumoconiosis dust exclusions" in the majority of jurisdictions where such action was warranted. "Mixed dust" is defined as dust, or a mixture of dusts, composed of one or more of the following: asbestos, silica, fiberglass, iron, tin, coal, cement, cadminium, carbon, mica, cobalt, barium, tungsten, kaolin, graphite, clay, ceramic, talc, vitallium, beryllium, zinc, cotton, hemp, flax or grain. This exclusion precludes liability coverage for "any injury, damage, expense, cost, loss, liability, defense or legal obligation arising out of, resulting from or in any way related to, in whole or in part "mixed dust" pneumoconiosis, pleural plaques, pleural effusion, mesothelioma, lung cancer, emphysema, bronchitis, tuberculosis or pleural thickening, or other pneumoconiosis- related ailments such as arthritis, cancer (other than lung), lupus, heart, kidney or gallbladder disease. It is anticipated that this mixed dust exclusion will further limit the Company's exposure in silica claims, and may be broad enough to limit exposure in other dust claims.
The Company's exposure to asbestos and environmental claims through assumed reinsurance is very limited due to the fact that the Company's reinsurance subsidiary entered into the reinsurance marketplace in the early 1980s after much attention had already been brought to these issues. The Company took action to commute one reinsurance contract during the first quarter of 2003 that had some asbestos and environmental reserves associated with it.
The Company's non-asbestos direct product liability claims are considered to be highly uncertain exposures due to the many uncertainties inherent in determining the loss, and the significant periods of time that can elapse between the occurrence of the loss and the ultimate settlement of the claim. The majority of the Company's product liability claims arise from small to medium sized manufacturers, contractors, petroleum distributors, and mobile home and auto dealerships. No specific claim trends are evident from the Company's manufacturer policies, as the claims activity on these policies is generally isolated and can be severe. Specific product coverage is provided to the Company's mobile home and auto dealership policyholders, and the claims from these policies tend to be relatively small. Certain construction defect claims are reported under product liability coverage. During 2004, 67 of these claims were reported to the Company.
The Company's assumed casualty excess reinsurance is also considered to be a highly uncertain exposure due to the significant periods of time that can elapse during the settlement of the underlying claims and the fact that a reinsurance company generally has less knowledge than the ceding company about the underlying book of business and the ceding company's reserving practices. The Company attempts to account for this uncertainty by establishing bulk IBNR reserves, using conservative assumed treaty limits and, to a much lesser extent, booking of individual treaty IBNR (if reported by the ceding company) or establishing additional case reserves if the reported case reserves appear inadequate on an individual claim. While the Company's reinsurance subsidiary is predominantly a property reinsurer, it does write casualty excess business oriented mainly towards shorter tail casualty lines of coverage. The Company avoids reinsuring large company working layer casualty risks, and does not write risks with heavy product liability exposures, risks with obvious latent injury manifestation, medical malpractice, and "for profit" Directors and Officers coverage. A small amount of casualty excess business on large companies is written, but generally on a "clash" basis only (layers above the limits written for any individual policyholder).
Following is a schedule of claims activity for asbestos, environmental, products liability and casualty excess reinsurance for 2004, 2003 and 2002.
Property and casualty insurance segment Reinsurance segment --------------------------- -------------------------- Settlement Settlement ($ in thousands) Case IBNR expense Case IBNR expense ------- ------- ------- ------- ------- ------- Reserves at 12/31/04 Asbestos ...........$ 1,395 $ 837 $ 651 $ 153 $ 515 $ - Environmental ...... 30 807 311 84 677 - Products(1) ........ 6,491 3,056 6,861 - - - Casualty excess(2) - - - 16,436 31,049 1,724
Reserves at 12/31/02 Asbestos ...........$ 451 $ 1,693 $ 839 $ 80 $ 454 $ - Environmental ...... 14 839 322 49 786 - Products(1) ........ 2,314 1,856 2,000 - - - Casualty excess(2) - - - 13,393 21,472 1,385
Paid during 2004 Asbestos ...........$ 47 $ 141 $ 64 $ - Environmental ...... 11 11 40 - Products(1) ........ 1,079 1,401 - - Casualty excess(2) - - 7,911 916
Open claims, 12/31/03 ... 41,076 7 1,784 Reported in 2003 ........ 40,893 7 1,008 Disposed of in 2003 ..... 123 6 304
The Company does not determine a range of estimates for all components of the loss and settlement expense reserves at the time those reserves are established. However, at each year-end an actuarially determined range of estimates is developed for the major components of the loss and settlement expense reserves. 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, 2004, along with the carried reserves. The last two columns display the estimated after-tax impact on earnings if the reserves were moved to the high endpoint and the low endpoint of the ranges.
During the three years ended December 31, 2004, the Company has experienced adverse development in the provision for insured events of prior years. The majority of this adverse development has come from the property and casualty insurance segment, primarily in the workers' compensation and other liability lines of business. Following are the significant issues and trends that have been identified as contributors to this adverse development.
Construction defect claims arising from general liability policies issued to contractors have contributed to adverse reserve development. States with significant construction defect losses include Alabama, Arizona, California, Colorado, Nevada and Texas.
Large umbrella claims have recently contributed to the adverse development experienced in the other liability line of business. A pattern of increasing umbrella claims severity is believed to be generally consistent with industry umbrella severity trends. Also contributing to overall umbrella reserve development is an increase in claims arising from underlying general liability policies.
Legal expenses for the other liability line of business have also increased rapidly over the past three years, with defense costs increasing at an average rate of approximately 14 percent per year. This increase in legal expenses has occurred despite a reduction in the number of new lawsuits.
For detailed discussion of the factors influencing the adverse development on prior years' reserves, see the discussion entitled "Loss and Settlement Expense Reserves" under the "Narrative Description of Business" heading in the Business Section under Item I of this Form 10-K.
Deferred policy acquisition costs are used to match the expenses incurred in the production of insurance business to the income earned on this business. This adjustment is necessary because statutory accounting principles require that expenses incurred in the production of insurance business be expensed immediately, while premium income is recognized ratably over the terms of the underlying insurance policies.
The realization of the deferred income tax asset is based upon projections that indicate that a sufficient amount of future taxable income will be earned to utilize the tax deductions that will reverse in the future. These projections are based on the Company's history of producing significant amounts of taxable income, the improved premium rate environment for both the property and casualty insurance segment and the reinsurance segment and loss and expense control initiatives that have been implemented in recent years. In addition, management has formulated tax-planning strategies that could be implemented to generate taxable income if needed. Should the projected taxable income and tax planning strategies not provide sufficient taxable income to recover the deferred tax asset, a valuation allowance would be required.
($ in thousands) 2004 2003 2002 -------- -------- -------- PROPERTY AND CASUALTY INSURANCE Premiums earned .......................... $250,035 $241,237 $225,013 Losses and settlement expenses ........... 196,460 168,239 156,152 Acquisition and other expenses ........... 85,837 80,493 72,483 -------- -------- -------- Underwriting loss ........................ $(32,262) $ (7,495) $ (3,622) ======== ======== ======== Loss and settlement expense ratio ........ 78.6% 69.7% 69.4% Acquisition expense ratio ................ 34.3 33.4 32.2 -------- -------- -------- Combined ratio ........................... 112.9% 103.1% 101.6% ======== ======== ======== Losses and settlement expenses: Insured events of current year ....... $172,722 $159,224 $151,507 Increase in provision for insured events of prior years .............. 23,738 9,015 4,645 -------- -------- -------- Total losses and settlement expenses ....................... $196,460 $168,239 $156,152 ======== ======== ======== Catastrophe and storm losses ............. $ 13,481 $ 17,531 $ 8,055 ======== ======== ========
The calculation of 2004 earning per share is impacted by the Company's recently completed follow-on stock offering in which 2.0 million new shares of common stock were issued on October 20, 2004. The Company earned approximately $170,000 of additional interest income on the net proceeds of the stock offering during the fourth quarter; however, this additional interest income was not sufficient to avoid an approximate 3.0 percent dilution in the 2004 earnings per share calculation.
Premiums earned increased 4.5 percent to $345,479,000 in 2004 from $330,623,000 in 2003. This increase is primarily attributed to rate increases implemented during the last few years in the property and casualty insurance business as well as moderate growth and improved pricing in the assumed reinsurance business. The overall market for property and casualty insurance was stable during 2004, but moderated slightly in certain lines of business and select territories due to an increase in price competition. Price competition is expected to increase for most lines of business in 2005, but not to the extent seen in the last soft market. The Company will continue its efforts to maintain current pricing levels and will implement rate increases in those lines of business and/or territories where such action is warranted; however, the overall impact of these rate increases will continue to dissipate as the increases become smaller and less frequent.
Premiums earned for the property and casualty insurance segment increased 3.6 percent to $250,035,000 in 2004 from $241,237,000 in 2003. This increase is primarily the result of rate increases that were implemented during the prior two years. After the broad-based rate increases implemented during the peak of the hard market in 2001 and 2002, premium rate levels for most lines of business were considered to be at, or near, adequate levels at the end of 2002. Accordingly, moderate and more targeted rate increases were implemented during 2003 and 2004. This fine tuning of the Company's rate structure has been directed toward specific accounts, territories and lines of business where additional rate increases were warranted. Due to the timing of policy renewals and the earning of premiums ratably over the terms of the underlying policies, a time delay exists for implemented rate increases to have a noticeable impact on premiums earned. During 2004, premiums written increased only 1.9 percent due to a decline in policy count and an increase in ceded premiums. The decline in policy count is attributed to several factors, including the non-renewal of existing business that was under-priced and/or under-performing, a reluctance to accept new risks in under-priced lines of business and a decrease in new business associated with a moderate increase in price competition. The increase in ceded premiums primarily reflects an increase in the cost of the Company's reinsurance programs. Premium rate levels for most lines of business are not expected to change significantly in 2005. In light of the improvements that have been achieved in both the pricing and the quality of the Company's book of business, management has become more receptive to opportunities to write new business, but continues to stress profitability over production.
Losses and settlement expenses increased 10.3 percent to $249,806,000 in 2004 from $226,505,000 in 2003. The loss and settlement expense ratio increased to 72.3 percent in 2004 from 68.5 percent in 2003. The increase in the 2004 ratio is primarily attributed to a significant amount of adverse development on prior years' reserves in the property and casualty insurance segment, but was partially offset by a decline in reported losses in the reinsurance segment. Catastrophe and storm losses declined 11.7 percent in 2004, but remained at an unusually high level.
The loss and settlement expense ratio for the property and casualty insurance segment increased to 78.6 percent in 2004 from 69.7 percent in 2003. The increase in the 2004 ratio is primarily attributed to a significant increase in adverse development on prior years' reserves. The adverse development of 2004 reflects a combination of newly reported claims in excess of carried IBNR reserves ($14,758,000), development on case reserves of previously reported claims ($11,037,000), bulk reserve strengthening ($2,350,000), and settlement expense reserve increases resulting from increases in case reserves ($6,209,000). This adverse development was partially offset by $10,437,000 of reinsurance recoveries associated with the case reserve development and IBNR emergence. Substantial case reserve strengthening performed at the branch offices, primarily in the workers' compensation and other liability lines of business, is the underlying reason for the adverse reserve development that occurred during 2004. As discussed further under the "Critical Accounting Policies" heading of this discussion, the economic factors behind this case reserve strengthening include, most notably, an increase in workers' compensation claim severity, increases in construction defect claim activity, the recent occurrence of several large umbrella claims, and increasing legal expenses in the other liability line of business. Loss severity continued to trend upward during 2004 while overall loss frequency continued to trend downward; however, there are some indications that loss frequency may be leveling out. Catastrophe and storm losses for 2004 include $2,888,000 (net of reinsurance) from the four hurricanes that hit the Southern United States in August and September.
For the reinsurance segment, the acquisition expense ratio increased to 28.1 percent in 2004 from 27.3 percent in 2003. The increase is primarily attributed to a large amount of contingent commission expense reported by MRB during 2004, but was reduced by a $666,000 increase in contingent commission income from a retrocession contract on the HORAD book of business. Both increases are a reflection of recent favorable underwriting performance. The asset for deferred acquisitions costs increased in 2004 and 2003 in connection with the increased participation in the MRB pool. These increases offset commission expense of $1,033,000 and $782,000 recorded for statutory purposes in those respective years with the increased participation in the MRB pool.
Income tax expense decreased 68.7 percent to $2,386,000 in 2004 from $7,633,000 in 2003. The effective tax rate declined to 15.3 percent in 2004 from 27.3 percent in 2003, primarily due to an increase in tax-exempt investment income and a decline in pre-tax income. Effective April 1, 2003, the Company was included in Employers Mutual's consolidated tax return due to the fact that Employers Mutual attained 80 percent ownership of the Company at the end of March. The Company filed a short-period tax return with its subsidiaries for the period January 1, 2003 through March 31, 2003. During October 2004 Employers Mutual's ownership of the Company fell below 80 percent upon successful completion of the follow-on stock offering. Accordingly, the Company will no longer be included in Employers Mutual's consolidated tax return effective October 1, 2004, and the Company will file a short-period tax return for the period October 1, 2004 through December 31, 2004.
Employers Mutual participated in the Company's Dividend Reinvestment and Common Stock Purchase Plan during the first two quarters of 2004 and reinvested 50 percent of its dividends in additional shares of the Company's common stock. Due to its participation in the Company's recent stock offering, Employers Mutual discontinued its participation in the plan for the third and fourth quarters of 2004 and has indicated that it will likely not participate in the plan in 2005.
On November 26, 2002, President Bush signed into law the Terrorism Risk Insurance Act of 2002 ("TRIA"). TRIA provides a temporary Federal backstop on losses from certified terrorism events from foreign sources and is effective until December 31, 2005. Coverage includes most direct commercial lines of business, including coverage for losses from nuclear, biological and chemical exposures. Each insurer has a deductible amount, which is calculated as a percentage of the prior year's direct earned commercial lines premium and a ten percent retention above the deductible. The percentage used in the deductible calculation increased from seven percent in 2003 to ten percent in 2004, and will increase to 15 percent in 2005. TRIA caps losses at $100 billion annually; no insurer that has met its deductible will be liable for payment of any portion above that amount. Congress is currently debating whether TRIA should be extended for one or possibly two years due to concerns that terrorism insurance may not be available in the private insurance market when TRIA expires; however, no action has yet been taken.
Premiums earned for the property and casualty insurance segment increased 7.2 percent to $241,237,000 in 2003 from $225,013,000 in 2002, primarily as a result of rate increases that were implemented during the preceding three years. The rate increases implemented in 2002 and 2001 were broad based in nature and resulted in premium rate levels for most lines of business that were considered to be at, or near, adequate levels at December 31, 2002. Accordingly, moderate and more targeted rate increases were implemented during 2003. This fine tuning of the Company's rate structure was directed toward specific accounts, territories and lines of business where additional rate increases were warranted. Due to the timing of policy renewals and the earning of premiums ratably over the terms of the underlying policies, a time delay exists for implemented rate increases to have a noticeable impact on premiums earned. Premiums earned for 2003 reflect this delay and continued to show strong growth as the rate increases obtained in 2002 became earned; however, the growth rate in 2003 was limited by a decline in policy count (overall approximately 5.8 percent from December 31, 2002) that resulted from a decrease in new business associated with a moderate increase in rate competition and a reluctance to accept new risks in under-priced lines of business, and the non-renewal of existing business that was under-priced and/or under-performing.
Premiums earned for the reinsurance segment increased 24.1 percent to $89,386,000 in 2003 from $72,030,000 in 2002, primarily as a result of improved premium rate levels and increased participation in the MRB reinsurance pool. Following the large across-the-board rate increases implemented in 2002, premium rate increases on excess of loss contracts moderated in 2003 due to the influx of new capital into the reinsurance marketplace; however, contracts with poor loss experience continued to receive exceptionally large rate increases. The rate increases implemented during 2003 and 2002 were realized in conjunction with moderate declines in the related exposure base due to increased retention levels and coverage exclusions for terrorist activities. In addition, both excess of loss and pro-rata contracts were benefiting from improved industry-wide rate levels at the primary company level. For 2003, Employers Mutual's participation in the MRB reinsurance pool increased to 25 percent from 20 percent in 2002,
The loss and settlement expense ratio for the reinsurance segment decreased to 65.2 percent in 2003 from 70.7 percent in 2002. This improvement was attributed to an unusually low level of reported loss activity from both proportional and excess of loss business, and from favorable development on prior years' reserves. However, this improvement was partially offset by a significant increase in catastrophe losses ($3,411,000 in 2003 compared to $249,000 in 2002). During 2003, two events (Midwest storms in the month of May and hurricane Isabel) reached the $1,500,000 cap on losses assumed per event from Employers Mutual. In addition, the reinsurance segment established $326,000 of additional IBNR reserves in 2003 in response to the findings of an independent study conducted on the Company's asbestos exposures.
Acquisition and other expenses increased 9.7 percent to $104,896,000 in 2003 from $95,633,000 in 2002. The expense ratio (acquisition and other expenses expressed as a percentage of premiums earned) decreased to 31.7 percent in 2003 from 32.2 percent in 2002, primarily due to the improvement in premium rate adequacy achieved in 2003.
For the property and casualty insurance segment, the expense ratio increased to 33.4 percent in 2003 from 32.2 percent in 2002. This increase was primarily due to an increase in contingent commission expense and higher employee benefit costs. The increase in contingent commission expense was a direct result of the fundamental improvement achieved in underwriting results. The increase in employee benefit costs was associated with a 50 basis-point decrease in the discount rate and expected long-term rate of return on plan assets assumptions utilized in the pension plan and postretirement benefit plans actuarial valuations.
Company was reluctant to invest in long-term securities in this current low interest rate environment and therefore had accumulated a significant amount of short-term and cash equivalent investments. Since these investments carry lower interest rates than long-term fixed maturity securities, the decline in the Company's rate of return was magnified.
Income tax expense increased 31.8 percent to $7,633,000 in 2003 from $5,790,000 in 2002. The effective tax rate increased slightly to 27.3 percent in 2003 from 26.4 percent in 2002.
Liquidity is a measure of a company's ability to generate sufficient cash to meet cash obligations as they come due. The Company generated positive cash flows from operations of $60,794,000 in 2004, $63,095,000 in 2003 and $56,566,000 in 2002. The Company typically generates substantial positive cash flows from operations because cash from premium payments is generally received in advance of cash payments made to settle claims. These positive cash flows provide the foundation of the Company's asset/liability management program and are the primary drivers of the Company's liquidity. When investing funds made available from operations, the Company invests in securities with maturities that approximate the anticipated liabilities of the insurance issued. In addition, the Company maintains a portion of its investment portfolio in relatively short-term and highly liquid assets as a secondary source of liquidity should net cash flows from operating activities prove inadequate to fund current operating needs. As of December 31, 2004, the Company did not have any significant variations between the maturity dates of its investments and the expected payment of its loss and settlement expense reserves.
The Company is a holding company whose principal assets are its investments in its insurance subsidiaries. As a holding company, the Company is dependent upon cash dividends from its insurance company subsidiaries to meet its obligations and to pay cash dividends to its stockholders. State insurance regulations restrict the maximum amount of dividends insurance companies can pay without prior regulatory approval. See note 6 of Notes to Consolidated Financial Statements for additional information regarding dividend restrictions. The maximum amount of dividends that the insurance company subsidiaries can pay to the Company in 2005 without prior regulatory approval is approximately $32.2 million. The Company received $7,029,000, $7,255,000 and $6,250,000 of dividends from its insurance company subsidiaries and paid cash dividends to its stockholders totaling $7,233,000, $6,874,000 and $6,828,000 in 2004, 2003 and 2002, respectively.
The Company's insurance company subsidiaries must have adequate liquidity to ensure that their cash obligations are met; however, because of their participation in the pooling agreement and the quota share agreement, they do not have the daily liquidity concerns normally associated with an insurance or reinsurance company. This is due to the fact that under the terms of the pooling and quota share agreements, Employers Mutual receives all premiums and pays all losses and expenses associated with the insurance business produced by the pool participants and the assumed reinsurance business ceded to the Company's reinsurance subsidiary, and then settles the inter-company balances generated by these transactions with the participating companies on a quarterly basis.
The Company maintains a portion of its investment portfolio in relatively short-term and highly liquid investments to ensure the availability of funds to pay claims and expenses. The remainder of the investment portfolio, excluding investments in equity securities, is invested in securities with maturities that approximate the anticipated liabilities of the insurance written. At December 31, 2004, approximately 27 percent of the Company's fixed maturity securities were in U.S. government or U.S. government agency issued securities. A variety of maturities are maintained in the Company's portfolio to assure adequate liquidity. The maturity structure of the fixed maturity investments is also established by the relative attractiveness of yields on short, intermediate and long-term securities. The Company does not invest in any high-yield debt investments (commonly referred to as junk bonds.)
The Company considers itself to be a long-term investor and generally purchases fixed maturity investments with the intent to hold them to maturity. Despite this intent, the Company has historically classified a portion of its fixed maturity investments as available-for-sale securities to provide flexibility in the management of the portfolio. Since the third quarter of 1999, all newly acquired fixed maturity investments have been classified as available-for-sale securities to provide increased management flexibility. The Company had unrealized holding gains, net of deferred taxes, on fixed maturity securities available-for-sale totaling $15,511,000 and $15,779,000 at December 31, 2004 and 2003, respectively. The fluctuation in the market value of these investments is primarily due to changes in the interest rate environment during this time period. Since the Company does not actively trade in the bond market, such fluctuations in the fair value of these investments are not expected to have a material impact on the operations of the Company, as forced liquidations of investments are not anticipated. The Company closely monitors the bond market and makes appropriate adjustments in its portfolio as changing conditions warrant.
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, primarily cash, equal to 102 percent of the market value of the loaned securities. The cash collateral that secures the Company's loaned securities is invested in a Delaware statutory trust that is managed by Mellon Bank. 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 carried a pension asset of $2,684,000 at December 31, 2004. At December 31, 2003 the Company reported a pension liability of $1,453,000 (including $1,016,000 of additional minimum liability). This change in the funded status of the pension plan was driven by a $5,236,000 pension plan contributions made during 2004. Along with the additional minimum liability reported on the Company's pension plan at December 31, 2003 was an intangible asset of $1,016,000. Postretirement benefit liabilities reflected in the Company's financial statements totaled $9,486,000 and $8,512,000 at December 31, 2004 and 2003, respectively.
The Company had total cash and invested assets with a carrying value of $779.4 million and $676.9 million as of December 31, 2004 and December 31, 2003, respectively. The following table summarizes the Company's cash and invested assets as of the dates indicated:
December 31, 2004 ----------------------------------- Percent of Amortized total at ($ in thousands) cost Fair value fair value --------- ---------- ---------- Fixed maturities, held-to-maturity .... $ 29,206 $ 30,594 3.9% Fixed maturities, available-for-sale .. 595,791 619,654 79.4 Equity securities, available-for-sale 59,589 78,693 10.1 Cash .................................. 61 61 - Short-term investments ................ 46,239 46,239 5.9 Other long-term investments ........... 5,550 5,550 0.7 -------- -------- ----- $736,436 $780,791 100.0% ======== ======== =====
these surplus notes were reissued at an annual interest rate of 3.09 percent. These notes do not have a maturity date. Payment of interest and repayment of principal can only be made out of the applicable subsidiary's statutory surplus and is subject to prior approval by the insurance commissioner of the respective state of domicile. The surplus notes are subordinate and junior in right of payment to all obligations or liabilities of the applicable insurance subsidiaries. The Company's subsidiaries incurred interest expense of $1,112,000, $1,320,000, and $1,639,000 in 2004, 2003, and 2002, respectively, on these surplus notes. The surplus notes were issued in response to statutory capital adequacy concerns raised by certain rating agencies because the statutory surplus position of the subsidiaries had declined over the preceding three years due to unfavorable operating results and the payment of dividends to the parent corporation. At December 31, 2004, the Company's subsidiaries had received approval for the payment of interest accrued on the surplus notes during 2004.
As of December 31, 2004, the Company had no material commitments for capital expenditures.
During 2004 the Company had one fixed maturity security series (MCI Communications Corporation) that was determined other-than-temporarily impaired. MCI Communications Corporation was owned by WorldCom Inc., whose corporate bonds were downgraded to junk status in May 2002 when it reported the detection of accounting irregularities. On June 30, 2002 the Company recognized $3,821,000 of realized loss when the carrying value of this investment was reduced from an aggregate book value of $5,604,000 to the then current fair value of $1,783,000. The fair value of the MCI bonds then partially recovered, resulting in pre-tax unrealized gains of $1,035,000 recognized during 2002 and $1,811,000 recognized during 2003. During the second quarter of 2004 the Company received three new series of fixed maturity securities (with impaired book values) issued by MCI Communications Corporation in conjunction with a payout award received under a bankruptcy court approved "Plan of Reorganization." This payout was recorded as a tax- free exchange and the new bonds were assigned a book value equal to the book value of the defaulted bonds that were replaced ($5,509,000). The par value of the new bonds reflected the settlement amount of 79.2 cents per dollar ($4,552,000) and the fair value of the new bonds was $4,241,000 at the time of the payout. Based on these facts, a realized investment gain of $3,826,000 was recognized in the second quarter of 2004 to offset the other-than- temporary impairment loss previously recognized in the second quarter of 2002 and an other-than-temporary impairment loss of $1,268,000 was recognized to reduce the book value of the new bonds to fair value at the time of the payout. The new bonds were sold during the third quarter of 2004, resulting in an additional realized gain of $187,000.
Following is a schedule of the length of time securities have continuously been in an unrealized loss position as of December 31, 2004.
Description of securities Fair value Unrealized losses - ------------------------- ---------- ----------------- ($ in thousands) Fixed maturity securities: Less than six months ........ $ 42,063 $ 183 Six to twelve months ........ 6,829 13 Twelve months or longer ..... 8,064 126 -------- ----- Total fixed maturity securities .............. 56,956 322 -------- ----- Equity securities: Less than six months ........ 7,061 111 Six to twelve months ........ 334 10 Twelve months or longer ..... - - -------- ----- Total equity securities ... 7,395 121 -------- ----- Total temporarily impaired securities ... $ 64,351 $ 443 ======== =====
Gross Book Sales realized ($ in thousands) value price loss --------- --------- --------- Fixed maturity securities available-for-sale: Three months or less ............... $ 5,509 $ 4,186 $ 1,323 Over three months to six months .... 14,202 14,000 202 Over six months to nine months ..... 2,601 2,550 51 Over nine months to twelve months .. - - - Over twelve months ................. - - - --------- --------- --------- $ 22,312 $ 20,736 $ 1,576 ========= ========= =========
Equity securities: Three months or less ............... $ 10,309 $ 9,279 $ 1,030 Over three months to six months .... 2,262 1,935 327 Over six months to nine months ..... 1,280 1,075 205 Over nine months to twelve months .. 1,018 712 306 Over twelve months ................. 1,271 1,113 158 --------- --------- --------- $ 16,140 $ 14,114 $ 2,026 ========= ========= =========
Payments due by period ----------------------------------------------- Less More than 1-3 4-5 than Total 1 year years years 5 years -------- -------- -------- ------- -------- ($ in thousands) Contractual Obligations - ----------------------- Loss and settlement expense reserves (1) ............. $429,677 $171,138 $157,146 $52,971 $ 48,422 Long-term debt (2) ......... 36,000 - - - 36,000 Real estate operating leases 6,863 1,086 1,977 1,560 2,240 Software operating leases .. 375 375 - - - -------- -------- -------- ------- -------- Total ...................... $472,915 $172,599 $159,123 $54,531 $ 86,662 ======== ======== ======== ======= ========
(2) Long-term debt reflects the surplus notes issued by the Company's insurance subsidiaries to Employer Mutual, which have no maturity date. Interest on the surplus notes amounts to $1,112,000 annually, and is subject to approval by the issuing company's state of domicile. Excluded from long- term debt are pension and other postretirement benefit obligations.
The participants in the pooling agreement have purchased annuities from life insurance companies, under which the claimant is payee, to fund future payments that are fixed pursuant to specific claim settlement provisions. The Company's share of loss reserves eliminated by the purchase of these annuities was $700,000 at December 31, 2004. The Company has a contingent liability of
Market risk represents the potential for loss due to adverse changes in the fair value of financial instruments. The market risks of the financial instruments of the Company relate to the investment portfolio, which exposes the Company to interest rate and equity price risk, and to a lesser extent credit quality and prepayment risk. Monitoring systems and analytical tools are in place to assess each of these elements of market risk.
The Company invests in high quality fixed maturity securities, thus minimizing credit quality risk. At December 31, 2004, the portfolio of long- term fixed maturity securities consists of 12.2 percent U.S. Treasury, 14.4 percent government agency, 0.5 percent mortgage-backed, 41.1 percent municipal, and 31.8 percent corporate securities. At December 31, 2003, the portfolio of long-term fixed maturity securities consisted of 26.7 percent U.S. Treasury, 13.0 percent government agency, 2.8 percent mortgage-backed, 25.6 percent municipal, and 31.9 percent corporate securities.
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, 2004.
Prepayment risk refers to the 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. The prepayment risk analysis is monitored regularly through the analysis of interest rate simulations. At December 31, 2004, the effective duration of the mortgage- backed securities is 1.7 years with an average life and current yield of 2.8 years and 7.1 percent, respectively. At December 31, 2003, the effective duration of the mortgage-backed securities was 1.6 years with an average life and current yield of 2.4 years and 7.0 percent, respectively.
Inflation has a widespread effect on the Company's results of operations, primarily through increased losses and settlement expenses. The Company considers inflation, including social inflation that reflects an increasingly litigious society and increasing jury awards, when setting reserve amounts. Premiums are also affected by inflation, although they are often restricted or delayed by competition and the regulatory rate-setting environment.
The management of EMC Insurance Group Inc. and Subsidiaries is responsible for the preparation, integrity and objectivity of the accompanying financial statements, as well as other financial information in this report. The financial statements have been prepared in accordance with U.S. generally accepted accounting principles and include amounts that are based on management's estimates and judgments where necessary.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. We were not engaged to perform an audit of the Company's internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
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, 2004 and 2003 and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2004, in conformity with U.S. generally accepted accounting principles.
December 31, -------------------------- 2004 2003 ------------ ------------ ASSETS Investments: Fixed maturities: Securities held-to-maturity, at amortized cost (fair value $16,908,726 and $21,167,655) .... $ 15,895,607 $ 19,423,013 Securities available-for-sale, at fair value (amortized cost $541,401,950 and $382,326,388) ............................... 565,000,931 405,758,798 Fixed maturity securities on loan: Securities held-to-maturity, at amortized cost (fair value $13,684,880 and $32,686,769) ... 13,310,264 30,422,335 Securities available-for-sale, at fair value (amortized cost $54,389,046 and $117,184,150) .............................. 54,653,472 118,026,960 Equity securities available-for-sale, at fair value (cost $59,589,434 and $38,998,075) ..... 78,692,893 49,008,498 Other long-term investments, at cost ........... 5,550,093 4,758,019 Short-term investments, at cost ................ 46,238,853 63,568,064 ------------ ------------ Total investments .......................... 779,342,113 690,965,687
Cash ............................................. 61,088 (14,069,102) Accrued investment income ........................ 8,726,292 7,821,652 Accounts receivable (net of allowance for uncollectible accounts of $0 and $0) ........... 216,836 379,423 Income taxes recoverable ......................... 3,399,485 - Deferred income taxes ............................ 9,504,193 10,345,429 Goodwill, at cost less accumulated amortization of $2,616,234 and $2,616,234 ................... 941,586 941,586 Securities lending collateral .................... 70,122,695 154,556,758 ------------ ------------ Total assets .............................. $934,815,932 $905,571,010 ============ ============
December 31, -------------------------- 2004 2003 ------------ ------------ LIABILITIES Balances resulting from related party transactions with Employers Mutual: Losses and settlement expenses ............. $429,677,302 $373,782,916 Unearned premiums .......................... 131,589,365 124,832,607 Other policyholders' funds ................. 2,825,809 1,390,594 Surplus notes payable ...................... 36,000,000 36,000,000 Indebtedness to related party .............. 6,058,848 2,175,118 Employee retirement plans .................. 9,764,406 9,965,600 Other liabilities .......................... 20,304,475 19,336,366
All balances presented below, with the exception of investment income, realized investment gains (losses) and income tax expense (benefit), are the result of related party transactions with Employers Mutual.
Year ended December 31, ------------------------------------- 2004 2003 2002 ----------- ----------- ----------- CASH FLOWS FROM OPERATING ACTIVITIES Net income .......................... $13,184,683 $20,349,123 $16,101,738
Deferred policy acquisition costs (1,202,799) (1,810,923) (3,563,333) Accrued investment income ....... (904,640) 1,357,903 (520,547) Accrued income taxes: Current ....................... (6,179,985) 2,994,004 (112,890) Deferred ...................... (2,197,191) (703,208) 729,205 Realized investment (gains) losses ........................ (4,379,314) (1,169,698) 3,159,201 Accounts receivable ............. 162,587 393,521 308,080 Other, net ...................... (672,675) (206,551) (1,717,779) ----------- ----------- ----------- 47,609,770 42,745,461 40,464,666 ----------- ----------- ----------- Net cash provided by operating activities .... $60,794,453 $63,094,584 $56,566,404 =========== =========== ===========
CASH FLOWS FROM FINANCING ACTIVITIES Balances resulting from related party transactions with Employers Mutual: Issuance of common stock through Employers Mutual's stock option plans ......... 1,531,860 1,944,652 1,326,451 Dividends paid to Employers Mutual ........... (5,292,178) (5,522,994) (5,423,042) Dividends paid to Employers Mutual (reimbursement for non-GAAP expense) .......... (293,583) (505,196) - Issuance of surplus notes .... - - 11,000,000
The Company's subsidiaries include EMCASCO Insurance Company, Illinois EMCASCO Insurance Company, Dakota Fire Insurance Company, Farm and City Insurance Company, EMC Reinsurance Company and EMC Underwriters, LLC.
Certain costs of acquiring new business, principally commissions, premium taxes and other underwriting expenses that vary with and are directly related to the production of business have been deferred. Such deferred costs are being amortized as premium revenue is recognized. The method followed in computing deferred policy acquisition costs limits the amount of such deferred costs to their estimated realizable value, which gives effect to the premium to be earned, related investment income, losses and settlement expenses and certain other costs expected to be incurred as the premium is earned.
Securities classified as held-to-maturity are purchased with the intent and ability to be held to maturity and are carried at amortized cost. Unrealized holding gains and losses on securities held-to-maturity are not reflected in the financial statements. All other securities have been classified as securities available-for-sale and are carried at fair value, with unrealized holding gains and losses reported as accumulated other comprehensive income in stockholders' equity, net of deferred income taxes. Other long-term investments represent minor ownership interests in limited partnerships and limited liability companies and are carried at cost. Short- term investments represent money market funds and are carried at cost, which approximates fair value.
The Company's carrying value for investments is reduced to its estimated realizable value if a decline in the fair value is deemed other-than- temporary. Such reductions in carrying value are recognized as realized losses and are charged to income. Premiums and discounts on debt securities are amortized over the life of the security as an adjustment to yield using the effective interest method. Realized gains and losses on 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, 2004 and 2003 are securities on deposit with various regulatory authorities as required by law amounting to $13,000,797 and $12,960,435, respectively.
The Company participates in a securities lending program whereby certain fixed maturity securities from the investment portfolio are loaned to other institutions for a short period of time. The Company requires initial collateral equal to 102 percent of the market value of the loaned securities. The collateral is invested by the lending agent, in accordance with the Company's guidelines, and generates fee income for the Company that is recognized ratably over the time period the security is on loan. 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.
The Company has no stock based compensation plans of its own; however, Employers Mutual has several stock plans that utilize the common stock of the Company. The Company receives the current fair value for any shares issued under these plans. Under the terms of the pooling and quota share agreements (see note 2), stock option expense is allocated to the Company as determined on a statutory basis of accounting; however, for these GAAP basis financial statements the Company accounts for the stock option plans using the intrinsic value method of accounting as prescribed by Accounting Principles Board (APB) Opinion No. 25, "Accounting for Stock Issued to Employees," and related interpretations. Under the provisions of APB 25, no compensation expense is recognized from the operation of Employers Mutual's stock option plans since the exercise price of the options is equal to the fair value of the stock on the date of grant.
The Company's insurance subsidiaries reimburse Employers Mutual for their share of the statutory-basis compensation expense associated with stock option exercises under the terms of the pooling and quota share agreements. Beginning in 2003, the statutory-basis compensation expense that was paid by the Company's subsidiaries to Employers Mutual ($293,583 in 2004 and $505,196 in 2003) was reclassified as a dividend payment to Employers Mutual in these GAAP-basis financial statements. Since the corresponding amount for 2002 was not material, the financial statements for 2002 were not restated.
The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards (SFAS) SFAS No. 123 (as amended by SFAS No. 148) "Accounting for Stock-Based Compensation" to Employers Mutual's stock option plans:
2004 2003 2002 ----------- ----------- ----------- Net income, as reported ........ $13,184,683 $20,349,123 $16,101,738 Deduct: Stock-based employee compensation expense determined under the fair value method for all awards, net of related tax effects .................. 32,373 25,383 18,992 ----------- ----------- ----------- Pro forma net income ........... $13,152,310 $20,323,740 $16,082,746 =========== =========== =========== Net income per share: Basic and diluted - As reported ................ $1.10 $1.78 $1.42 Pro forma .................. $1.10 $1.77 $1.41
In December 2004, the FASB issued SFAS No. 123 (revised 2004) "Share- Based Payment," which is a revision of SFAS No. 123 and supersedes APB No. 25. SFAS No. 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements based on their fair values beginning with the first interim and annual periods after June 15, 2005, with earlier adoption encouraged. The pro forma disclosures previously allowed under SFAS No. 123 will no longer be an alternative to financial statement recognition. The transition methods for adoption include the modified-prospective and modified-retroactive methods. The modified-prospective method requires that compensation expense be recorded for all unvested stock options that exist upon the adoption of Statement 123(R). Under the modified-retroactive method, prior periods may be restated either as of the beginning of the year of adoption or for all periods presented. The Company is currently evaluating the requirements of Statement 123(R), but does not expect adoption of this statement to have a material effect on the financial position or the results of operations of the Company.
Operations of the pool give rise to inter-company balances with Employers Mutual, which are settled on a quarterly basis. The investment and income tax activities of the pool participants are not subject to the pooling agreement. Effective December 31, 2003, the pooling agreement was amended to provide that Employers Mutual will make up any shortfall or difference resulting from an error in its systems and/or computational processes that would otherwise result in the required restatement of the pool participants' financial statements.
On October 20, 2004, the Company successfully completed a follow-on stock offering and sold 2.0 million new shares of its common stock to the public at a price of $18.75 per share. Employers Mutual participated in the stock offering as a selling shareholder and sold 2.1 million shares of the Company's common stock that it previously owned. As a result of these transactions, Employers Mutual's ownership of the Company was reduced from approximately 80.9 percent to approximately 53.7 percent.
Net proceeds from the follow-on stock offering totaled $34,890,085. These proceeds were contributed to three of the Company's property and casualty insurance subsidiaries in late December to support a planned 6.5 percentage point increase in the Company's aggregate participation in the pooling agreement effective January 1, 2005. As a result of this change, the Company's aggregate participation in the pooling agreement will increase from the current 23.5 percent to 30.0 percent and Employers Mutual's participation will decrease from the current 65.5 percent to 59.0 percent. In connection with this change in the pooling agreement, the Company's liabilities will increase $115,042,355 and invested assets will increase $108,798,583. The Company will reimburse Employers Mutual $6,518,735 for expenses that were incurred to generate the additional business assumed by the Company, but this expense will be offset by an increase in deferred policy acquisition costs. The Company will also receive $274,963 in interest income from Employers Mutual as the actual cash transfer did not occur until February 15, 2005.
In addition to changing the individual pool participation percentages of Employers Mutual and three of the Company's property and casualty insurance subsidiaries, the pooling agreement has been amended effective January 1, 2005 to comply with certain conditions established by the Iowa Insurance Department and A.M. Best Company. These amendments: (1) provide for a fixed term of three years commencing January 1, 2005 and continuing until December 31, 2007, during which period the pooling agreement may not be terminated and the revised participation interests will not be further amended, absent the occurrence of a material event not in the ordinary course of business that could reasonably be expected to impact the appropriateness of the participation interests in the pool; (2) provide that if a pool participant becomes insolvent, or is otherwise subject to liquidation or receivership proceedings, each of the other participants will, on a pro rata basis, adjust their assumed portions of the pool liabilities in order to assume in full the liabilities of the impaired participant, subject to compliance with all regulatory requirements applicable to such adjustment under the laws of all states in which the participants are domiciled; (3) clarify that all development on prior years' outstanding losses and settlement expenses of the participants will remain in the pool and be pro rated pursuant to the pooling agreement; and (4) clarify that all liabilities incurred prior to a participant withdrawing from the pool, and associated with such withdrawing participant, shall remain a part of the pool and subject to the pooling agreement.
During 2004, the Company's wholly-owned subsidiary, Farm and City Insurance Company, discontinued writing new nonstandard risk automobile insurance business and began instituting non-renewal procedures on all existing business. The effective dates for these actions were determined by the requirements of the six states in which it conducts business and the terms of the individual policies. Farm and City will continue to participate in the pooling agreement even though it will no longer write any direct insurance business. Discontinuance of the nonstandard risk automobile insurance business did not have a material impact on the results of operations of the Company. In 2004, Farm and City's direct premiums written declined to $1,553,000 from $9,849,000 in 2003. Under the terms of the pooling agreement, only 23.5 percent of this decline ($1,950,000) was assumed by the Company.
Premiums assumed by the reinsurance subsidiary from Employers Mutual amounted to $97,637,066, $90,057,773 and $76,203,278 in 2004, 2003 and 2002, respectively. It is customary in the reinsurance business for the assuming company to compensate the ceding company for the acquisition expenses incurred in the generation of the business. Commissions paid by the reinsurance subsidiary to Employers Mutual amounted to $20,621,898, $18,936,008 and $18,117,058 in 2004, 2003 and 2002, respectively.
The reinsurance subsidiary pays an annual override commission to Employers Mutual in connection with the $1,500,000 cap on losses assumed per event. The override commission rate is charged at 4.50 percent of written premiums. Total override commission paid to Employers Mutual amounted to $4,393,668, $4,052,600 and $3,429,148 in 2004, 2003 and 2002, respectively. Employers Mutual retained losses and settlement expenses under this agreement totaling $11,277,246 in 2004, $2,747,334 in 2003 and $1,186,598 in 2002. The reinsurance subsidiary also pays for 100 percent of the outside reinsurance protection Employers Mutual purchases to protect itself from catastrophic losses on the assumed reinsurance business, excluding reinstatement premiums. This cost is recorded as a reduction to the premiums received by the reinsurance subsidiary and amounted to $3,626,833, $3,802,878 and $3,247,969 in 2004, 2003 and 2002, respectively.
Employers Mutual provides various services to all of its subsidiaries and affiliates. Such services include data processing, claims, financial, actuarial, auditing, marketing and underwriting. Employers Mutual allocates a portion of the cost of these services to the subsidiaries that do not participate in the pooling agreement based upon a number of criteria, including usage and 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 $2,300,700, $2,097,057 and $1,765,287 in 2004, 2003 and 2002, respectively. Costs allocated to the Company through the operation of the pooling agreement amounted to $73,305,162, $63,293,517 and $56,897,066 in 2004, 2003 and 2002, respectively.
Investment expenses are based on actual expenses incurred by the Company plus an allocation of other investment expenses incurred by Employers Mutual, which is based on a weighted average of total invested assets and number of investment transactions. Investment expenses allocated to the Company by Employers Mutual amounted to $699,807, $699,954 and $559,136 in 2004, 2003 and 2002, respectively.
As of December 31, 2004, reinsurance ceded to two nonaffiliated reinsurers aggregated $12,495,837, which represents a significant portion of the total prepaid reinsurance premiums and reinsurance receivables for losses and settlement expenses. These amounts reflect the property and casualty insurance subsidiaries' aggregate pool participation percentage of amounts ceded by Employers Mutual to these organizations in connection with its role as "service carrier". Under these arrangements, Employers Mutual writes business for these organizations on a direct basis and then cedes 100 percent of this business to these organizations. Credit risk associated with these amounts is minimal, as all companies participating in these organizations are responsible for the liabilities of such organizations on a pro rata basis.
The effect of reinsurance on premiums written and earned, and losses and settlement expenses incurred, for the three years ended December 31, 2004 is presented below. The 2003 losses and settlement expenses incurred amounts for direct, assumed from affiliates, ceded to non-affiliates and ceded to affiliates amounts incurred have been restated to reflect change in recording claims associated with the MCCA. There was no effect on net losses and settlement expenses incurred.
Year ended December 31, ---------------------------------------- 2004 2003 2002 ------------ ------------ ------------ Premiums written Direct ......................... $191,823,068 $220,741,419 $235,596,547 Assumed from nonaffiliates ..... 4,125,092 3,816,789 3,985,370 Assumed from affiliates ........ 366,224,505 351,641,368 320,940,551 Ceded to nonaffiliates ......... (18,445,768) (15,808,709) (11,089,041) Ceded to affiliates ............ (191,823,068) (220,741,419) (235,596,547) ------------ ------------ ------------ Net premiums written ......... $351,903,829 $339,649,448 $313,836,880 ============ ============ ============ Premiums earned Direct ......................... $197,051,604 $221,662,098 $241,939,466 Assumed from nonaffiliates ..... 3,933,665 3,629,346 3,501,616 Assumed from affiliates ........ 359,605,116 341,947,846 304,462,790 Ceded to nonaffiliates ......... (18,060,320) (14,954,382) (10,921,373) Ceded to affiliates ............ (197,051,604) (221,662,098) (241,939,466) ------------ ------------ ------------ Net premiums earned .......... $345,478,461 $330,622,810 $297,043,033 ============ ============ ============ Losses and settlement expenses incurred Direct ......................... $132,616,303 $176,461,490 $165,218,514 Assumed from nonaffiliates ..... 2,897,364 3,270,406 2,876,808 Assumed from affiliates ........ 258,134,261 239,682,836 206,614,356 Ceded to nonaffiliates ......... (11,225,415) (16,448,692) (2,433,308) Ceded to affiliates ............ (132,616,303) (176,461,490) (165,218,514) ------------ ------------ ------------ Net losses and settlement expenses incurred .......... $249,806,210 $226,504,550 $207,057,856 ============ ============ ============
------------ ------------ ------------ Incurred losses and settlement expenses Provision for insured events of the current year ............ 229,667,776 219,028,236 200,059,798
Increase in provision for insured events of prior years .. 20,138,434 7,476,314 6,998,058 ------------ ------------ ------------ Total incurred losses and settlement expenses ...... 249,806,210 226,504,550 207,057,856 ------------ ------------ ------------ Payments Losses and settlement expenses attributable to insured events of the current year ............ 83,530,727 86,072,127 81,124,276
Underwriting results of the Company are significantly influenced by estimates of loss and settlement expense reserves. Changes in reserve estimates are reflected in operating results in the year such changes are recorded. The property and casualty insurance segment experienced adverse development on prior years' reserves for all three years presented, while the reinsurance segment experienced favorable development in the two most recent
2002 Development - ---------------- For the property and casualty insurance segment, the December 31, 2002 estimate of loss and settlement expense reserves for accident years 2001 and prior increased $4,645,194 from the estimate at December 31, 2001. This increase represents 2.1% of the December 31, 2001 carried reserves and is primarily attributable to three sources: direct IBNR reserves, involuntary pools and contingent salary plan reserves. With regard to direct IBNR reserves, the methodology utilized to establish these reserves assumes consistency in claims reporting patterns. However, in recent years emerged IBNR losses have increased as a percentage of earned premiums. As a result of these actuarial indications, the Company strengthened direct IBNR reserves by $3,564,000 in 2002, $1,697,000 of which was allocated to accident years 2001 and prior. In addition, the Company established $2,068,705 of additional IBNR asbestos reserves at December 31, 2002 based on the results of a recently completed study of the Company's asbestos exposures, all of which was allocated to accident years 2001 and prior. As previously noted, the Company books the reserves reported by the management of the involuntary pools and in 2002 these bookings resulted in modest upward development of $353,000. Finally, Employers Mutual implemented a contingent salary plan in 2002 and $376,000 of the reserve established for this plan at December 31, 2002 was allocated to settlement expenses for accident years 2001 and prior.
The Company has exposure to asbestos and environmental related claims associated with the insurance business written by the parties to the pooling agreement and the reinsurance business assumed from Employers Mutual by the reinsurance subsidiary. These exposures are not considered to be significant. Asbestos and environmental losses paid by the Company have averaged only $244,000 per year over the past five years. During 2002, the Company re- evaluated the estimated ultimate losses for direct asbestos and environmental exposures. Based on this re-evaluation, the Company reallocated $752,000 of bulk IBNR reserves and $324,303 of settlement expense reserves to these exposures. In addition, the Company diligently evaluated the adequacy of its asbestos reserves by commissioning a "ground-up" study to better quantify its exposure to asbestos liabilities. This study concluded that the Company's exposure for direct asbestos claims ranged from $1,000,000 to $5,100,000, with a point estimate of $3,000,000. Based on the results of this study, the Company elected to increase the IBNR and settlement expense reserves carried for direct asbestos exposures by $2,068,705 at December 31, 2002, to $2,985,402. The study's results for asbestos exposures on assumed reinsurance business were received during 2003, and the Company elected to increase its IBNR reserves carried for assumed asbestos exposures by $326,000 to the study's point estimate. The study and its results assume no improvement in the current asbestos litigation environment; however, continued efforts for federal legislation could reduce the ultimate loss projections for asbestos litigation below the levels currently projected for the industry. Reserves for asbestos and environmental related claims for direct insurance and assumed reinsurance business totaled $5,459,912 and $5,584,196 at December 31, 2004 and 2003, respectively.
At present, the Company is defending approximately 500 asbestos bodily injury lawsuits. Most of these defenses are subject to express reservation of rights based upon the lack of an injury within the Company's policy periods, because many asbestos lawsuits do not specifically allege dates of asbestos exposure or dates of injury. During 2003, as a direct result of proposed federal legislation in the areas of asbestos and class action reform, the Company was presented with several hundred additional lawsuits filed against three former policyholders representing approximately 40,500 claims related to exposure to asbestos or asbestos containing products. These claims are based upon nonspecific asbestos exposure and nonspecific injuries. As a result, management did not establish a significant amount of loss reserves associated with these claims. The Company has denied coverage to one of the former policyholders, representing approximately 10,000 claims, because of express asbestos exclusion language contained in the policy. Minimal expense payments have been made to date on the lawsuits related to the other two former policyholders and no payments have been made for either defense or indemnity. Defense costs, on the other hand, have typically increased due to the increased number of parties involved in the litigation and the length of time required to obtain a favorable judgment. Whenever possible, the Company has participated in cost sharing agreements with other insurance companies to reduce overall asbestos claim expenses.
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 2004, 2003 and 2002.
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, 2004, the Company's insurance subsidiaries had total adjusted statutory capital of $216,868,207, which is well in excess of the minimum risk-based capital requirement of $43,484,541.
Retained earnings of the Company's insurance subsidiaries available for distribution as dividends are limited by law to the statutory unassigned surplus of each of the subsidiaries as of the previous December 31, as determined in accordance with accounting practices prescribed by insurance regulatory authorities of the state of domicile of each subsidiary. Subject to this limitation, the maximum dividend that may be paid within a 12 month period without prior approval of the insurance regulatory authorities is restricted to the greater of 10 percent of statutory surplus as regards policyholders as of the preceding December 31, or net income of the preceding calendar year on a statutory basis. At December 31, 2004, $32,232,101 was available for distribution to the Company in 2005 without prior approval.
Property Year ended and casualty Parent December 31, 2004 insurance Reinsurance company Consolidated - ----------------- ------------ ------------ ------------ -------------- Premiums earned ....... $250,034,561 $ 95,443,900 $ - $ 345,478,461
Property Year ended and casualty Parent December 31, 2003 insurance Reinsurance company Consolidated - ----------------- ------------ ------------ ------------ ------------- Premiums earned ....... $241,237,313 $ 89,385,497 $ - $ 330,622,810
Underwriting gain (loss) .............. (7,493,703) 6,716,356 - (777,347) Net investment income 20,724,017 8,948,076 30,368 29,702,461 Realized gains (losses) 1,312,252 (142,554) - 1,169,698 Interest expense ...... (919,362) (400,904) - (1,320,266) Other income .......... 862,070 - - 862,070 Other expenses ........ (1,044,757) - (609,563) (1,654,320) ------------ ------------ ------------ -------------- Income (loss) before income tax expense (benefit) ......... $ 13,440,517 $ 15,120,974 $ (579,195)$ 27,982,296 ============ ============ ============ ==============
The amortized cost and estimated fair value of securities held-to- maturity and available-for-sale as of December 31, 2004 and 2003 are as follows. The estimated fair value is based on quoted market prices, where available, or on values obtained from independent pricing services.
Gross Gross Estimated Amortized unrealized unrealized fair cost gains losses value ------------ ----------- ----------- ------------ December 31, 2003 - ----------------- Securities held-to-maturity: Fixed maturity securities: U.S. treasury securities and obligations of U.S. government corporations and agencies ............. $ 47,547,267 $ 3,780,331 $ - $ 51,327,598 Mortgage-backed securities ........... 2,298,081 228,745 - 2,526,826 ------------ ----------- ----------- ------------ Total securities held-to-maturity $ 49,845,348 $ 4,009,076 $ - $ 53,854,424 ============ =========== =========== ============ Securities available-for- sale: Fixed maturity securities: U.S. treasury securities and obligations of U.S. government corporations and agencies ............. $170,445,955 $ 703,239 $ - $171,149,194 Obligations of states and political subdivisions ......... 140,694,351 6,381,069 (300,188) 146,775,232 Mortgage-backed securities ........... 19,311,455 1,967,145 - 21,278,600 Public utilities ....... 20,171,434 1,714,421 (86,518) 21,799,337 Corporate securities ... 148,887,343 14,194,708 (298,656) 162,783,395 ------------ ----------- ----------- ------------ Total fixed maturity securities ....... 499,510,538 24,960,582 (685,362) 523,785,758 ------------ ----------- ----------- ------------ Equity securities: Common stocks .......... 38,498,075 10,188,751 (206,828) 48,479,998 Non-redeemable preferred stocks ..... 500,000 28,500 - 528,500 ------------ ----------- ----------- ------------ Total equity securities ....... 38,998,075 10,217,251 (206,828) 49,008,498 ------------ ----------- ----------- ------------ Total securities available-for-sale $538,508,613 $35,177,833 $ (892,190)$572,794,256 ============ =========== =========== ============
The Company uses several factors to determine whether the carrying value of an individual security has been other-than-temporarily impaired. Such factors include, but are not limited to, the security's value and performance in the context of the overall markets, length of time and extent the security's fair value has been below carrying value, key corporate events and collateralization of fixed maturity securities. Based on these factors, and the Company's ability and intent to hold the fixed maturity securities until maturity, it was determined that the carrying value of these securities was not other-than-temporarily impaired at December 31, 2004.
The mortgage-backed securities shown in the above table include $3,405,529 of securities issued by government corporations and agencies. Investment yields may vary from those anticipated due to changes in prepayment patterns of the underlying collateral.
Fixed maturity securities available-for-sale: (2) Gross realized investment gains .. 5,188,496 8,624,525 960,705 Gross realized investment losses (1,576,462) (4,877,307) (3,831,374)
Equity securities available-for-sale: (3) Gross realized investment gains .. 2,784,039 2,885,412 4,654,622 Gross realized investment losses (2,025,858) (5,463,713) (4,943,154) ----------- ----------- ----------- Totals ......................... $ 4,379,314 $ 1,169,698 $(3,159,201) =========== =========== ===========
Year ended December 31, ---------------------------------------- 2004 2003 2002 ------------ ------------ ------------ Fixed maturity securities ......... $ (411,813) $ (1,735,818) $ 19,097,214 Applicable deferred income tax expense (benefit) ............... (144,134) (607,536) 6,684,025 ------------ ------------ ------------ Total fixed maturity securities (267,679) (1,128,282) 12,413,189 ------------ ------------ ------------ Equity securities ................. 9,093,037 13,857,468 (8,483,491) Applicable deferred income tax expense (benefit) ............... 3,182,563 4,850,114 (2,969,226) ------------ ------------ ------------ Total equity securities ....... 5,910,474 9,007,354 (5,514,265) ------------ ------------ ------------ Total available-for-sale
The actual income tax expense for the years ended December 31, 2004, 2003 and 2002 differed from the "expected" tax expense for those years (computed by applying the United States federal corporate tax rate of 35 percent to income before income tax expense) as follows:
Comprehensive income tax expense included in the consolidated financial statements for the years ended December 31, 2004, 2003 and 2002 is as follows:
On December 28, 2001, three of the Company's property and casualty insurance subsidiaries issued surplus notes totaling $25,000,000 to Employers Mutual at an annual interest rate of 5.38 percent. On June 27, 2002, the Company's reinsurance subsidiary issued an $11,000,000 surplus note to Employers Mutual at an annual interest rate of 5.25 percent. These surplus notes do not have a maturity date. Effective April 1, 2003, the surplus notes were reissued at an annual interest rate of 3.09 percent. Payment of interest and repayment of principal can only be repaid out of the subsidiary's statutory surplus earnings and is subject to approval by the issuing company's state of domicile. The surplus notes are subordinate and junior in right of payment to all obligations or liabilities of the subsidiaries. Interest expense on surplus notes amounted to $1,112,400 for 2004, $1,320,266 for 2003 and $1,638,716 for 2002.
Employers Mutual has various employee benefit plans, including a defined benefit retirement plan (pension) and two postretirement benefit plans. Although the Company has no employees of its own, under the terms of the pooling agreement and the allocation of costs to the subsidiaries that do not participate in the pooling agreement (see note 2) the Company is responsible for its share of Employers Mutual's benefit plan expenses and related benefit plan prepaid assets and liabilities. Accordingly, the Company's consolidated balance sheets reflect the Company's share of the total plans' assets and liabilities.
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 five years of service. It is Employers Mutual's policy to fund pension costs according to regulations provided under the Internal Revenue Code.
Employers Mutual also offers postretirement benefit plans, which provide certain health care and life insurance benefits for retired employees. Substantially all of its employees may become eligible for those benefits if they reach normal retirement age and have attained the required length of service while working for Employers Mutual or its subsidiaries. The health care postretirement plan requires contributions from participants and contains certain cost sharing provisions such as coinsurance and deductibles. The life insurance plan is noncontributory. The benefits provided under both plans are subject to change.
The effect of the subsidy on the measurement of Employers Mutual's postretirement benefit plan resulted in a decrease in the accumulated projected benefit obligation of $9,899,120 and the net periodic postretirement benefit cost for 2004 was reduced by $1,536,635. The components of the reduction in the net periodic postretirement benefit cost for 2004 are as follows:
Adoption of FAS 106-2 resulted in a $344,235 reduction in the Company's share of the net periodic postretirement benefit cost for the year ended December 31, 2004.
The following table sets forth the funded status of the Employers Mutual pension plan and postretirement benefit plans as of December 31, 2004 and 2003, based upon a measurement date of November 1, 2004 and 2003, respectively:
Funded status ......... (14,211,577) (26,940,028) (49,491,325) (56,813,230) Unrecognized net actuarial loss ...... 22,513,895 21,576,909 5,056,132 15,587,383 Unrecognized prior service costs ....... 3,343,641 4,109,466 - - Employer contributions - - 610,000 500,000 ------------ ------------ ------------ ------------ Net amount recognized ......$ 11,645,959 $ (1,253,653) $(43,825,193) $(40,725,847) ============ ============ ============ ============ Amounts recognized in EMC Insurance Companies balance sheets consist of: Accrued benefit liability .......$ - $ (4,831,428) $(43,825,193) $(40,725,847) Prepaid pension asset ........... 11,645,959 - - - Intangible asset .. - 3,577,775 - - ------------ ------------ ------------ ------------ Net amount recognized ..$ 11,645,959 $ (1,253,653) $(43,825,193) $(40,725,847) ============ ============ ============ ============
During 2003, Employers Modern Life Company (EML), an affiliate of Employers Mutual, acquired National Travelers Life Company (NTL) and the company's name was changed to EMC National Life Company (EMCNL). EML participated in Employers Mutual's pension plan and postretirement benefit plans. As a result of the acquisition, EML pension plan participants were "spun-off" into a separate EMCNL pension plan. A payment of $2,567,367 was made from Employers Mutual's plan assets to the EMCNL pension plan, which is reflected as a benefit payment. The corresponding reduction in the benefit obligation is reflected as an actuarial gain of the plan. The employees and retirees of NTL were also granted benefits under the Employers Mutual postretirement benefit plans. As a result, an additional liability of $4,453,847 was recognized by the plans. EMCNL is responsible for the entire additional liability.
Year ended December 31, ------------------------------------- 2004 2003 2002 ----------- ----------- ----------- Pension plan: Service cost ....................... $ 6,818,518 $ 6,161,019 $ 5,299,831 Interest cost ...................... 7,020,887 6,992,656 6,576,584 Expected return on plan assets ..... (6,760,528) (6,516,913) (6,744,907) Recognized net actuarial loss ...... 855,686 967,226 - Amortization of prior service costs 765,825 789,648 784,219 ----------- ----------- ----------- Net periodic pension benefit cost ....................... $ 8,700,388 $ 8,393,636 $ 5,915,727 =========== =========== =========== Postretirement benefit plans: Service cost ....................... $ 3,995,555 $ 4,401,000 $ 2,964,000 Interest cost ...................... 3,819,081 4,263,000 3,223,000 Expected return on assets .......... (900,883) (737,000) (518,000) Amortization of net loss ........... 130,593 1,011,000 150,000 Amortization of prior service costs - - 535,000 ----------- ----------- ----------- Net periodic postretirement benefit cost ................. $ 7,044,346 $ 8,938,000 $ 6,354,000 =========== =========== ===========
The weighted average assumptions used to measure the net periodic benefit cost are as follows:
Year ended December 31, ---------------------------------- 2004 2003 2002 -------- -------- -------- Pension plan: Discount rate ...................... 6.00% 6.50% 7.00% Expected long-term rate of return on plan assets ........................ 7.50% 8.00% 8.50% Rate of compensation increase ..... 4.82% 5.93% 5.96%
The expected long-term rates of return on plan assets were developed considering actual historical results, current and expected market conditions, plan asset mix and management's investment strategy.
The assumed weighted average annual rate of increase in the per capita cost of covered health care benefits (i.e. the health care cost trend rate) for 2004 is 10 percent, and is assumed to decrease gradually to 5 percent in 2009 and remain at that level thereafter. The health care cost trend rates have a significant effect on the amounts reported for the health care plan. A one-percentage-point change in assumed health care cost trend rates would have the following effects:
One-Percentage-Point ----------------------------- Increase Decrease ----------- ------------- Effect on total of service and interest cost .. $ 1,628,900 ($ 1,265,062) Effect on postretirement benefit obligation ... $11,146,706 ($ 8,871,308)
The Company's financial statements reflect a pension asset of $2,684,463 in 2004 and a pension liability of $1,453,421 (including $1,016,492 of additional minimum liability) in 2003. The Company's financial statements also reflect an intangible asset associated with the pension plan of $0 in 2004 and $1,016,492 in 2003. Pension expense allocated to the Company amounted to $2,114,890, $2,023,292 and $1,406,306 in 2004, 2003 and 2002, respectively.
Plan Assets at November 1, --------------------------- Asset Category 2004 2003 - -------------- ------------ ------------ Equity securities ............................ 56.0% 51.0% Debt securities .............................. 32.0 41.0 Real estate .................................. 12.0 8.0 ----- ----- Total ...................................... 100.0% 100.0%
Plan Assets at November 1, --------------------------- Asset Category 2004 2003 - -------------- ------------ ------------ Life insurance policies ...................... 52.8% 64.3% Short-term investments ....................... 13.8 29.4 Real estate .................................. 1.0 - Equity securities ............................ 22.1 - Debt securities .............................. 10.3 6.3 ----- ----- Total ...................................... 100.0% 100.0%
Employers Mutual plans to contribute approximately $2,500,000 to the pension plan and $3,800,000 to the postretirement benefit plans in 2005.
Postretirement Benefits ------------------------------------------ Pension Benefits Gross Medicare Subsidy Net ---------------- ----------- ---------------- ----------- 2005 ......... $ 8,713,000 $ 2,056,651 $ - $ 2,056,651 2006 ......... 8,284,000 2,334,266 254,146 2,080,120 2007 ......... 8,976,000 2,605,362 292,745 2,312,617 2008 ......... 10,220,000 2,888,512 340,904 2,547,608 2009 ......... 12,718,000 3,303,794 385,068 2,918,726 2010 - 2014 .. 105,127,000 23,222,122 3,011,185 20,210,937
The Company has no stock based compensation plans of its own; however, Employers Mutual has several stock plans which utilize the common stock of the Company. Employers Mutual can provide the common stock required under its plans by: 1) using shares of common stock that it currently owns; 2) purchasing common stock on the open market; or 3) directly purchasing common stock from the Company at the current fair value. Employers Mutual has historically purchased common stock from the Company for use in its incentive stock option plans and its non-employee director stock purchase plan. Employers Mutual generally purchases common stock on the open market to fulfill its obligations under its employee stock purchase plan.
Employers Mutual maintains two separate stock option plans for the benefit of officers and key employees of Employers Mutual and its subsidiaries. A total of 500,000 shares have been reserved for the 2003 Employers Mutual Casualty Company Incentive Stock Option Plan (2003 Plan) and a total of 1,000,000 shares have been reserved for issuance under the 1993 Employers Mutual Casualty Company Incentive Stock Option Plan (1993 Plan).
There is a ten year time limit for granting options under the plans. Options can no longer be granted under the 1993 Plan. Options granted under the plans have a vesting period of two, three, four or five years with options becoming exercisable in equal annual cumulative increments. Option prices cannot be less than the fair value of the stock on the date of grant.
During 2004, 70,025 options were granted under the 2003 Plan to eligible participants at a price of $22.28 and 108,648 options were exercised under the plans at prices ranging from $19.71 to $24.95. A summary of the activity under Employers Mutual's incentive stock option plans for 2004, 2003 and 2002 is as follows:
2004 2003 2002 ------------------- ------------------ ----------------- Weighted- Weighted- Weighted- Average Average Average Exercise Exercise Exercise Shares Price Shares Price Shares Price ------ -------- ------ -------- ------ --------- Outstanding, beginning of year 630,615 $12.86 678,757 $11.65 723,378 $10.84 Granted ............. 70,025 22.28 113,225 16.88 65,900 18.30 Exercised ........... (108,648) 11.21 (157,392) 10.50 (98,864) 10.26 Expired ............. (8,454) 10.03 (3,975) 13.96 (11,657) 10.88 -------- -------- -------- Outstanding, end of year ....... 583,538 14.34 630,615 12.86 678,757 11.65 ======== ======== ======== Exercisable, end of year ....... 332,918 $12.33 349,960 $11.85 404,807 $11.35 ======== ======== ========
December 31, 2004 ---------------------------------------------------------- Options Outstanding Options Exercisable ----------------------------------- --------------------- Weighted- Weighted- average Weighted- average remaining average Range of option Number exercise contractual Number exercise exercise prices outstanding price life exercisable price - ------------------ ----------- --------- ----------- ----------- --------- $ 9.25 - $12.69 253,359 $10.35 4.46 200,124 $10.59 13.25 - 16.88 198,414 15.41 5.61 109,034 14.21 18.30 - 22.28 131,765 20.42 8.16 23,760 18.30 ------- ------- 583,538 14.34 5.68 332,918 12.33 ======= =======
During 2004, a total of 13,531 options were exercised at prices of $20.06 and $18.46. Activity under the plan was as follows:
Year ended December 31, ---------------------------- 2004 2003 2002 -------- -------- -------- Shares available for purchase, beginning of year ...................... 288,322 300,206 311,922 Shares purchased under plan .............. (13,531) (11,884) (11,716) -------- -------- -------- Shares available for purchase, end of year 274,791 288,322 300,206 ======== ======== ========
A total of 200,000 shares of the Company's common stock have been reserved for issuance under the 2003 Employers Mutual Casualty Company Non- Employee Director Stock Purchase Plan. All non-employee directors of Employers Mutual and its subsidiaries and affiliates who are not serving on the "Disinterested Director Committee" of the Board as of the beginning of the option period are eligible to participate in the plan. Each eligible director can purchase shares of common stock at 75 percent of the fair value of the stock in an amount equal to a minimum of 25 percent to a maximum of 100 percent of their annual cash retainer. The plan will continue through the option period for options granted at the 2012 annual meetings. The plan is administered by the Disinterested Director Committee of the Board. The Board may 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. The Employers Mutual Casualty Company Non-Employee Director Stock Purchase Plan previously in place expired on May 20, 2003 and the remaining 139,328 shares were deregistered. Expenses allocated to the Company in connection with these plans totaled $4,080, $1,878 and $0 in 2004, 2003 and 2002, respectively.
During 2004, a total of 1,359 options were exercised at prices ranging from $14.97 to $15.81. Activity under the plan was as follows:
Year ended December 31, ---------------------------- 2004 2003 2002 -------- -------- -------- Shares available for purchase, beginning of year ...................... 198,156 141,197 143,158 Shares purchased under expired plan ...... - (1,869) - Shares deregistered under expired plan ... - (139,328) - Shares registered for use in 2003 plan ... - 200,000 - Shares purchased under plans ............. (1,359) (1,844) (1,961) -------- -------- -------- Shares available for purchase, end of year 196,797 198,156 141,197 ======== ======== ========
The Company maintains a dividend reinvestment and common stock purchase plan which provides stockholders with the option of reinvesting cash dividends in additional shares of the Company's common stock. Participants may also purchase additional shares of common stock without incurring broker commissions by making optional cash contributions to the plan and may sell shares of common stock through the plan. Since the third quarter of 1998, all shares of common stock issued under the plan have been purchased in the open market through the Company's transfer agent. Employers Mutual participated in the Dividend Reinvestment Plan in 2002, 2003 and the first two quarters of 2004, reinvesting 50 percent of its dividends in additional shares of the Company's common stock in all but the second and third quarters of 2003, when it reinvested 75 percent and 25 percent, respectively, and in 2002, when it reinvested 25 percent. Due to its participation in the Company's recent stock offering, Employers Mutual discontinued its participation in the plan for the third and fourth quarters of 2004 and has indicated that it will likely not participate in the plan in 2005. Activity under the plan was as follows:
December 31, 2003 - ----------------- Assets: Fixed maturity securities: Held-to-maturity ............................ $ 49,845,348 $ 53,854,424 Available-for-sale .......................... 523,785,758 523,785,758 Equity securities available-for-sale .......... 49,008,498 49,008,498 Short-term investments ........................ 63,568,064 63,568,064 Other long-term investments ................... 4,758,019 4,758,019 Liabilities: Surplus notes ................................. 36,000,000 36,000,000
Payments due by period ------------------------------------------------------ Less More than 1-3 4-5 than Total 1 year years years 5 years ---------- ---------- ---------- ---------- ---------- Lease Commitments - ----------------- Real estate operating leases ............. $6,863,044 $1,086,053 $1,976,714 $1,559,701 $2,240,576 Software operating leases ............. 375,363 375,363 - - - ---------- ---------- ---------- ---------- ---------- Total ................ $7,238,407 $1,461,416 $1,976,714 $1,559,701 $2,240,576 ========== ========== ========== ========== ==========
The participants in the pooling agreement have purchased annuities from life insurance companies, under which the claimant is payee, to fund future payments that are fixed pursuant to specific claim settlement provisions. The Company's share of loss reserves eliminated by the purchase of these annuities was $699,913 at December 31, 2004. The Company has a contingent liability of $699,913 should the issuers of these annuities fail to perform under the terms of the annuities. The Company's share of the amount due from any one life insurance company does not equal or exceed one percent of its subsidiaries' policyholders' surplus.
- ---- Total revenues ........ $86,646,867 $90,215,736 $92,594,260 $92,900,176 =========== =========== =========== =========== Income before income tax expense (benefit) $ 9,543,476 $ 1,419,592 $ 8,922,814 $ 8,096,414 Income tax expense (benefit) ........... 3,097,798 (10,600) 2,540,710 2,005,265 ----------- ----------- ----------- ----------- Net income ....... $ 6,445,678 $ 1,430,192 $ 6,382,104 $ 6,091,149 =========== =========== =========== =========== Net income per share - basic and diluted* $ .57 $ .12 $ .56 $ .53 =========== =========== =========== ===========
- ---- Total revenues ........ $77,157,134 $78,582,787 $81,763,105 $90,024,758 =========== =========== =========== =========== Income before income tax expense ......... $ 5,470,323 $ 3,518,303 $ 5,971,780 $ 6,931,630 Income tax expense .... 1,780,446 573,617 1,670,595 1,765,640 ----------- ----------- ----------- ----------- Net income ....... $ 3,689,877 $ 2,944,686 $ 4,301,185 $ 5,165,990 =========== =========== =========== =========== Net income per share - basic and diluted* $ .33 $ .26 $ .38 $ .45 =========== =========== =========== ===========
* Since the weighted average shares for the quarters are calculated independent of the weighted average shares for the year, quarterly net income (loss) per share may not total to annual net income (loss) per share.
We have audited the consolidated financial statements of EMC Insurance Group Inc. and Subsidiaries as of December 31, 2004 and 2003, and for each of the three years in the period ended December 31, 2004, and have issued our report thereon dated March 11, 2005 (included elsewhere in this Annual Report on Form 10-K). Our audits also included 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.
Amount at which shown Fair in the Type of investment Cost value balance sheet ------------------ ------------ ------------ ------------- Securities held-to-maturity: Fixed maturities: United States Government and government agencies and authorities .............. $ 28,037,203 $ 29,316,549 $ 28,037,203 Mortgage-backed securities ..... 1,168,668 1,277,057 1,168,668 ------------ ------------ ------------ Total fixed maturity securities ............. 29,205,871 30,593,606 29,205,871 ------------ ------------ ------------
Short-term investments ............. 46,238,853 46,238,853 46,238,853 ------------ ------------ ------------ Total investments ...... $736,375,247 $780,729,848 $779,342,113 ============ ============ ============
Reclassification adjustment for (gains) losses included in net income (loss), net of income tax
Adjustment for minimum pension liability associated with Employers Mutual's pension plan, net of deferred income tax expense (benefit) .............. - 188,266 (188,266) ------------ ------------ ------------ Other comprehensive income ....... 5,642,795 8,067,338 6,710,658 ------------ ------------ ------------ Total comprehensive income ... $ 18,827,478 $ 28,416,461 $ 22,812,396