Our discontinued operations lease approximately 22,500 square feet in Philadelphia, Pennsylvania. We also lease approximately 63,000 square feet of office space in Yardley, Pennsylvania, which previously housed our excess and surplus lines business and now is subleased to an unaffiliated third party.
Operating income (loss), which we define as GAAP net income (loss) excluding net realized investment gains (losses) and results from discontinued operations, is the financial performance measure used by our management and Board of Directors to evaluate and assess the results of our businesses. Net realized investment activity is excluded because (i) net realized investment gains and losses are unpredictable and not necessarily indicative of current operating fundamentals or future performance of the business segments and (ii) in many instances, decisions to buy and sell securities are made at the holding company level, and such decisions result in net realized gains and losses that do not relate to the operations of the individual segments. Accordingly, we report operating income (loss) by segment in Note 17 of our Consolidated Financial Statements. Operating income (loss) does not replace net income (loss) as the GAAP measure of our consolidated results of operations.
We are a holding company whose operating subsidiaries provide insurance and fee-based services. The PMA Insurance Group earns revenue and generates cash primarily by writing insurance policies and collecting insurance premiums. Direct premiums written at The PMA Insurance Group were $517.9 million in 2008, compared to $510.3 million in 2007 and $431.6 million in 2006. Because time normally elapses between the receipt of premiums and the payment of claims and certain related expenses, we are able to invest the available premiums and earn investment income. The types of payments that we make at The PMA Insurance Group are:
In 2007, we began reporting the results of our Run-off Operations as discontinued operations. The sale of our Run-off Operations is currently pending regulatory approval from the Pennsylvania Insurance Department. In accordance with Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-lived Assets” (“SFAS 144”), the balance sheets have been presented with the gross assets and liabilities of discontinued operations in separate lines and the statements of operations have been presented with the net results from discontinued operations, shown after the results from continuing operations. For comparative purposes, we have reclassified our prior period
Consolidated revenues were $494.2 million in 2008, compared to $455.8 million in 2007 and $432.6 million in 2006. The increase in consolidated revenues in 2008, compared to 2007, primarily reflected an increase in fee-based revenues of $32.7 million and growth in net premiums earned of $12.0 million. Included in the fee-based revenue increase were increases in claims service revenues of $23.3 million and commission income of $9.4 million. The increases in claims service revenues and commission income were primarily due to revenues resulting from our acquisition of Midlands, while the growth in net premiums earned mainly reflected an increase in direct premium production, which was due to increases in renewal premiums and larger account business. The increase in consolidated revenues in 2007, compared to 2006, primarily reflected growth in net premiums earned of $10.8 million and an increase in fee-based revenues of $9.2 million. The growth in net premiums earned in 2007 was mainly due to an increase in our renewal retention rate, while the increase in fee-based revenues was primarily due to revenues resulting from our acquisition of Midlands in the fourth quarter of 2007.
The following is a reconciliation of our segment operating results to GAAP net income (loss). See Note 17 of our Consolidated Financial Statements for additional information.
We provide combined ratios and operating ratios for The PMA Insurance Group below. The “combined ratio” is a measure of property and casualty underwriting performance. The combined ratio computed on a GAAP basis is equal to losses and loss adjustment expenses, plus acquisition and operating expenses and policyholders’ dividends, all divided by net premiums earned. A combined ratio of less than 100% reflects an underwriting profit. Because time normally elapses between the receipt of premiums and the payment of claims and certain related expenses, we invest the available premiums. Underwriting results do not include investment income from these funds. Given the long-tail nature of our liabilities, we believe that the operating ratios are also important in evaluating our business. The operating ratio is equal to the combined ratio less the net investment income ratio, which is computed by dividing net investment income by net premiums earned.
Direct workers’ compensation premiums written were $455.1 million in 2008, compared to $457.4 million in 2007 and $382.9 million in 2006. The decline in direct workers’ compensation premiums written for 2008, compared to 2007, was due to a reduction in fronting premiums and higher return premium adjustments, which were largely offset by an increase in direct premium production. The premium adjustments, which increased by $13.7 million for workers’ compensation business in 2008, primarily reflect favorable loss experience on loss-sensitive products where the insured shares in the underwriting result of the policy. We write these retrospective products because we believe they provide us with greater certainty in achieving our targeted underwriting results as the customer shares in the underwriting result of the policy with us. The increase in direct workers’ compensation premiums written for 2007, compared to 2006, was primarily due to an increase in fronting premiums and, to a lesser extent, an increase in direct premium production. Our renewal retention rate on existing workers’ compensation accounts was 87% for both 2008 and 2007, compared to 85% for 2006. Excluding fronting business, we wrote $116.1 million of new workers’ compensation business in 2008, compared to $101.1 million in 2007 and $83.5 million in 2006.
We entered into two fronting arrangements in the third quarter of 2008. The workers’ compensation business produced under these arrangements is primarily located in the southeastern part of the United States and California. We retain approximately 10% of the underwriting results on one of the arrangements and approximately 20% of the underwriting results on the other. We also earn an administrative fee based upon the direct premiums earned under each agreement as well as fees for providing claims services on the business placed under one of the arrangements. All of the participating reinsurers have current A.M. Best financial strength ratings of “A-” (Excellent) or higher. Total direct premiums written under these two arrangements were $22.5 million in 2008. We expect that direct premiums written under these arrangements will be between $70 million and $100 million on an annualized basis, and we expect that the fees from these arrangements will fully replace the fees from our expired agreement with Midwest.
Our pricing on rate-sensitive workers’ compensation business written in 2008 decreased 22% in New York and 18% in Florida. The pricing reductions in both New York and Florida were mainly driven by manual loss cost changes filed by each respective state’s rating bureau. These two states collectively represent about 16% of our overall rate-sensitive workers’ compensation business written during 2008. Exclusive of business written in New York and Florida, our pricing on rate-sensitive workers’ compensation business decreased 3% in 2008.
Pricing on our rate-sensitive workers’ compensation business in Pennsylvania declined 5% in 2008. In Pennsylvania, we were affected by a 10.2% reduction in loss costs, which was approved by the Pennsylvania Insurance Department and became effective on April 1, 2008. While this resulted in lower filed loss costs in Pennsylvania, we have continued our practice of underwriting our business with a goal of achieving a reasonable level of profitability on each account. We continue to determine our business pricing through schedule charges and credits that we file and use to limit the effect of filed loss cost changes and have not experienced a decrease in premiums equal to the reduction in filed rates. We also believe the nature of our loss-sensitive and alternative market books of business, which represent approximately 41% of our Pennsylvania workers’ compensation business, mitigates the impact of reductions in filed loss costs.
Direct premiums written for commercial lines of business other than workers’ compensation, such as commercial auto, general liability, umbrella, multi-peril and commercial property lines (collectively, “Commercial Lines”), increased by $9.8 million in 2008, compared to 2007. Our renewal retention rate on existing Commercial Lines accounts in 2008 was 89%, and new business was $19.4 million. Direct premiums written for Commercial Lines increased by $4.3 million in 2007, compared to 2006. Our renewal retention rate on existing Commercial Lines accounts in 2007 was 89% and new business was $13.4 million, compared to 84% and $6.9 million, respectively, in 2006. Overall pricing on Commercial Lines decreased 6% in 2008 and 2% in 2007, and increased modestly in 2006, compared to the immediately preceding year.
Total premiums assumed decreased by $3.0 million in 2008 and $10.3 million in 2007, compared to the immediately preceding year. The declines for both periods were primarily due to reductions in the involuntary residual market business assigned to us. Although our total direct premiums written in both 2008 and 2007 increased, we believe the declines in assumed premiums assigned to us were a result of more business written in the traditional market and less business assigned to the total involuntary market pool. Companies that write premiums in certain states generally must share in the risk of insuring entities that cannot obtain insurance in the voluntary market. Typically, an insurer’s share of this residual market business is assigned on a lag based on its market share in terms of direct premiums in the voluntary market. These assignments are accomplished either by direct assignment or by assumption from pools of residual market business.
Net premiums earned increased 3% in both 2008 and 2007, compared to the immediately preceding year. Generally, trends in net premiums earned follow patterns similar to net premiums written, adjusted for the customary lag related to the timing of premium writings within the year. In periods of increasing premium writings, the dollar increase in premiums written will typically be greater than the increase in premiums earned, as was the case in both 2008 and 2007. Direct premiums are earned principally on a pro rata basis over the terms of the policies. However, with respect to policies that provide for premium adjustments, such as experience or exposure-based adjustments, such premium adjustment may be made subsequent to the end of the policy’s coverage period and will be recorded as earned premium in the period in which the adjustment is made.
The acquisition expense ratio improved 2.3 points in 2008, compared to 2007. The acquisition expense ratio in 2008 benefited by 2.0 points from reductions in premium-based state assessments. Commissions earned under our fronting arrangements reduced the acquisition expense ratio by 0.7 points in 2008, as the ceding commissions earned on this business reduce our commission expense. Although our agreement with Midwest terminated in March 2008, we continue to earn commissions on the business until the underlying policies expire. In 2007, the acquisition expense ratio improved 0.6 points, compared to 2006. The decrease in 2007 primarily reflected commissions earned under our fronting agreement with Midwest, which reduced the acquisition expense ratio by 0.7 points.
The lower operating expense ratio in 2007, compared to both 2008 and 2006, reflected recoveries on reinsurance receivable balances that had previously been written-off.
Pre-tax operating income for the Fee-based Business was $7.2 million in 2008, compared to $3.7 million in 2007 and $2.8 million in 2006. The increase in pre-tax operating income in 2008, compared to 2007, primarily related to the inclusion of Midlands’ results for full year 2008. The increase in pre-tax operating income in 2007, compared to 2006, primarily related to the inclusion of Midlands’ results for the quarter ended December 31, 2007.
Fee-based revenues were $71.6 million in 2008, compared to $38.1 million in 2007. The increase was primarily due to the inclusion of Midlands’ revenues, which contributed $28.0 million in 2008, compared to $6.5 million in 2007. The increase also reflected additional claims services provided to self-insured clients of $5.9 million and an increase in managed care services of $4.7 million. Managed care services include medical bill review services and access to our preferred provider network partnerships. Commission income is primarily derived from producing excess workers’ compensation business and providing program administrator services to self-insured clients. We have experienced an increase in the competitiveness in the excess workers’ compensation business during 2008.
Fee-based revenues increased by $9.6 million in 2007, compared to 2006. The increase was primarily due to the inclusion of Midlands’ revenues in 2007, and also reflected an increase in managed care services of $1.4 million.
Operating expenses were $8.7 million higher in 2007 than in 2006. The increase in operating expenses primarily reflected the inclusion of Midlands’ operating expenses in 2007, which included $1.1 million in commission expense and $167,000 related to the amortization of intangible assets. The increase also reflected higher direct costs of $2.2 million associated with additional claims and managed care services provided to self-insured clients.
For segment reporting purposes, we allocate interest income for the portion of our debt held at The PMA Insurance Group back to this segment and reduce investment income in the Corporate and Other segment. Although the Corporate and Other segment did not benefit from the reduced level of consolidated interest expense on the $9.1 million principal amount of our 6.50% Senior Secured Convertible Debt due 2022 (“6.50% Convertible Debt”) held at The PMA Insurance Group at December 31, 2008, 2007 and 2006, it did benefit from the reduced level of 6.50% Convertible Debt due to the $35.0 million mandatory redemption which occurred in June 2006, as well as the $18.1 million and $25.4 million of open market purchases made by PMA Capital Corporation in 2007 and 2006, respectively.
Discontinued operations, formerly reported as our Run-off Operations, include the results of our reinsurance and excess and surplus lines businesses, from which we withdrew in November 2003 and May 2002, respectively. In 2007, we determined that these operations should be reflected as discontinued operations. On March 28, 2008, we entered into a Stock Purchase Agreement to sell our Run-off Operations to Armour Reinsurance Group Limited, a Bermuda-based corporation. We continue to work with the buyer to ensure that the Pennsylvania Insurance Department has the information it needs to approve the transaction.
In 2007, we increased the net loss reserves at our discontinued operations for prior accident years by $21.6 million, which included a $22.0 million charge taken in the third quarter. During the third quarter, our actuaries conducted their periodic comprehensive reserve review. Based on the actuarial work performed, our actuaries observed increased loss development from a limited number of ceding companies on our claims-made general liability business, primarily related to professional liability claims. This increase in 2007 loss trends caused management to determine that reserve levels, primarily for accident years 2001 to 2003, needed to be increased by $22.0 million.
The losses and LAE incurred benefit reported in 2006 was mainly attributable to favorable loss development and the amortization of the deferred gain on retroactive reinsurance. During 2006, we recorded $1.3 million in favorable development, net of discount accretion, largely due to commutations of reinsurance treaties with some of our ceding companies. Amortization of the deferred gain on retroactive reinsurance reduced losses and LAE incurred by $1.8 million in 2007 and $1.7 million in 2006.
In accordance with our exit plan, 111 employees have been terminated and 18 positions, primarily claims and financial personnel, remain at December 31, 2008. We have established an employee retention arrangement for the remaining employees. Under this arrangement, we have recorded operating expenses of $787,000, $838,000 and $1.0 million, which included retention bonuses and severance, in 2008, 2007 and 2006, respectively.
Estimated sales proceeds were based on a non-binding letter of intent received from Armour Re in February 2008. This estimate reflected amounts anticipated at closing, subject to adjustments following Armour Re’s review of the final purchase price calculation, but excluded future contingent payments that may be received from Armour Re.
As a result of adverse loss development recorded in 2008, we have estimated that the cash to be received, or the estimated sales proceeds, and the value of the promissory note at closing will each be reduced by $7.5 million. As only the expected cash amount is reflected in our financial statements, the $7.5 million related to the reduction in the value of the promissory note was reflected as a valuation adjustment. The valuation adjustment reflects operating activity at the discontinued operations which is not expected to affect the sale proceeds at closing.
Net investment income was $560,000, $2.8 million and $7.7 million in 2008, 2007 and 2006, respectively. The decrease in net investment income for 2008, compared to 2007, was primarily the result of higher net interest credited on funds held arrangements of $2.9 million and, to a lesser extent, lower yields on investments. In a funds held arrangement, the ceding company normally retains premiums in an experience account. Losses are offset against these amounts and interest is normally credited to the experience account based upon the account balance and a predetermined credited interest rate. These declines in 2008 were partially offset by an increase in the average invested asset base, which resulted from cash received at the end of 2007 that related to the commutation of a reinsurance agreement covering potential adverse loss development.
Our unpaid losses and LAE, net of reinsurance, at December 31, 2008 and 2007 were $432.8 million and $444.8 million, respectively, net of discount of $27.5 million and $21.5 million, respectively. Included in unpaid losses and LAE were amounts related to our workers’ compensation claims of $382.1 million and $379.5 million, net of discount of $27.4 million and $21.4 million at December 31, 2008 and 2007, respectively. The discount rate used was approximately 5% at December 31, 2008 and 2007.
At December 31, 2008, 2007 and 2006, our gross reserves for asbestos-related losses were $29.5 million, $25.7 million and $17.3 million, respectively ($11.4 million, $10.8 million and $9.8 million, net of reinsurance, respectively). At December 31, 2008, 2007 and 2006, our gross reserves for environmental-related losses were $10.1 million, $10.3 million and $11.9 million, respectively ($463,000, $0 and $3.0 million, net of reinsurance, respectively).
Estimating reserves for asbestos and environmental exposures continues to be difficult because of several factors, including: (i) evolving methodologies for the estimation of the liabilities; (ii) lack of reliable historical claim data; (iii) uncertainties with respect to insurance and reinsurance coverage related to these obligations; (iv) changing judicial interpretations; and (v) changing government standards. We believe that our reserves for asbestos and environmental claims have been appropriately established based upon known facts, existing case law and generally accepted actuarial methodologies. However, the potential exists for changes in federal and state standards for clean-up and liability and changing interpretations by courts resulting from the resolution of coverage issues. Coverage issues in cases in which we are a party include disputes concerning proof of insurance coverage, questions of allocation of liability and damages among the insured and participating insurers, assertions that asbestos claims are not products or completed operations claims subject to an aggregate limit and contentions that more than a single occurrence exists for purposes of determining the available coverage. Therefore, our ultimate exposure for these claims may vary significantly from the amounts currently recorded, resulting in potential future adjustments that could be material to our financial condition, results of operations and liquidity.
Under our reinsurance and retrocessional coverages in place for our continuing operations during 2008, 2007 and 2006, we ceded earned premiums totaling $117.5 million, $117.6 million and $58.8 million, and we ceded losses and LAE of $93.5 million, $102.8 million and $36.0 million to reinsurers and retrocessionaires.
(2) Includes QBE Reinsurance Corporation ($43.9 million) and Unigard Insurance Company ($295,000).
We perform credit reviews of our reinsurers focusing on, among other things, financial capacity, stability, trends and commitment to the reinsurance business. Reinsurers failing to meet our standards are excluded from our reinsurance programs. In addition, we require collateral, typically assets in trust, letters of credit or funds withheld, to support balances due from certain reinsurers, generally those not authorized to transact business in the applicable jurisdictions. At December 31, 2008 and 2007, our reinsurance receivables were supported by $367.4 million and $351.4 million of collateral, respectively. Of the uncollateralized reinsurance receivables at December 31, 2008, approximately 88% was due from reinsurers rated “A-” or better by A.M. Best and is broken down as follows: “A++” - 2%; “A+” - 36%; “A” - 39% and “A-” - 11%. We believe that our reinsurance receivables, net of the valuation allowance, are fully collectible. The timing of payments and the collectibility of reinsurance receivables have not had a material adverse effect on our liquidity.
In February 2006, A.M. Best downgraded the rating of PXRE Reinsurance Company (“PXRE”) to “B+” from “A-,” and in April 2006, PXRE’s rating was further downgraded to “B” and subsequently withdrawn shortly thereafter. In 2007, PXRE was acquired by the Argonaut Insurance Group, which is rated “A” by A.M. Best, and PXRE now has an A.M. Best rating of “B+.” Our collateral from PXRE is in the form of an investment portfolio that is held in trust for our benefit, and we believe that the investment securities, together with the interest earned thereon, will be sufficient to pay all billings that we submit.
Our maximum limit for any one claimant is $5.8 million. Effective January 1, 2009, our maximum limit increased to $7.5 million in layers excess of $10.0 million.
The PMA Insurance Group retains 25% of the first $3.0 million in property losses (including auto physical damage) on a quota share basis. Excess of loss reinsurance extends our per risk limits as shown above.
For one of the fronting arrangements we entered into during 2008, workers’ compensation policies are underwritten in California, which is exposed to earthquake peril. Upon inception, we retained a 20% quota share of the first $1.0 million of loss per occurrence on this business and ceded the other 80% to non-affiliated reinsurers. Included, as part of our reinsurance program for this business, is dedicated workers’ compensation catastrophe protection up to a limit of $80.0 million, plus an additional $55.0 million of coverage in excess of the $80.0 million under the reinsurance protection included in the table above.
Certain portions of The PMA Insurance Group’s workers’ compensation reinsurance include coverage for terrorist acts. Effective January 1, 2009, our reinsurance of $129.0 million excess of $1.0 million includes coverage for certified and non-certified terrorist acts, except for nuclear, biological, chemical and radiological events. In all cases, at least two full limits of coverage are available in the aggregate. For nuclear, biological, chemical and radiological events, our coverage includes domestic and non-certified events for $5.0 million excess of $1.0 million.
(1) Includes $17.4 million of discount on excess of loss reinsurance reserves.
Unpaid losses and LAE of our discontinued operations are presented with the gross liabilities of discontinued operations in a separate line on the balance sheet. The unpaid losses and LAE for these operations, net of reinsurance, at December 31, 2008 and 2007 were $164.3 million and $195.8 million, respectively, net of discount of $17.4 million and $22.1 million, respectively. Included in the unpaid losses and LAE of these operations were amounts related to our workers’ compensation claims of $50.1 million and $48.8 million, net of discount of $17.2 million and $19.5 million at December 31, 2008 and 2007, respectively. The discount rate used was approximately 5% at December 31, 2008 and 2007.
Reinsurers are dependent on their ceding companies for reporting information regarding incurred losses. The nature and extent of information provided to reinsurers may vary depending on the ceding company as well as the type of reinsurance purchased by the ceding company. Ceding companies may also independently adjust their reserves over time as they receive additional data on claims and go through their own actuarial process for evaluating reserves. For casualty liability lines of reinsurance, significant periods of time may elapse between when a loss is incurred and reported by the ceding company’s insured, the investigation and recognition of such loss by the ceding insurer, and the reporting of the loss and evaluation of coverage by a reinsurer. As all of our reinsurance business was produced through independent brokers, an additional lag occurs because the ceding companies report their experience to the placing broker, who then reports such information to the reinsurer. Because of these time lags, and because of the variability in reserving and reporting by ceding companies, it takes longer for reinsurers to find out about reported claims than for primary insurers and those claims are subject to more unforeseen development and uncertainty.
We believe that the potential for adverse reserve development is increased because our reinsurance business is in run-off and we no longer have ongoing business relationships with most of our ceding companies. As a result, to the extent that there are disputes with our ceding companies over claims coverage or other issues, we believe that it is more likely that we will be required to arbitrate these disputes. Although we believe that we have incorporated this potential in our reserve analyses, we also believe that as a result of the nature of the reinsurance business and the fact that the reinsurance business is in run-off, there exists a greater likelihood that reserves may develop adversely in this business. See the discussion under “Discontinued Operations - Premiums, Losses and Expenses” beginning on page 42 for additional information regarding increases in loss reserves for prior years.
At December 31, 2008, 2007 and 2006, our discontinued operations’ gross reserves for asbestos-related losses were $7.9 million, $7.5 million and $5.9 million, respectively ($1.3 million, $1.6 million and $825,000, net of reinsurance, respectively). At December 31, 2008, 2007 and 2006, our discontinued operations’ gross reserves for environmental-related losses were $931,000, $877,000 and $1.5 million, respectively ($539,000, $364,000 and $1.1 million, net of reinsurance, respectively).
Amounts receivable from our reinsurers and retrocessionaires for our discontinued operations are presented with the gross assets of discontinued operations in a separate line on the balance sheet. At December 31, 2008 and 2007, we had amounts receivable from our reinsurers and retrocessionaires totaling $95.0 million and $150.1 million, respectively. As of December 31, 2008, $16.0 million, or 17%, of these amounts were due to us on losses we have already paid, compared to $10.0 million, or 7%, at December 31, 2007. The remainder of the reinsurance receivables related to unpaid claims.
(1) Includes Swiss Reinsurance America Corporation ($18.6 million) and GE Reinsurance Corp. ($2.8 million).
The following table summarizes the effect on our assets and liabilities of discontinued operations for the commutation of certain reinsurance and retrocessional contracts occurring in 2008 and 2007. In 2007, the commutation of a reinsurance agreement covering potential adverse loss development also resulted in our receipt of $171.9 million in cash. Commutations did not have a material impact on our loss from discontinued operations in 2008 or 2007.
Liquidity is a measure of an entity’s ability to secure sufficient cash to meet its contractual obligations and operating needs. Our insurance operations generate cash by writing insurance policies and collecting premiums. The cash generated is used to pay losses and LAE and operating expenses. Any excess cash is invested and earns investment income. Our fee-based businesses generate cash by providing services to clients. The cash generated is used to pay operating expenses, including commissions to sub-producers.
As a result of our decision to exit from the reinsurance and excess and surplus lines of business, we expect that we will continue to use cash from the operating activities of these operations into the foreseeable future. The positive operating cash flows at our discontinued operations in 2007 were due to cash received of $171.9 million related to the commutation of the reinsurance agreement covering potential adverse loss development. In March 2008, we entered into a Stock Purchase Agreement with Armour Re to sell our Run-off Operations. The closing of the sale and transfer of ownership are subject to regulatory approval by the Pennsylvania Insurance Department. Under the Agreement, we can receive up to $10.0 million in cash and a $10.0 million promissory note, subject to certain adjustments at closing. The promissory note is also subject to certain downward adjustments based on the future development of the business’ loss reserves over the next five years. As a result of adverse loss development during 2008, the cash to be received and the value of the promissory note at closing will each be reduced by $7.5 million. We also expect to pay closing costs of approximately $500,000 related to the sale.
Net tax payments received from subsidiaries were $25.1 million, $37.7 million and $9.4 million in 2008, 2007 and 2006, respectively. Net tax payments received in 2008 and 2007 included tax payments related to off-shore reinsurance.
We acquired all of the stock of PMA Management Corp. of New England, Inc. for $7.3 million on June 30, 2008. The purchase price adjusted for certain closing adjustments and net of cash received on the sale resulted in a net cash outflow on this transaction of $5.7 million.
Assumes holders of this debt require us to repurchase all of this debt on the next put date. Holders, at their option, may require us to repurchase all or a portion of their debt on September 30, 2010, 2012 and 2017. This debt may be converted at any time, at the holder’s option, at a current price of $16.368 per share.
See discussion below for the variable interest rates on the junior subordinated debt and the Floating Rate Surplus Notes due 2035 (“Surplus Notes”). The obligations related to the junior subordinated debt and the Surplus Notes have been calculated using the interest rates in effect at December 31, 2008. This calculation includes the impact of interest rate swap agreements.
The operating lease obligations referred to in the table above are primarily obligations of our insurance subsidiaries and are net of sublease rentals of $1.6 million in 2009 and 2010, $1.7 million in 2011, 2012 and 2013, and $1.1 million in 2014. The operating lease obligations also include amounts for our discontinued operations of $480,000 in 2009, $475,000 in 2010 and $474,000 in 2011.
when we expect our unpaid losses and LAE (without the benefit of reinsurance recoveries) to be paid. We maintain an investment portfolio with varying maturities that we believe will provide adequate cash for the payment of claims.
We have the right to defer interest payments on the junior subordinated securities for up to twenty consecutive quarters but, if so deferred, we may not declare or pay cash dividends or distributions on our Class A Common Stock. We have guaranteed the obligations of these statutory trust subsidiaries with respect to distributions and payments on the trust preferred securities issued by these trusts.
Our remaining junior subordinated debt of $43.8 million matures in 2033. The weighted average interest rates on this junior subordinated debt equal the three-month LIBOR plus 4.12%, and interest on this debt is also payable on a quarterly basis. At December 31, 2008, the weighted average interest rate on all of our junior subordinated securities was 5.94%.
In June 2007, we entered into new interest rate swaps that we designated as cash flow hedges to manage interest costs and cash flows associated with the variable interest rates on a portion of our junior subordinated debt and our Surplus Notes. There was no consideration paid or received for these swaps. The swaps effectively convert $10.0 million of the junior subordinated debt and $10.0 million of Surplus Notes to fixed rate debt with interest rates of 9.40% and 9.93%, respectively. The swap on the $10.0 million of junior subordinated debt expired on September 30, 2008. The swap on the $10.0 million of Surplus Notes matures in November 2010.
During 2008, 2007 and 2006, we incurred $10.9 million, $11.7 million and $13.5 million of interest expense, and paid interest of $11.0 million, $11.8 million and $13.7 million in each respective year. The reductions in interest expense and interest paid in 2008 and 2007, compared to the immediately preceding year, were both due to a lower average amount of debt outstanding. The decrease in 2008 was also due to lower interest rates on our variable rate debt.
assets by $28.9 million and $4.9 million at December 31, 2008 and December 31, 2007, respectively. The funded status of our qualified pension plan declined in 2008, due primarily to the decrease in the fair value of the investments that support these obligations. In 2008, 2007 and 2006, we were not required to make any contribution to the pension plan under the minimum funding requirements of the Employee Retirement Income Security Act of 1974. Although we were not required to make any minimum funding contributions, we believe that the Pension Protection Act, enacted in 2006, will accelerate the timing of our future contributions. Our plan assets were composed of 38% fixed maturities, 50% equities and 12% other investments at December 31, 2008. We currently estimate that the pension plan’s assets will generate a long-term rate of return of 8.25%, which we believe is a reasonable long-term rate of return, in part because of the historical performance of the broad financial markets. Pension expense in 2008, 2007 and 2006 was ($162,000), $59,000 and $593,000, respectively.
In 2005, we decided to “freeze” our Qualified Pension Plan and Non-qualified Pension Plans as of December 31, 2005. Under the terms of the freeze, eligible employees retained all of the rights under these plans that they had vested as of December 31, 2005. Effective January 1, 2006, our 401(k) and 401(k) Excess Plans were renamed The PMA Capital Corporation Retirement Savings Plan and The PMA Capital Retirement Savings Excess Plan and were enhanced to include quarterly age-based employer contributions.
We have structured our investment portfolio to provide an appropriate matching of maturities with anticipated claims payments. If we decide or are required in the future to sell securities in a rising interest rate environment, we would expect to incur losses from such sales. As of December 31, 2008, the duration of our investments that support the insurance reserves was 3.2 years and the duration of our insurance reserves was 3.7 years. The difference in the duration of our investments and our insurance reserves reflects our decision to maintain shorter asset duration as a means of maintaining adequate liquidity and reducing the portfolio’s sensitivity to interest rate volatility.
Mortgage-backed and other asset-backed securities (“structured securities”) in the table above include collateralized mortgage obligations (“CMOs”) of $215.6 million and $318.2 million carried at fair value as of December 31, 2008 and 2007, respectively. CMO holdings are all AAA rated and concentrated in tranches with limited prepayment, extension and default risk, such as planned amortization class bonds.
Of the $215.6 million in CMOs at December 31, 2008, $133.3 million, or 34% of our structured securities, were commercial mortgage-backed securities (“CMBS”). The CMBS were carried at 83% of amortized cost at December 31, 2008. All of the CMBS in our portfolio were either the senior or super senior tranches of their respective mortgage pools, and had a weighted average life of 5.2 years and an average credit quality of AAA. During 2008, the CMBS generated cash flows which totaled $22.7 million of principal paydowns from their underlying mortgages. On a weighted average basis, the CMBS we hold have a current credit support of 28% of the par of the securities, and 1% of the underlying pool collateral is delinquent.
The portfolio also held securities with a fair value of $33.7 million, or 4% of our investment portfolio, whose credit ratings were enhanced by various financial guaranty insurers. Of the credit enhanced securities, $11.0 million were asset-backed securities with a weighted average life of 3.7 years and whose underlying collateral had an imputed internal rating of “A”. None of these securities were wrapped asset-backed security collateralized debt obligation exposures.
The net unrealized loss on our investments at December 31, 2008 was $30.8 million, or 4% of the amortized cost basis. The net unrealized loss included gross unrealized gains of $15.8 million and gross unrealized losses of $46.6 million.
At December 31, 2008 and 2007, our fixed maturities had overall average credit quality of AA+ and AAA-, respectively. The credit quality of our fixed maturities at the end of each year was broken down as follows:
At December 31, 2008, all but six of the publicly traded securities in our fixed income portfolio were of investment grade credit quality. The six below investment grade securities had an aggregate fair value of $4.0 million and an aggregate unrealized loss of $2.2 million.
Average invested assets throughout the year, at amortized cost, including cash.
For securities that were in an unrealized loss position, the length of time that such securities have been in an unrealized loss position, as measured by their month-end fair values, was as follows:
At December 31, 2008, of the 34 securities that have been in an unrealized loss position for more than 12 months, 33 securities have a total fair value of 81% of their combined amortized cost basis at December 31, 2008, and an average unrealized loss per security of approximately $383,000. The other security that has been in an unrealized loss position for more than 12 months at December 31, 2008 has a fair value of $300,000 and an amortized cost of $1.4 million. This security, whose $1.4 million principal is backed and guaranteed at maturity by discounted GSE securities, matures in 2033 and is rated AAA. We have both the ability and intent to hold this security until it matures. Of the remaining 33 securities, six were corporate debt securities issued by financial institutions that had a total fair value of 87% of their combined amortized cost basis at December 31, 2008.
The fair value of the investment portfolio at our discontinued operations at December 31, 2008 and 2007 was $146.0 million and $219.7 million, respectively, and had an amortized cost of $143.7 million and $219.2 million, respectively. These amounts included accrued investment income of $543,000 and $322,000 related to trading securities in the portfolio at December 31, 2008 and 2007, respectively. The investment portfolio consisted of 63% in short-term investments at December 31, 2008 and 85% at December 31, 2007.
See Note 5 to our Consolidated Financial Statements for additional discussion about investments at our discontinued operations.
In general, the changing social, economic, legal, legislative and regulatory environment could materially affect our business. Some of the changes include initiatives to restrict insurance pricing and the application of underwriting standards and reinterpretations of insurance contracts long after the policies were written in an effort to provide coverage unanticipated by us. The eventual effect on us of the changing environment in which we operate remains uncertain.
Results presented in accordance with GAAP vary in certain respects from results presented in accordance with statutory accounting practices prescribed or permitted by the Pennsylvania Insurance Department (collectively “SAP”). Prescribed SAP includes state laws, regulations and general administrative rules, as well as a variety of National Association of Insurance Commissioners publications. Permitted SAP encompasses all accounting practices that are not prescribed. Our domestic insurance subsidiaries use SAP to prepare various financial reports for use by insurance regulators.
In March 2008, the FASB issued Statement of Financial Accounting Standards No. 161, “Disclosures about Derivative Instruments and Hedging Activities - an amendment of FASB Statement No. 133” (“SFAS 161”), which requires additional disclosures about an entity’s derivative instruments and hedging activities. Entities are required to provide additional disclosures about (a) how and why an entity uses derivative instruments, (b) how derivative instruments and related hedged items are accounted for under Statement 133 and its related interpretations and (c) how derivative instruments and related hedged items affect an entity’s financial position, financial performance, and cash flows. SFAS 161 is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008. SFAS 161 is a disclosure standard and as such will not impact our financial position, results of operations or liquidity.
In October 2008, the FASB issued FSP FAS 157-3, “Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active” (“FSP FAS 157-3”). The purpose of FSP FAS 157-3 was to clarify the application of SFAS 157, for a market that is not active. It also allows for the use of management’s internal assumptions about future cash flows with appropriately risk-adjusted discount rates when relevant observable market data does not exist. FSP FAS 157-3 did not change the objective of SFAS 157, which is the determination of the price that would be received in an orderly transaction that is not a forced liquidation or distressed sale at the measurement date. FSP FAS 157-3 was effective upon issuance, including prior periods for which financial statements had not been issued. Our adoption of FSP FAS 157-3 for the year ended December 31, 2008 did not have a material effect on our financial position, results of operations or liquidity.
At December 31, 2008, we estimated that under all insurance policies and reinsurance contracts issued by our ongoing insurance business, our liability for all events that occurred as of December 31, 2008 was $1,242 million. This amount included estimated losses from claims plus estimated expenses to settle claims. Our estimate also included estimated amounts for losses occurring on or prior to December 31, 2008 whether or not these claims had been reported to us. At December 31, 2008, our estimate for such amounts recorded as liabilities of discontinued operations was $247.4 million.
Our actuaries utilize a variety of actuarial techniques based on various assumptions to derive reserve estimates on subsets of the business within our operations. The techniques and assumptions vary depending upon the characteristics particular to the business. Our actuaries periodically perform detailed studies of historical data on incurred claims, reported claims and paid claims for each major line of business and by accident year and also analyze data for the current accident year. The actuarial techniques typically used by our actuaries are as follows:
Claim Count Times Average - This method projects the ultimate number of claims based on the historical development trends of incurred or closed claims and projects the average size of a claim based on the historical development of the average incurred or the average paid claim. The projected ultimate loss equals the ultimate number of claims multiplied by the average size of a claim.
Within the workers’ compensation line of business, we review medical and indemnity costs separately. We undertake this review because we believe that the medical cost component of workers’ compensation claims has a different development pattern than the indemnity payments, and also because we believe that certain assumptions within the medical cost
component, such as the rate of medical cost inflation, can lead to more volatility as compared to the indemnity component. For example, a one percentage-point change in current year medical inflation would result in about three tenths of a point change in our overall loss and LAE ratio. At December 31, 2008, our medical loss reserves were approximately 51% of the workers’ compensation loss reserves, with the balance being indemnity costs. We also review the workers’ compensation line of business by state for some of our larger states. We undertake this review because workers’ compensation benefits vary by state and this can cause loss development patterns to vary by state.
After our actuaries complete the analyses described above, management reviews the data along with various industry benchmarks, and using its informed judgment, selects its best estimate of the amounts needed to pay all pending and future claims and related expenses, including those not yet reported to us. This best estimate is recorded as a loss and LAE reserve on our balance sheet. Our practice is to establish reserves for unpaid losses and LAE at a level where we believe it is likely that such unpaid losses and LAE could ultimately settle at similar amounts either above or below management’s best estimate. At December 31, 2008, management’s best estimate reflects an estimate of loss and LAE reserves that is approximately the mid-point of our actuaries’ range of loss reserves.
It is important to understand that the process of estimating our ultimate claims liability is necessarily a complex and judgmental process inasmuch as the amounts are based on management’s informed estimates, assumptions and judgments using data currently available. The assumptions we utilize in developing a range of loss reserves are based on the premise that past experience, adjusted for the effects of current developments and anticipated trends, is an appropriate basis for establishing our reserve ranges. As more current and additional experience and data become available regarding the existence and the dollar amounts of claims, claims payment and reporting patterns, legal and legislative developments, judicial theories of liability, the impact of regulatory trends on benefit levels for both medical and indemnity payments, and changes in social attitudes and economic conditions, we revise our actuarially determined range of estimates accordingly. Because of the aforementioned factors, actual results can differ from our current estimates in both The PMA Insurance Group and in our discontinued operations. While all of these factors affect the reserving process and results, we believe that the major factors that can cause actual results to vary from our estimates for The PMA Insurance Group are a change in frequency of reported claims, a change in the severity of claims reported to us, and in particular for workers’ compensation, a change in the rate of medical cost inflation.
At December 31, 2008, unpaid losses and loss adjustment expenses at the continuing operations were $1,242 million, which included case reserves of $614 million and IBNR reserves of $628 million. At December 31, 2008, unpaid losses and loss adjustment expenses at the discontinued operations were $247.4 million, which included case reserves of $220.9 million and IBNR reserves of $26.5 million.
A significant portion of the business at our discontinued operations is “long-tailed” in nature and is dependent on its ceding companies for reporting information regarding incurred losses, most of which it no longer has ongoing relationships with due to its businesses being in run-off. The loss reserves recorded represent management’s best estimate of future amounts needed to pay claims and related settlement costs with respect to insured events that have occurred, including events that have not been reported to us; as such, these estimates have contemplated the effect of prior adverse development when developing new loss reserve estimates. As the amounts recorded represent our best estimate, we believe that the past loss development which we recorded is not indicative of expected future loss development in our discontinued operations.
For additional information about our investments, see Notes 2-B, 5, 6 and 14 to the Consolidated Financial Statements as well as “Investments” beginning on page 52.
Based on our evaluation of reinsurance receivables at December 31, 2008, we have established an allowance for amounts that we have concluded are uncollectible at the balance sheet date. In evaluating collectibility, we considered historical payment performance of our reinsurers, the fact that our reinsurers are current on their obligations to our insurance subsidiaries, and any known disputes or collection issues as of the balance sheet date. To these factors, we applied our informed judgment in ascertaining the appropriate level of allowance for uncollectible amounts. At December 31, 2008, approximately $53.3 million of uncollateralized reinsurance receivables at our continuing operations, including $36.5 million due for ceded IBNR, are due from reinsurers who have ratings that declined to below “Adequate,” defined as B++ or below by A.M. Best, or who were under regulatory supervision or in liquidation.
For additional information about reinsurance receivables, see Notes 5 and 8 to the Consolidated Financial Statements as well as “Reinsurance” beginning on page 45.
We record deferred tax assets and liabilities to the extent of the tax effect of differences between the financial statement carrying values and tax bases of assets and liabilities. The recoverability of deferred tax assets is evaluated based upon management’s estimates of the future profitability of our taxable entities based on current forecasts. We establish a valuation allowance for deferred tax assets where it appears more likely than not that we will not be able to recover the deferred tax asset. At December 31, 2008, PMA Capital has a net deferred tax asset of $138.5 million, resulting from $229.2 million of gross deferred tax assets reduced by a deferred tax asset valuation allowance of $60.5 million and by $30.2 million of deferred tax liabilities. In establishing the appropriate value of this asset, management must make judgments about our ability to utilize the net tax benefit from the reversal of temporary differences and the utilization of operating loss carryforwards that expire mainly from 2018 through 2028.
Prior to 2006, we had established a valuation allowance in the amount of $60.5 million. This was based upon our assessment that it was more likely than not that a portion of the gross deferred tax assets related to the NOL carryforward and all of the deferred tax asset related to the AMT credit carryforward would not be realized. We periodically reassess the valuation allowance previously established against the net deferred tax assets. Factors considered in our reassessment included historical earnings, scheduled reversal of deferred tax liabilities and revised projections of future earnings.
For additional information about our discontinued operations, see Note 5 to the Consolidated Financial Statements as well as “Segment Results - Discontinued Operations” beginning on page 41.
This annual report contains forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995 with respect to the Company’s business, financial condition and results of operations and the plans and objectives of its management. Forward-looking statements can generally be identified by use of forward-looking terminology such as “may,” “will,” “plan,” “expect,” “intend,” “anticipate,” and “believe.” These forward-looking statements may include estimates, assumptions or projections and are based on currently available financial, industry, competitive and economic data and our current operating plans. All forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from those expressed or implied by the forward-looking statements.
regulatory changes in risk-based capital or other standards that affect the cost of, or demand for, our products or otherwise affect our ability to conduct business, including any future action with respect to our business taken by the Pennsylvania Insurance Department or any other state insurance department;
our concentration in workers’ compensation insurance, which makes us particularly susceptible to adverse changes in that industry segment;
disruptions in the financial markets that affect the value of our investment portfolio and our ability to sell our investments;
our ability to raise additional capital on financially favorable terms when required;
Consolidated Statements of Operations for the years ended December 31, 2008, 2007 and
Reinsurance receivables (net of valuation allowance: 2008 - $4,608; 2007 - $4,608)
The accompanying consolidated financial statements include the accounts of PMA Capital Corporation and its subsidiaries (collectively referred to as “PMA Capital” or the “Company”). PMA Capital Corporation is a holding company whose operating subsidiaries provide insurance and fee-based services. Insurance products are underwritten and marketed under the trade name The PMA Insurance Group. Fee-based services include third party administrator (“TPA”), managing general agent and program administrator services. The Company also manages the run-off of its reinsurance and excess and surplus lines operations, which have been recorded as discontinued operations.
A. Basis of Presentation - The consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). All significant intercompany accounts and transactions have been eliminated in consolidation. The preparation of consolidated financial statements in conformity with GAAP requires management to make certain estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the period. Actual results could differ from those estimates.
C. Premiums - Premiums, including estimates of premiums resulting from audits of insureds’ records are earned principally on a pro rata basis over the terms of the policies. Any changes occurring or reported to the Company after the policy term are recorded as earned premiums in the period in which the adjustment is made. With respect to policies that provide for premium adjustments, such as experience or exposure-based adjustments, such premium adjustment may be made subsequent to the end of the policy’s coverage period and will be recorded as earned premium in the period in which the adjustment is made. Premiums applicable to the unexpired terms of policies in force are reported as unearned premiums. The estimated premiums receivable on experience or exposure-based policies are reported as a component of premiums receivable. For reinsurance premiums assumed at the Company’s discontinued operations, management must estimate the subject premiums associated with the treaties in order to determine the level of written and earned premiums for a reporting period. Such estimates are based on information from brokers and ceding companies, which can be subject to change as new information becomes available.
Certain of the Company’s assumed and ceded reinsurance contracts are funds held arrangements. In a typical funds held arrangement, the ceding company retains the premiums instead of paying them to the reinsurer and losses are offset against these funds in an experience account. Because the reinsurer is not in receipt of the funds, the reinsurer will generally earn interest on the experience fund balance at a predetermined credited rate of interest. The interest earned or credited on funds held arrangements is included in net investment income in the statement of operations. In addition, interest on funds held arrangements will continue to be earned or credited until the experience account is fully depleted, which can extend many years beyond the expiration of the coverage period.
H. Income Taxes - The Company records deferred tax assets and liabilities to the extent of the tax effect of differences between the financial statement carrying values and tax bases of assets and liabilities. A valuation allowance is recorded for deferred tax assets where it appears more likely than not that the Company will not be able to recover the deferred tax asset. See Note 15 for additional information.
In December 2007, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 141 (revised 2007), “Business Combinations” (“SFAS 141R”). SFAS 141R replaces Statement of Financial Accounting Standards No. 141, “Business Combinations” (“SFAS 141”), although it retains the fundamental requirement in SFAS 141 that the purchase method of accounting be used for all business combinations. SFAS 141R establishes principles and requirements for how the acquirer in a business combination (a) recognizes and measures the assets acquired, liabilities assumed and any non-controlling interest in the acquiree, (b) recognizes and measures the goodwill acquired in a business combination or a gain from a bargain purchase and (c) determines what information to disclose regarding the business combination. SFAS 141R applies prospectively to business combinations for which the acquisition date is on or after the beginning of the Company’s 2009 fiscal year, and therefore, had no impact on the accounting for the Company’s 2007 acquisition of Midlands, nor its 2008 acquisition of PMA Management Corp. of New England, Inc.
In March 2008, the FASB issued Statement of Financial Accounting Standards No. 161, “Disclosures about Derivative Instruments and Hedging Activities - an amendment of FASB Statement No. 133” (“SFAS 161”), which requires additional disclosures about an entity’s derivative instruments and hedging activities. Entities are required to provide additional disclosures about (a) how and why an entity uses derivative instruments, (b) how derivative instruments and related hedged items are accounted for under Statement 133 and its related interpretations and (c) how derivative instruments and related hedged items affect an entity’s financial position, financial performance, and cash flows. SFAS 161 is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008.
SFAS 161 is a disclosure standard and as such will not impact the Company’s financial position, results of operations or liquidity.
On June 30, 2008, the Company acquired all of the stock of PMA Management Corp. of New England, Inc. for $7.3 million.
The value of the non-contractual customer relationships was calculated using a 15% annual attrition rate. The non-contractual customer relationships are being amortized on a straight-line basis over 10 years. The Company recognized $669,000 of expenses related to the amortization of non-contractual customer relationships in 2008 and $167,000 in 2007. The Company expects to recognize $669,000 of amortization expense per year over the next five years and $2.5 million thereafter.
Changes in the net carrying amounts of the Company’s intangible assets, all of which relate to its Fee-based Business, were as follows:
Annual impairment testing was performed during the second quarter of 2008 on the intangible assets that relate to the prior year acquisition of Midlands. Based upon this review, the assets were not impaired.
In 2007, the Company announced that it was actively pursuing the sale of its Run-off Operations. The Company’s Run-off Operations include its reinsurance and excess and surplus lines businesses, which were placed into run-off in 2003 and 2002, respectively. Because of the expected divestiture, the Company determined that its Run-off Operations should be reflected as discontinued operations in accordance with SFAS 144.
On March 28, 2008, the Company entered into a Stock Purchase Agreement (the “Agreement”) to sell its Run-off Operations to Armour Reinsurance Group Limited (“Armour Re”), a Bermuda-based corporation. Armour Re is an indirect wholly-owned subsidiary of Brevan Howard P&C Master Fund Limited, a Cayman-based fund, which specializes in insurance and reinsurance investments. On May 22, 2008, Armour Re filed the Form A application with the Pennsylvania Insurance Department, which formally started the regulatory review process. The closing of the sale and transfer of ownership are subject to regulatory approval by the Department.
As of March 9, 2009, the Department’s financial examination of PMA Capital Insurance Company (“PMACIC”), which includes its review of the loss reserves, was still in process. PMACIC is the Company’s reinsurance subsidiary in run-off. Under the original terms of the Agreement, either Armour Re or the Company could have terminated the Agreement if the closing of the sale had not occurred within six months of signing the Agreement. The Company amended the Agreement with Armour Re to extend the termination date to March 31, 2009, or such later date as mutually agreed.
Under the Agreement, the Company can receive up to $10.0 million in cash and a $10.0 million promissory note, subject to certain adjustments at closing. The promissory note is also subject to certain downward adjustments based on the future development of the business’ loss reserves over the next five years. As a result of adverse loss development in 2008, the cash to be received and the value of the promissory note at closing have each been reduced by $7.5 million. Only the $2.5 million expected cash amount is reflected in the Company’s financial statements.
The Company has reclassified the results of operations, including the related tax effects, and the assets and liabilities related to its Run-off Operations to discontinued operations, in accordance with SFAS 144. The following table provides detailed information regarding the after-tax losses from discontinued operations included in the Company’s Consolidated Statements of Operations.
In 2007, the Company recognized an after-tax impairment loss of $40.0 million related to the expected sale of the Run-off Operations. The components of the loss were as follows:
At December 31, 2007, the Company recorded an income tax benefit on the impairment loss, as it believes it will be able to use the loss to offset future operating earnings.
At December 31, 2008 and 2007, the fair value of the investment portfolio at the discontinued operations was $146.0 million and $219.7 million, respectively, and had an amortized cost of $143.7 million and $219.2 million, respectively. These amounts included accrued investment income of $543,000 and $322,000 related to trading securities in the portfolio at December 31, 2008 and 2007, respectively. The investment portfolio consisted of 63% in short-term investments at December 31, 2008 and 85% at December 31, 2007.
SFAS 159 was effective as of the beginning of an entity’s first fiscal year that begins after November 15, 2007. Early adoption was permitted as of the beginning of the previous fiscal year provided that the entity makes that choice within the first 120 days of that fiscal year and also elects to apply the provisions of SFAS 157. The Company early adopted SFAS 159, effective January 1, 2007. Upon adoption of SFAS 159, the Company elected to reclassify all of the fixed income securities in its discontinued operations’ investment portfolio from available for sale to trading. Although the Company’s adoption of this Statement had no net impact on shareholders’ equity, it may result in future volatility in net income as changes in fair value will be recorded through realized gains and losses rather than other comprehensive income. The Company’s discontinued operations recognized pre-tax net realized gains of $1.8 million in 2008 and $1.1 million in 2007 for subsequent changes in fair value on its trading securities.
The Company adopted SFAS 159 because the investment portfolio at the discontinued operations decreased by 50% in the first quarter of 2007, compared to the first quarter of 2006. The Company also considered that, given the unpredictability of cash flows for commutations, combined with the shrinking size of the portfolio, trading activity was expected to increase in 2007. The discontinued operations’ investment portfolio was also reduced significantly during the second quarter of 2007 as a result of the $37.5 million extraordinary dividend payment to PMA Capital Corporation in April 2007.
The balance sheet impact of the SFAS 159 adoption on our discontinued operations was as follows:
On December 31, 2008, the Company had securities with a total amortized cost of $12.0 million and fair value of $13.8 million on deposit with various governmental authorities, as required by law. In addition, the Company had securities with a total amortized cost of $13.2 million and fair value of $13.3 million held in trust for the benefit of certain ceding companies on reinsurance balances assumed by the Run-off Operations. The securities held on deposit are included in assets of discontinued operations on the balance sheet.
Because reinsurers rely on their ceding companies to provide them with information regarding incurred losses, it takes longer for reinsurers to find out about reported claims than for primary insurers and those claims are subject to more unforeseen development and uncertainty. See Note 7 for additional information regarding management estimates included in unpaid losses and LAE.
The discontinued operations’ losses and LAE paid in 2008 and 2007 were both impacted by the commutation of retrocessional reinsurance agreements, which reduced the amounts paid for each period. In 2007, losses and LAE paid were significantly reduced by the commutation of the discontinued operations’ retrocessional contract covering potential adverse loss development, which also resulted in the discontinued operations receiving $171.9 million in cash. The following table summarizes the effect on the Company’s assets and liabilities of discontinued operations for the commutation of certain reinsurance and retrocessional contracts occurring in 2008 and 2007. Commutations did not have a material impact on the loss from discontinued operations in 2008 or 2007.
During 2006, the discontinued operations recorded $5.3 million in favorable prior year loss development, primarily due to commutations of structured reinsurance treaties with some of its ceding companies. The discontinued operations do not typically record favorable prior year loss development on commutations unless the treaties are structured reinsurance, where IBNR reserves are directly attributable to a treaty.
Unpaid losses and LAE for the Company’s discontinued operations’ workers’ compensation claims, net of reinsurance, at December 31, 2008 and 2007 were $50.1 million and $48.8 million, net of discount of $17.2 million and $19.5 million, respectively. The discount rate used was approximately 5% at December 31, 2008 and 2007.
The Company’s discontinued operations’ loss reserves were stated net of salvage and subrogation of $283,000 and $407,000 at December 31, 2008 and 2007, respectively.
At December 31, 2008, 2007 and 2006, the discontinued operations’ gross reserves for asbestos-related losses were $7.9 million, $7.5 million and $5.9 million, respectively ($1.3 million, $1.6 million and $825,000, net of reinsurance, respectively). Of the net asbestos reserves, $50,000, $350,000 and $38,000 related to IBNR losses at December 31, 2008, 2007 and 2006, respectively.
At December 31, 2008, 2007 and 2006, the discontinued operations’ gross reserves for environmental-related losses were $931,000, $877,000 and $1.5 million, respectively ($539,000, $364,000 and $1.1 million, net of reinsurance, respectively). Of the net environmental reserves, $110,000, $0 and $373,000 related to IBNR losses at December 31, 2008, 2007 and 2006, respectively. All incurred asbestos and environmental losses were for accident years 1986 and prior.
The Company’s investment portfolio is diversified and does not contain any significant concentrations in single issuers other than U.S. Treasury and agency obligations. In addition, the Company does not have a significant concentration of investments in any single industry segment other than finance companies, which comprised 17% of invested assets at December 31, 2008. Included in this industry segment are diverse financial institutions, including banks and insurance companies, with no single issuer exceeding 3% of the total investment portfolio. The Company does not believe that there are credit related risks associated with its U.S. Treasury and agency securities.
For securities that were in an unrealized loss position, the length of time that such securities have been in an unrealized loss position, as measured by their month-end fair values, were as follows:
The amortized cost and fair value of fixed maturities at December 31, 2008, by contractual maturity, were as follows:
The impairment losses for 2008 were related to write-downs of the Company’s investments in three corporate senior debt securities, which were issued by Lehman Brothers Holdings, Inc., and perpetual preferred stock issued by the Federal National Mortgage Association (“Fannie Mae”). The Company’s write-down of the Lehman Brothers senior debt was for $8.2 million and its write-down of the Fannie Mae preferred stock was for $967,000. The impairment loss for 2007 was related to a security issued by a national provider of higher education loans. The write-downs were measured based on public market prices at the time when the Company determined the decline in value was other than temporary.
The change in fair value of trading securities during 2007 related to a security that was previously held at the Company’s discontinued operations and transferred to PMA Capital Corporation as part of the $37.5 million dividend in April 2007. Fixed income securities held at the discontinued operations were selected for the fair value option and reclassified from the available for sale to the trading category in conjunction with the Company’s adoption of SFAS 159, effective January 1, 2007.
The Company’s loss reserves were stated net of salvage and subrogation of $16.3 million and $18.0 million at December 31, 2008 and 2007, respectively.
At December 31, 2008, 2007 and 2006, gross reserves for environmental-related losses were $10.1 million, $10.3 million and $11.9 million, respectively ($463,000, $0 and $3.0 million, net of reinsurance, respectively). Of the net environmental reserves, $118,000, $0 and $1.0 million related to IBNR losses at December 31, 2008, 2007 and 2006, respectively. All incurred asbestos and environmental losses were for accident years 1986 and prior.
The components of net premiums written and earned, and losses and LAE incurred were as follows:
In September 2008, the Company retired $410,000 principal amount of its 4.25% Senior Convertible Debt due 2022, $20,000 of which was put to the Company on September 30, 2008. The Company paid par for these bond purchases, exclusive of accrued interest.
The remaining junior subordinated debt of $43.8 million matures in 2033. The weighted average interest rates on this junior subordinated debt equal the three-month LIBOR plus 4.12%, and interest on this debt is also payable on a quarterly basis. At December 31, 2008, the weighted average interest rate on all of the junior subordinated securities was 5.94%.
respectively. The swap on the $10.0 million of junior subordinated debt expired on September 30, 2008. The swap on the $10.0 million of Surplus Notes matures in November 2010.
In September 2007, the Company entered into a new interest rate swap that it designated as a cash flow hedge to manage interest costs and cash flows associated with the variable interest rates on a portion of its junior subordinated debt. There was no consideration paid or received for this swap. The swap effectively converts $20.0 million of the junior subordinated debt to fixed rate debt with an interest rate of 8.29%. This swap matures in June 2012.
The Company leases certain facilities, office equipment and automobiles under non-cancelable operating leases. Future minimum net operating lease obligations as of December 31, 2008 are as follows:
See Note 8 for information regarding the terms of the sale of PMA Cayman in 1998.
See Note 12 for information regarding shares reissued under stock-based compensation plans.
The Company currently has stock-based compensation plans in place for directors, officers and other key employees of the Company. Pursuant to the terms of these plans, under which 4,143,788 shares of Class A Common Stock are reserved for issuance at December 31, 2008, the Company grants restricted shares of its Class A Common Stock and options to purchase the Company’s Class A Common Stock. Stock-based compensation is granted under terms and conditions determined by the Compensation Committee of the Board of Directors (“Compensation Committee”). Stock options have a maximum term of ten years, generally vest over periods ranging between one and four years, and are typically granted with an exercise price at least equal to the market value of the Class A Common Stock on the date of grant. Restricted stock is valued at the market value of the Class A Common Stock on the date of grant and generally vests (restrictions lapse) between one and three years.
On January 1, 2006, the Company adopted Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123R”), using the modified-prospective transition method. SFAS 123R requires all share-based payments to employees, including grants of employee stock options, be recognized as compensation expense in the income statement at fair value. Under the modified-prospective transition method, the Company recognized expense over the remaining required service period for stock options granted prior to January 1, 2006 for the portion of those grants for which the requisite service had not yet been rendered. No adjustment was made to prior period amounts nor was any expense recorded for options granted prior to January 1, 2006 for which the requisite service had been rendered by that date. The Company recognized stock-based compensation expense of $2.4 million, $1.8 million and $2.4 million for the years ended December 31, 2008, 2007 and 2006, respectively. The stock-based compensation expense included amounts related to stock options of $44,000 in 2007 and $602,000 in 2006.
Information regarding these option plans for prior years was as follows:
The effects of 328,000, 380,000 and 426,000 stock options were excluded from the computations of diluted earnings per share for 2008, 2007 and 2006, respectively, because they were anti-dilutive.
In September 2006, the FASB issued SFAS 157. This Statement defines fair value, establishes a framework for measuring fair value in accordance with GAAP and expands disclosures about fair value measurements. SFAS 157 is applicable in conjunction with other accounting pronouncements that require or permit fair value measurements, but does not expand the
use of fair value to any new circumstances. More specifically, SFAS 157 emphasizes that fair value is a market-based measurement, not an entity-specific measurement, and sets out a fair value hierarchy with the highest priority given to quoted prices in active markets and the lowest priority to unobservable inputs. Further, SFAS 157 requires tabular disclosures of the fair value measurements by level within the fair value hierarchy. This Statement was effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. However, early adoption was permitted as of the beginning of a fiscal year. The Company early adopted SFAS 157, effective January 1, 2007. The Company’s adoption of SFAS 157 did not have an impact on its financial condition or results of operations.
The following table provides a summary of changes in the fair value of Level 3 assets within the fair value hierarchy for the year ended December 31, 2008.
considered by management in its assessment included historical earnings, scheduled reversal of deferred tax liabilities and projections of future earnings.
In 2005, the Company decided to “freeze” its Qualified Pension Plan and Non-qualified Pension Plans as of December 31, 2005. Under the terms of the freeze, eligible employees retained all of the rights under these plans that they had vested as of December 31, 2005. Effective January 1, 2006, the Company’s 401(k) and 401(k) Excess Plans were renamed The PMA Capital Corporation Retirement Savings Plan and The PMA Capital Retirement Savings Excess Plan and were enhanced to include quarterly age-based employer contributions.
The Company was required to adopt Statement of Financial Accounting Standards No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans” (“SFAS 158”), in 2006. SFAS 158 requires that an employer recognize the overfunded or underfunded status of each defined benefit postretirement plan as an asset or liability on the balance sheet. Changes in the funded status during any given period of time shall be recognized as a change in comprehensive income. The statement has no impact on the recognition of benefit costs. The Company’s 2006 adoption of this statement resulted in a $13.5 million decrease in Other assets, a $15.2 million decrease in Accounts payable, accrued expenses and other liabilities, and a $1.1 million increase in Accumulated other comprehensive loss.
The Company uses a December 31 measurement date for its Plans. For the measurement of other postretirement benefits, an 8% annual rate of increase in the per capita cost of covered health care benefits was assumed for 2008. The rate was assumed to decrease gradually to 5% by 2014 and remain at that level thereafter. A one-percentage point change in assumed health care cost trend rates would have an immaterial impact on the total service and interest cost components of the net periodic benefit cost and the postretirement benefit obligation.
The decline in Qualified Pension Plan asset performance prior to 2006, combined with historically low interest rates (which are the key assumption in estimating plan liabilities) caused the Company to record a $30.3 million increase in its accrued Qualified Pension Plan liability and record a $19.7 million charge to shareholders’ equity. In 2006 and 2007, the Company reversed $5.7 million and $5.4 million of its qualified pension liability and increased shareholders’ equity by $3.7 million and $3.5 million, respectively, due primarily to the increases in interest rates and higher than expected returns on plan assets. In 2008, the Company increased its qualified pension liability by $26.8 million and recorded a charge to shareholders’ equity of $17.4 million due primarily to a decrease in the value of the investments that support these obligations.
The projected benefit obligation, accumulated benefit obligation and fair value of plan assets for the Qualified Pension Plan were $81.0 million, $81.0 million and $52.1 million, respectively, at December 31, 2008, and $79.0 million, $79.0 million and $74.1 million, respectively, at December 31, 2007.
Qualified Pension Plan benefits will be paid from the pension trust assets which have a fair value of $52.1 million at December 31, 2008. Non-qualified Pension Plan and other postretirement benefits will be paid from the general assets of the Company.
B. Defined Contribution Savings Plan - The Company also maintains defined contribution savings plans covering substantially all employees. These plans include a voluntary employee contribution component, in which the Company matches employee contributions, up to 6% of compensation and, effective January 1, 2006, an aged-based company contribution. Contributions expensed under these plans in 2008, 2007 and 2006 were $6.3 million, $5.3 million and $4.9 million, respectively.
Depreciation and amortization expense for the Fee-based Business segment included $742,000 in 2008 and $167,000 in 2007 related to the amortization of intangible assets.
The PMA Insurance Group’s operations are concentrated in twelve contiguous states in the eastern part of the U.S. The economic trends in these individual states may not be independent of one another. Also, The PMA Insurance Group’s products are highly regulated by each of these states. For most of The PMA Insurance Group’s products, the insurance departments of the states in which it conducts business must approve rates and policy forms. In addition, workers’ compensation benefits are determined by statutes and regulations in each of these states. While The PMA Insurance Group considers factors such as rate adequacy, regulatory climate and economic factors in its underwriting process, unfavorable developments in these factors could have an adverse impact on the Company’s financial condition and results of operations. Since November 2003, The PMA Insurance Group has been the Company’s sole remaining ongoing insurance segment. In 2008 and 2007, workers’ compensation net premiums written represented 92% of The PMA Insurance Group’s net premiums written and comprised 90% in 2006.
The Company incurred legal and consulting expenses aggregating approximately $623,000, $810,000 and $3.0 million in 2008, 2007 and 2006, respectively, from firms in which directors of the Company were partners or principals. The directors to whom these incurred expenses related no longer currently serve on the Company’s Board of Directors.
We have audited the accompanying consolidated balance sheets of PMA Capital Corporation and subsidiaries (the Company) as of December 31, 2008 and 2007, and the related consolidated statements of operations, cash flows, shareholders’ equity and comprehensive income (loss) for each of the years in the three-year period ended December 31, 2008. The Company’s management is responsible for these consolidated financial statements. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), PMA Capital Corporation and subsidiaries’ internal control over financial reporting as of December 31, 2008, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 9, 2009 expressed an unqualified opinion.
In our opinion, PMA Capital Corporation and subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 31, 2008, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets and the related consolidated statements of operations, cash flows, shareholders’ equity, comprehensive income (loss) and financial statement schedules of PMA Capital Corporation and subsidiaries, and our reports dated March 9, 2009 expressed an unqualified opinion.
(1) See Note 5 for information regarding the results of the Company’s discontinued operations during these periods.