The selected financial data set forth in the following table for each of the five years in the period ended December 31, 2005 have been derived from the audited consolidated financial statements of the Company.
For a discussion of the relationship between the Company and Mutual, see “Relationship with Mutual,” below, and “Item 1. BUSINESS - Administration,” above.
Mutual’s monoline commercial umbrella program (the Umbrella Program) is marketed exclusively through one independent agent and approximately 95% of the premiums related to Umbrella Program policies are reinsured with an “A” rated national reinsurer through a quota share reinsurance treaty.
Total revenues for 2005 were $57,425,000, a decrease of $8,080,000 or 12%, from $65,505,000 in 2004.
The 6.9 percentage point decrease in the loss and ALAE ratio for the current accident year primarily resulted from:
The Company recorded decreases to its estimate of losses and LAE related to prior accident years of $3,303,000 and $843,000 in 2005 and 2004, respectively, a difference of $2,460,000. These decreases in losses and LAE relating to prior accident years reduced the loss and LAE ratio in 2005 and 2004 by 6.7 and 1.5 percentage points, respectively. The reserve development for each product and for each accident year during 2005 was within the range of reasonably likely reserves by product as of December 31, 2004. It is not appropriate to predict future increases or decreases in the estimate of losses and LAE for prior accident years from past experience. See “Critical Accounting Policies and Estimates” for a further discussion of the Company’s Reserves for Losses and LAE. The following table documents the changes in the estimate of losses and LAE related to prior accident years recorded in 2005 for the Company’s primary products.
The Company experienced favorable development during 2005 in its workers’ compensation product of $1,856,000 relating to accident years prior to 2002. The development for accident years prior to 2002 primarily resulted from lower than expected emergence of paid losses and incurred losses during 2005, and a resulting reduction in the expected loss per claim.
The Company made no significant changes to its procedures for processing or reserving for workers’ compensation claims during 2005. In addition to the comments above related to accident years prior to 2002, the favorable loss development on the workers’ compensation product stems from inherent uncertainty in estimating ultimate costs in circumstances that involve the complex and changing medical condition of claimants.
The Company made no changes to the key assumptions used in evaluating the adequacy of its reserves for losses and LAE during 2005. A reasonable possibility exists in any year that relatively minor fluctuations in the estimate of reserves for losses and LAE may have a significant impact on the Company’s net income. This is due primarily to the size of the Company’s reserves for losses and LAE ($115,191,000 at December 31, 2005) relative to its net income.
expenses in 2004 also included $266,000 related to the November 2004 resignation of the Company’s President and $486,000 of consulting and due diligence expenses pertaining to the investigation of business opportunities. Other underwriting expenses also included $329,000 and $462,000 in 2005 and 2004, respectively, related to the purchase of territorial credits against NYAIP assignments discussed earlier in this item. Commissions (other than retrospective commissions under the Reinsurance Pooling Agreement), premium taxes and other state assessments that vary directly with the Company’s premium volume represented 19.7% and 19.9% of net premiums earned in 2005 and in 2004, respectively.
Results of operations for 2004 and 2003 reflect the effects of the Services Agreement and the Reinsurance Pooling Agreement among the Company, its wholly-owned insurance subsidiary, MNH, and Mutual, effective January 1, 2003. MNH’s share of pooled premiums earned and losses and LAE for 2004 and 2003 in accordance with the Reinsurance Pooling Agreement was 35% and 40%, respectively. The Reinsurance Pooling Agreement pertains to premiums earned and incurred losses and LAE.
Total combined Mutual and MNH or “group-wide” DWP for the year ended December 31, 2004 were $191,138,000, an increase of $15,995,000 or 9%, from $175,143,000 in 2003. The Company’s pro-forma share of combined DWP in 2004, in accordance with the Reinsurance Pooling Agreement, was $66,900,000 compared to $70,057,000 in 2003. The table below shows a comparison of direct premiums written by major category in 2004 and 2003:
Mutual introduced a monoline commercial umbrella program in the fourth quarter of 2003 (the Umbrella Program). The Umbrella Program is marketed exclusively through one independent agent and
approximately 95% of the premiums related to Umbrella Program policies are reinsured with an “A” rated national reinsurer through a quota share reinsurance treaty.
Group-wide voluntary commercial DWP were $119,113,000, an increase of $15,851,000, or 15%, from $103,262,000 in 2003. This increase resulted from period to period increases in every significant group-wide commercial product. The average premium per group-wide, non-Umbrella Program commercial policy increased 7% from the year earlier period. Total non-Umbrella Program commercial policies in force at December 31, 2004 were 33,415, an increase of 6% from 31,485 at December 31, 2003.
Group-wide pooled net premiums written for 2004 were $163,546,000, an increase of $1,857,000, or 1%, from $161,689,000 for 2003. This increase resulted from the 9% increase in group-wide DWP, offset by an increase in 2004 as compared to 2003 of reinsurance premiums ceded to third parties, primarily for premiums written related to the Umbrella Program. The Company’s share of pooled net premiums written in 2004 in accordance with the Reinsurance Pooling Agreement was $53,102,000, a decrease of $11,077,000 or 17% from $64,179,000 in 2003. This decrease resulted primarily from the 5 percentage point decrease in the Company’s participation in the Reinsurance Pooling Agreement.
Net investment income was $7,881,000, a decrease of $934,000 or 11% from $8,815,000 in 2003. The average pre-tax yield on the investment portfolio decreased 40 basis points to 4.0% in 2004 compared to 2003. Average invested assets for 2004 decreased 2% from the year earlier period.
Other revenues were $722,000 in 2004, an increase of $162,000 or 29% from $560,000 in 2003, primarily due to a $180,000 decrease in premium receivable charge-offs.
The 9.0 percentage point decrease in the loss and LAE ratio for the current accident year primarily resulted from:
A reduction in PPA liability net earned premium as a percentage of total Company net earned premium to 16.7% in 2004 from 20.2% in 2003. PPA liability was the Company’s highest loss and LAE ratio product and accounted for 1.5 percentage points of the decrease.
The Company recorded decreases to its estimate of losses and LAE related to prior accident years of $843,000 and $90,000 in 2004 and 2003, respectively, a change of $753,000. These decreases in losses and LAE relating to prior accident years reduced the loss and LAE ratio in 2004 and 2003 by 1.5 and .1 percentage points, respectively. The reserve development for each product and for each accident year during 2004 was within the range of reasonably likely reserves by product as of December 31, 2003. It is not appropriate to predict future increases or decreases in the estimate of losses and LAE for prior accident years from past experience. See “Critical Accounting Policies and Estimates” for a further discussion of the Company’s Reserves for Losses and LAE. The following table documents the changes in the estimate of losses and LAE related to prior accident years recorded in 2004 for the Company’s primary products.
The Company experienced favorable development during 2004 in its PPA liability product of $1,529,000 relating to accident year 2003, primarily due to lower claims frequency and lower estimated severity on involuntary business assigned from the NYAIP. These changes are consistent with increased fraud prevention, detection and prosecution efforts stemming from certain legislative changes in New York State. Furthermore, the Company believes that due to increased market availability in the “voluntary” market, many of the worst drivers previously insured in the NYAIP no longer obtain insurance from the NYAIP. The impact of the legislative activity and the shift in the market was not evident until 2004 and as such are reflected in current reserve estimates.
The Company experienced favorable development during 2004 in its workers’ compensation product of $1,221,000 relating to accident year 2001 and $921,000 relating to accident year 2002. The accident year 2001 development resulted from lower than expected emergence of paid losses and incurred losses in 2004, and a reduction in the expected loss per claim to $11,500 as of 2004 from $12,200 as of 2003.
During 2004, the Company experienced unfavorable development in its commercial package and general liability products amounting to $3,302,000 related to accident years prior to 2001, due to greater than anticipated incurred loss development. For instance, the Company experienced adverse jury verdicts in 2004 that it believed had no merit and were therefore not reflected in case reserves. These claims, when considered in the loss development factors used during 2004, impacted severity for several accident years.
The Company has made no changes to its procedures for processing or reserving for commercial package and general liability claims and is not aware of any changes to its business that might have caused a change in loss development patterns, except for the two large claims noted above.
The Company’s reduction in its estimate of losses and LAE related to prior accident years represented less than 1% of the recorded reserve for losses and LAE at December 31, 2003 and is within a reasonable range of loss reserve volatility for the products being underwritten.
The Company made no changes to the key assumptions used in evaluating the adequacy of its reserves for losses and LAE during 2004. A reasonable possibility exists in any year that relatively minor fluctuations in the estimate of reserves for losses and LAE may have a significant impact on the Company’s net income. This is due primarily to the size of the Company’s reserves for losses and LAE ($128,415,000 at December 31, 2004) relative to its net income.
Involuntary automobile insurance business increased the Company’s calendar year loss and LAE ratio by approximately .2 and 1.8 percentage points for the years ended December 31, 2004 and 2003, respectively.
Other underwriting expenses also included $266,000 related to the November 2004 resignation of the Company’s President and $486,000 of consulting and due diligence expenses pertaining to the investigation of business opportunities. Other underwriting expenses also included $462,000 and $228,000 in 2004 and 2003, respectively, related to the purchase of territorial credits against NYAIP assignments discussed earlier in this item. Commissions (other than retrospective commissions under the Reinsurance Pooling Agreement), premium taxes and other state assessments that vary directly with the Company’s premium volume represented 19.9% and 19.7% of net premiums earned in 2004 and 2003, respectively.
Tax exempt income reduced the Company’s effective income tax rate by 8 and 4 percentage points, respectively, for the years ended December 31, 2004 and 2003. In addition, the Company recorded adjustments to prior years’ taxes and reversed excess tax reserves related to uncertain tax positions which reduced the Company’s effective income tax rate by 4 and 3 percentage points, respectively, for the years ended December 31, 2004 and 2003. The provision for income taxes for 2003 also included the effect of a May 2003 change in New York State law with respect to the taxation of non-life insurance companies. This change eliminated state income taxes for all non-life insurance companies and increased the premium tax rate from 1.3% to 2.0%. This change in New York State law lowered the Company’s effective income tax rate by approximately 4 percentage points in 2003. Further, as a result of this change, the Company reduced its deferred tax liability with respect to New York State income taxes to $0 during 2003. This one time benefit reduced the Company’s effective income tax rate for 2003 by 9 percentage points.
This method multiplies the estimated number of ultimate claims by a selected ultimate average loss for each accident year to produce ultimate loss estimates. If loss development methods produce erratic or unreliable estimates, this method can provide more stable estimates, consistent with recent loss history. This method may produce erratic results if there has been a change in the way claims
are counted or in the mix of types of loss. The occurrence or absence of large losses can also distort the average loss estimate.
The Bornhuetter-Ferguson (BF) with ultimate loss and paid ALAE method is a combination of the paid ALAE development method and an expected ratio of ultimate ALAE to ultimate loss. The expected ALAE to loss ratios are modified to the extent paid ALAE differ from expected based on the selected paid ALAE development pattern. This method avoids possible distortions resulting from a large development factor being applied to a small base of paid ALAE in order to estimate ultimate ALAE. This is a useful method for estimating ultimate ALAE for less mature accident years.
management’s consideration of other factors such as premium and loss trends, large loss experience, legislative and judicial changes and changes in underwriting guidelines and practices.
The products shown in this table are those used by the Company in its loss reserving process. The Company’s reserve for unpaid losses and LAE as appears in the table that follows, are segregated by product type as defined in the Company’s Annual Statement filed with insurance department regulators.
Because the reserve estimates by product are independent of each other it is highly unlikely that the actual results for each of the products will be consistent with all of the high estimates, or with all of the low estimates, at the same time. Accordingly, the low and the high estimates for “All Products” shown above are greater than the sum of the low estimates and less than the sum of the high estimates resulting in a narrower range.
Despite the many factors considered in the reserving process, it is reasonably probable that actual payments for losses and LAE will differ from those contemplated in the Company’s reserves. Such fluctuations could have a significant impact on the Company’s net income. This is primarily due to the size of the Company’s reserves for losses and LAE ($115,191,000 at December 31, 2005) relative to its net income.
Policy acquisition costs, such as commissions (net of reinsurance commissions), premiums taxes and certain other underwriting expenses which vary directly with premium volume, are deferred and amortized over the terms of the related insurance policies. Deferred policy acquisition costs are evaluated on an aggregate basis at least quarterly to determine if recorded amounts exceed estimated recoverable amounts after allowing for anticipated investment income. Premium deficiencies, if any, are recorded as amortization of deferred policy acquisition costs. Actual amounts may vary from the Company’s estimates.
The Company’s investment committee, comprised of the Chief Operating Officer, the Chief Investment Officer and the Chief Financial Officer, meets monthly and monitors the Company’s investment
In developing its investment strategy the Company determines a level of cash and short-term investments which, when combined with expected cash flow, is estimated to be adequate to meet expected cash obligations. Due to declining written premiums however, the Company’s operating activities have resulted in a use of cash each year since 2001. The Company’s decreasing participation percentage in the pooled business over the remaining years of the Reinsurance Pooling Agreement will likely result in continued negative cash flows from operations. Net cash used in operations was $1,653,000 in 2005. The Company believes that careful management of the relationship between assets and liabilities will minimize the likelihood that investment portfolio sales will be necessary to fund insurance operations, and that the effect of such sales, if any, on the Company’s stockholders’ equity will not be material.
Included in net investment losses for the year ended December 31, 2004 are write-downs on two investment securities held in the Company’s investment portfolio at December 31, 2004 determined to have had an other-than-temporary impairment in market value. The total amount of other-than-temporary impairments recorded as losses amounted to $700,000 in 2004. No other-than-temporary impairments were recorded in 2005 or 2003.
The Company designates newly acquired fixed maturity investments as available for sale and carries these investments at fair value. Unrealized gains and losses related to these investments are recorded as accumulated other comprehensive income within stockholders’ equity. At December 31, 2005, the Company recorded as accumulated other comprehensive loss in its Consolidated Balance Sheet $2,540,000 of net unrealized losses, net of taxes, associated with investments classified as available for sale.
At December 31, 2005, $97,044,000, or 58.3%, of the Company’s fixed maturity portfolio was invested in mortgage-backed and other asset-backed securities. The Company invests in a variety of collateralized mortgage obligation (“CMO”) products but has not invested in the derivative type of CMO products such as interest only, principal only or inverse floating rate securities. All of the Company’s CMO investments have a secondary market and their effect on the Company’s liquidity does not differ significantly from that of other fixed maturity investments.
At December 31, 2005, the Company owed $2,590,000 of retrospective commissions to Mutual in accordance with the Reinsurance Pooling Agreement (see the “2005 compared to 2004” section of this Item for a discussion of retrospective commissions). The Reinsurance Pooling Agreement requires the amount of retrospective commissions to be calculated and paid annually, six months after the end of each calendar year.
During 2005 stock options for 18,500 shares of the Company’s stock were exercised. Proceeds to the Company from the exercise of these options amounted to $389,000.
As a holding company, the Company is dependent upon cash dividends from MNH to meet its obligations and to pay any cash dividends. MNH is subject to New Hampshire insurance laws which place certain restrictions on its ability to pay dividends without the prior approval of state regulatory authorities. These restrictions limit dividends to those that, when added to all other dividends paid within the preceding twelve months, would not exceed 10% of the insurer’s policyholders’ surplus as of the preceding December 31st. The maximum amount of dividends that MNH could pay during any twelve month period ending in 2006 without the prior approval of the New Hampshire Insurance Commissioner is $6,639,000. MNH paid $800,000, $1,200,000, $800,000 and $600,000 of dividends to the Company in February 2005, October 2005, November 2005 and December 2005, respectively. The Company paid aggregate quarterly cash dividends to its common stockholders of $.55 per share in 2005, which amounted to $1,164,000.
Statement of Financial Accounting Standards (SFAS) No. 154 “Accounting Changes and Error Corrections - a replacement of APB Opinion No. 20 and FASB Statement No. 3”.
In September 2005, the Accounting Standards Executive Committee (AcSEC) issued Statement of Position 05-1, “Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection with Modifications of Exchanges of Insurance Contracts” (SOP 05-1). SOP 05-1 provides guidance on accounting by insurance enterprises for deferred acquisition costs on internal replacements of insurance and investment contracts other than those specifically described in SFAS No. 97, “Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments.” SOP 05-1 defines an internal replacement as a modification in product benefits, features, rights, or coverages that occurs by the exchange of a contract for a new contract, or by amendment, endorsement, or rider to a contract, or by the election of a feature or coverage within a contract. SOP 05-1 is effective for internal replacements occurring in fiscal years beginning after December 15, 2006, with earlier adoption encouraged. The Company has not yet determined the impact of adopting SOP 05-1 on its consolidated financial statements, if any.
MNH, like many other property and casualty insurance companies, is subject to environmental damage claims asserted by or against its insureds. Management of the Company is of the opinion that based on various court decisions throughout the country, certain of these claims should not be recoverable under
Inflation affects the Company, like other companies in the property and casualty insurance industry, by contributing to higher losses, LAE and operating costs, as well as greater investment income resulting from the higher interest rates which can prevail in an inflationary period. Premium rates, however, may not keep pace with inflation since competitive forces may limit the Company’s ability to increase premium rates. The Company considers inflationary trends in estimating its reserves for reported and IBNR claims.
The Company’s and MNH’s business and day-to-day operations are closely aligned with those of Mutual. This is the result of a combination of factors. Mutual has had a historical ownership interest in the Company and MNH. Prior to November 1986 MNH was a wholly-owned subsidiary of Mutual. Following the Company’s initial public offering in November 1986 and until a secondary stock offering in July 1993 the Company was a majority-owned subsidiary of Mutual. At December 31, 2005 Mutual owned 12.0% of the Company’s common stock. Under the Services Agreement, Mutual provides the Company and MNH with all facilities and personnel to operate their business. The officers of the Company or MNH are employees of Mutual whose services are provided to, and paid for by, the Company and MNH through the Services Agreement. Also, the operation of MNH’s insurance business, which offers substantially the same products as Mutual through the same independent insurance agents, creates a very close relationship among the companies.
With the exception of historical information, the matters and statements discussed, made or incorporated by reference in this Annual Report on Form 10-K constitute forward-looking statements and are discussed, made or incorporated by reference, as the case may be, pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements include, without limitation, statements relating to the Company’s plans, strategies, objectives, expectations and intentions. Words such as “believes,” “forecasts,” “intends,” “possible,” “expects,” “anticipates,” “estimates,” or “plans,” and similar expressions are intended to identify forward-looking statements. Such forward-looking statements involve certain assumptions, risks and uncertainties that include, but are not limited to, those associated with factors affecting the property-casualty insurance industry generally, including price competition, the Company’s dependence on state insurance departments for approval of rate increases, size and frequency of claims, escalating damage awards, natural disasters, fluctuations in interest rates and general business conditions; the Company’s dependence on investment income; the geographic concentration of the Company’s business in the northeastern United States and in particular in New York, New Hampshire, New Jersey, Rhode Island, Pennsylvania and Massachusetts; the adequacy of the Company’s loss reserves; the Company’s dependence on the general reinsurance market; government regulation of the insurance industry; exposure to environmental claims; dependence of the Company on its relationship with Merchants Mutual Insurance Company; and the other risks and uncertainties discussed or indicated in all documents
filed by the Company with the Securities and Exchange Commission. Forward-looking statements are not guarantees of future performance and involve known and unknown risks, uncertainties and other factors that may cause the Company’s actual results, performance, achievements or financial condition to be materially different from any future results, performance, achievements, or financial condition expressed or implied by the forward-looking statements. The Company expressly disclaims any obligation to update any forward-looking statements as a result of developments occurring after the filing of this report.
Quarterly data for the two most recent fiscal years is set forth below: