PROPERTIES. ------- ----------- Lease costs of the Company's two office facilities in West Des Moines, Iowa total approximately $73,000 and $31,000 annually. These leases expire March 31, 1998 and November 30, 1995, respectively.
Lease costs of the Company's office facilities in Oak Brook, Illinois, and Bismarck, North Dakota, which total approximately $220,000 and $126,000 annually, are included as expenses under the pooling agreement. See "Property and Casualty Insurance - Pooling Agreement" under Item 1 of this Form 10-K.
SELECTED FINANCIAL DATA. ------- ------------------------ Year ended December 31, -------------------------------------------- 1994 1993 1992 1991 1990 -------- -------- -------- -------- -------- (In thousands, except per share amounts)
Income taxes ................... 5,171 1,885 759 3,124 2,894 -------- -------- -------- -------- -------- Income from continuing operations ................... 13,506 7,134 216 7,308 7,946
Income from accounting changes - 2,621 - - - -------- -------- -------- -------- -------- Net income ............... $ 13,506 $ 9,755 $ 216 $ 9,161 $ 8,265 ======== ======== ======== ======== ========
Premiums earned by segment: Property and casualty ........ $115,412 $109,585 $109,139 $ 78,413 $ 70,597 Reinsurance .................. 37,256 33,324 26,615 25,009 20,696 Nonstandard risk automobile .. 12,161 13,529 11,656 9,997 10,030 -------- -------- -------- -------- -------- Total .................... $164,829 $156,438 $147,410 $113,419 $101,323 ======== ======== ======== ======== ========
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL ------- ------------------------------------------------- CONDITION AND RESULTS OF OPERATIONS. ------------------------------------
The purpose of the pooling agreement is to reduce the risk of an exposure insured by any of the pool participants by spreading it among all the companies. The pooling agreement produces a more uniform and stable underwriting result from year to year for all companies in the pool than might be experienced individually. In addition, each company benefits from the capacity of the entire pool, rather than being limited to policy exposures of a size commensurate with its own assets, and from the wide range of policy forms and lines of insurance written and the variety of rate filings and commission plans offered by each of the companies. A single set of reinsurance treaties is maintained for the protection of all six companies in the pool.
($ in thousands) 1994 1993 1992 -------- -------- -------- Premiums earned .......................... $164,829 $156,438 $147,410 Losses and settlement expenses ........... 116,944 120,355 122,088 Other expenses ........................... 51,092 48,787 46,271 -------- -------- -------- Underwriting loss ........................ (3,207) (12,704) (20,949) Net investment income .................... 20,930 20,780 21,540 Realized investment gains ................ 520 684 384 Other income ............................. 434 259 - -------- -------- -------- Operating income before income taxes ..... $ 18,677 $ 9,019 $ 975 ======== ======== ======== Incurred losses and settlement expenses: Insured events of the current year ..... $123,344 $119,896 $116,616 (Decrease) increase in provision for insured events of prior years ........ (6,400) 459 5,472 -------- -------- -------- Total losses and settlement expenses .. $116,944 $120,355 $122,088 ======== ======== ======== Catastrophe losses ....................... $ 5,487 $ 8,513 $ 16,569 ======== ======== ========
Premiums earned have increased steadily over the last three years despite the competitive market conditions. For the year 1994, production increases in the property and casualty insurance subsidiaries and the reinsurance subsidiary were partially offset by a production decrease in the nonstandard risk automobile insurance subsidiary. For the year 1993, production increased for the reinsurance subsidiary and the nonstandard risk automobile insurance subsidiary, while the property and casualty insurance subsidiaries remained relatively flat.
Investment income increased in 1994 after experiencing a decrease in 1993. The decrease in 1993 is primarily due to a decline in invested assets resulting from the transfer of $24,853,000 to Employers Mutual in connection with the change in the property and casualty insurance subsidiaries' pooling agreement relating to the voluntary assumed reinsurance business and the commutation of two reinsurance contracts under the reinsurance subsidiary's quota share agreement.
Realized gains on investments are primarily the result of calls and prepayments on fixed maturity securities.
Other income amounts represent the amortization of deferred income related to reserve discounting on the commutation of one of the reinsurance subsidiary's reinsurance contracts under the quota share agreement in 1993.
Effective January 1, 1994, the Company adopted Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits." Adoption of this statement had no effect on the operations of the Company.
Effective December 31, 1994, the Company adopted Statement of Financial Accounting Standards No. 119, "Disclosure about Derivative Financial Instruments and Fair Value of Financial Instruments." Adoption of this statement had no effect on current disclosures as the Company did not hold or issue any derivative financial instruments at December 31, 1994.
* Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 106 (SFAS 106), "Employers' Accounting for Postretirement Benefits Other Than Pensions." The Company adopted SFAS 106 by recognizing the transition obligation as a cumulative effect adjustment to income. The Company's transition obligation amounted to $2,166,000 ($.21 per share), net of income tax benefits of $1,116,000.
* Effective January 1, 1993, the property and casualty insurance subsidiaries changed their method of calculating unearned premiums from the monthly pro rata method to the daily method. The property and casualty insurance subsidiaries changed their accounting method because of management's belief that the new method provides for a more accurate matching of revenues and expenses over the terms of the underlying insurance policies. This change resulted in a cumulative increase in unearned premiums of $1,110,000 and a decrease in income of $808,000 ($.08 per share), net of income tax benefits of $302,000.
* Effective December 31, 1993, the Company adopted Statement of Financial Accounting Standards No. 115 (SFAS 115), "Accounting for Certain Investments in Debt and Equity Securities." SFAS 115 provides that investments in all debt securities and those equity securities with readily determinable market values are to be classified in one of three categories: held-to-maturity, trading or available-for-sale. Classification of investments is based upon management's current intent. Debt securities which management has a positive intent and ability to hold to maturity are classified as "securities held-to-maturity" and are carried at amortized cost. Unrealized holding gains and losses on securities held-to-maturity are not reflected in the consolidated financial statements. Debt and equity securities that are held for current resale are classified as "trading securities" and are reported at market value, with unrealized holding gains and losses included in earnings. All other debt and equity securities are classified as "securities available-for-sale" and are carried at market value, with unrealized holding gains and losses excluded from earnings and reported as a separate component of stockholders' equity, net of tax. Adoption of this statement had no effect on the income of the Company. Unrealized holding (losses) gains on securities available-for- sale had the effect of (decreasing) increasing stockholders' equity by ($1,317,000) and $2,048,000 at December 31, 1994 and 1993, respectively, net of income taxes of $0 and $1,055,000. At December 31, 1994 and 1993, the Company did not have any investments categorized as trading securities.
As previously noted, Employers Mutual voluntarily assumes reinsurance business from nonaffiliated insurance companies and cedes 95 percent of this business to the Company's reinsurance subsidiary, exclusive of certain reinsurance contracts. Prior to 1993, amounts not ceded to the reinsurance subsidiary were retained by Employers Mutual and were subject to cession to the pool members. Effective January 1, 1993, the pooling agreement was amended so that the voluntary assumed reinsurance business written by Employers Mutual is no longer subject to cession to the pool members. As a result, amounts assumed by the Company from nonaffiliates have declined from the amounts assumed in 1992. In connection with this change in the pooling agreement, the Company's liabilities decreased $4,470,000 and invested assets decreased $4,427,000. Employers Mutual reimbursed the Company $43,000 for commissions incurred to generate this business.
Prior to December 31, 1993, the parties to the pooling agreement recorded amounts assumed from the National Workers' Compensation Reinsurance Pool on a net basis. Under this approach, reserves for outstanding losses and unearned premiums were reported as liabilities under "Indebtedness to Related Party" in the Company's consolidated financial statements. Effective December 31, 1993, the parties to the pooling agreement began recording these amounts as outstanding losses and unearned premiums and restated all prior year consolidated financial statements for comparative purposes. There was no income effect from this reclassification. In connection with this gross-up of balances, amounts due from Employers Mutual increased $13,148,000 at December 31, 1993. Under the terms of the pooling agreement, these balances were settled in the first quarter of 1994.
Underwriting results have improved significantly over the last three years, primarily due to improved results in the workers' compensation line of business. Reform measures implemented by several states to control administrative costs related to workers' compensation insurance have been a major factor in this improvement. By monitoring this reform on a state by state basis and writing more business in states that show a potential for profit, management has been able to achieve improved results. Underwriting results for 1994 reflect a net decline of $6,332,000 in the estimate of prior year loss reserves. This decline reflects savings associated with the reform measures noted above. Underwriting results for 1993 and 1992 were negatively impacted by reserve strengthening in the workers' compensation line of business related to greater than expected increases in the price and usage of drugs, medical durables and medical services. Results for 1992 also reflect $1,427,000 of underwriting losses associated with the voluntary assumed reinsurance business written by Employers Mutual that effective January 1, 1993 is no longer subject to cession to the pool members.
Effective January 1, 1993, the quota share agreement was amended so that losses in excess of $1,000,000 per event are retained by Employers Mutual. The reinsurance subsidiary pays an annual override commission to Employers Mutual for this additional protection, which totaled $2,095,000 in 1994 and $1,809,000 in 1993. The reinsurance subsidiary also pays for 95 percent of the outside reinsurance protection Employers Mutual purchases to protect itself from catastrophic losses on the assumed reinsurance business. This cost is recorded as a reduction to the premiums received by the reinsurance subsidiary and amounted to $2,563,000 and $2,867,000 in 1994 and 1993, respectively. Employers Mutual retained losses and settlement expenses totaling $7,020,000 in 1994 and $615,000 in 1993 under this agreement. In conjunction with this amendment to the quota share agreement, the reinsurance subsidiary terminated its catastrophe reinsurance contracts with Employers Mutual and other nonaffiliated reinsurers. Effective January 1, 1993, the reinsurance subsidiary no longer cedes reinsurance to nonaffiliated reinsurers and only cedes reinsurance to Employers Mutual under an aggregate "excess of loss" treaty.
Effective June 30, 1993, Employers Mutual commuted the portion of the quota share agreement that pertained to a casualty pool that is in a run-off position. In connection with this change in the quota share agreement, the Company's liabilities decreased $19,783,000 and invested assets decreased $17,806,000. The reserve discount amount of $1,977,000 was recorded as deferred income and is being amortized into operations over the estimated settlement period of the reserves, which is ten years. The amount recognized as income totaled $434,000 in 1994 and $259,000 in 1993.
During 1994, the reinsurance subsidiary commuted all outstanding reinsurance balances ceded to Employers Mutual under catastrophe and aggregate excess of loss reinsurance treaties related to accident years 1991 through 1993. In connection with these commutations, the Company's assets and liabilities increased $687,000. There was no income effect from these commutations.
The reinsurance subsidiary has an aggregate excess of loss treaty with Employers Mutual which provides protection from a large accumulation of retentions resulting from multiple catastrophes in any one year. The coverage provided is $2,000,000, excess of $2,500,000 aggregate loss retained, excess of $200,000 per event. Maximum recovery is limited to $4,000,000 per accident year. The reinsurance subsidiary recovered $0, $144,000 and $4,221,000 under this treaty and paid reinstatement premiums of $0, $280,000 and $745,000 in 1994, 1993 and 1992, respectively. Total premiums paid to Employers Mutual amounted to $558,000, $708,000 and $1,125,000 in 1994, 1993 and 1992, respectively.
Operating results for the three years ended December 31, 1994 are as follows:
Premiums earned have increased steadily over the last three years. Under the terms of the amended quota share agreement with Employers Mutual, the amounts for 1994 and 1993 reflect a reduction of $2,836,000 and $2,439,000, respectively, related to the reinsurance subsidiary's payment of 95 percent of the cost of the reinsurance protection purchased by Employers Mutual to protect itself from catastrophic losses. Prior to 1993, the reinsurance subsidiary purchased its own catastrophe protection. Premiums earned for 1992 reflect $6,481,000 in premiums ceded (including $3,149,000 of reinstatement premiums) to Employers Mutual and other nonaffiliated reinsurers for this catastrophe protection. Operations for 1994 and 1993 reflect a shift from catastrophe "excess of loss" business to "pro rata" business. Premiums earned for 1994 reflect an increased participation in a voluntary pool and additional premium volume on new and existing pro rata contracts. Rates for pro rata business deteriorated somewhat during 1994 due to competitive market conditions at the primary company level.
Due to poor underwriting results achieved over the last several years, four large national pro rata contracts with approximately $3,500,000 of earned premium were cancelled effective December 31, 1994. As a result of these cancellations, earned premiums for 1995 are expected to remain relatively flat. During 1995, more emphasis will be placed upon writing excess of loss business in non-hurricane prone areas and increasing participation on existing contracts that have favorable terms. Pro rata business will continue to be written, but the focus will be on properly structured regional accounts rather than large national accounts. This gradual movement towards excess of loss business is prompted by the continued deterioration of pro rata rates and a greater control over the pricing of excess of loss business.
The nonstandard risk marketplace is very competitive. Policies are written for relatively short periods of time and insureds continually search for the most attractive rates. In response to favorable results achieved in prior years, the company began increasing market share in 1992 by offering more competitive rates. The company experienced adverse selection in this new business as the standard market began to accept more of the marginal risks during this same time period. As a result, losses associated with this new business exceeded the premiums received.
Investment income has declined slightly over the last three years. This decline is due to reduced interest rates available for current investments.
Operating income before income taxes increased to $505,000 in 1994 from $103,000 in 1993 and $496,000 in 1992. The improvement in 1994 is the result of a new management plan put into effect which places more emphasis on writing excess and surplus lines business through Employers Mutual's agency force. Operating results for 1993 and 1992 were negatively impacted by the termination of business with a large agency that had previously represented over 50 percent of this segment's volume.
Operating loss before income taxes decreased to $84,000 in 1994 from $161,000 in 1993 and a profit of $171,000 in 1992. The improvement in 1994 reflects a decline in operating expenses and an increase in investment income. The large decline in 1993 reflects a substantial reduction in investment income. Invested assets decreased in 1993 due to a capital contribution made to the reinsurance subsidiary in 1992 and a reduction in the amount of dividends received from the insurance company subsidiaries.
Over the last several years, the Company's financial results have not been materially affected by losses associated with environmental and asbestos claims. The Company's environmental claims activity is predominately from hazardous waste and pollution-related claims. The parties to the pooling agreement have not written primary coverage for the major oil or chemical companies; the greatest exposure arises out of commercial general liability and umbrella policies issued to municipalities during the 1970s which allegedly cover contamination emanating from closed landfills. The remaining exposure is for claims from small regional operations or local businesses involved with disposing wastes at dump sites or having pollution on their own property due to hazardous material use or leaking underground storage tanks. These insureds include small manufacturing operations, tool makers, automobile dealerships, contractors, gasoline stations and real estate developers.
During 1994, Congress debated potential reforms to the "Superfund" law which included a new tax on commercial lines insurance companies. This tax would have been used to fund clean-up costs and settle lawsuits between potentially responsible parties and their insurers. This legislation was not successful in 1994 and it is currently unknown whether similar legislation will be introduced in 1995.
The major ongoing sources of the Company's liquidity are insurance premium income, investment income and cash provided from maturing or liquidated investments. The principal outflows of cash are payments of claims, commissions, premium taxes, operating expenses, income taxes, dividends and investment purchases.
During 1994, the Company generated positive cash flows from operations of $39,006,000, which included $13,148,000 related to the gross-up of reserve amounts associated with the National Workers' Compensation Reinsurance Pool, as previously noted. This compares to a negative operating cash flow of $8,794,000 in 1993, which included $24,853,000 paid to Employers Mutual in connection with the change in the property and casualty insurance subsidiaries' pooling agreement relating to the voluntary assumed reinsurance business and the commutation of two reinsurance contracts under the reinsurance subsidiary's quota share agreement. Operating cash flows of $50,826,000 in 1992 included $29,402,000 received from Employers Mutual in connection with the increase in the property and casualty insurance subsidiaries' pool participation.
A major source of cash flows for the holding company is dividend payments from its subsidiaries. State insurance regulations restrict the maximum amount of dividends insurance companies can pay without prior regulatory approval. See note 7 of Notes to Consolidated Financial Statements for additional information regarding dividend restrictions. The Company collected $3,068,000, $860,000 and $3,288,000 of dividends from its insurance subsidiaries in 1994, 1993 and 1992, respectively. The Company paid cash dividends to stockholders totaling $3,511,000, $3,443,000 and $5,104,000 in 1994, 1993 and 1992, respectively. The decrease from 1992 is due to the fact that Employers Mutual received 50 percent of its dividends in common stock under the Company's dividend reinvestment and common stock purchase plan in 1994 and 1993.
The National Association of Insurance Commissioners (NAIC) adopted certain risk-based capital standards in 1994 for property and casualty insurance companies. Risk-based capital requirements attempt to measure minimum statutory capital needs based upon the risks in a company's mix of products and investment portfolio. The formula has been designed to help state regulators assess capital adequacy of insurance companies and identify property/casualty insurers that are in (or are perceived as approaching) financial difficulty by establishing minimum capital needs based upon the risks applicable to the operations of the individual insurer. The formula takes into consideration industry performance and individual insurer financial characteristics by examining a number of financial criteria to test its perceived levels of risk against assets available to bear such risks. The model act adopted by the NAIC provides a minimum level of capital at which a State Commissioner of Insurance may act to place an insurer under certain restraints or in the worst case, to place an insurer under his or her control. These risk-based capital rules are a quantitative measurement technique which purport to quantify the minimum amount of capital necessary to match the degree of financial risk. It is a method for specifying how much minimum capital an insurer must have, based on the risks it has assumed, to assure that it maintains an acceptably low probability of financial impairment.
The risk-based capital requirements measure three major areas of risk facing property and casualty insurers: asset risk, credit risk and underwriting risk. Companies having less statutory surplus than required by the risk-based capital requirements are subject to varying degrees of regulatory scrutiny and intervention, depending on the severity of the inadequacy. The Company's insurance subsidiaries' ratio of total adjusted capital to risk-based capital at December 31, 1994 is well in excess of the minimum level required.
The consolidated financial statements are examined by KPMG Peat Marwick LLP, independent certified public accountants. Their report appears elsewhere in this annual report.
/s/ E. H. Creese ------------------------------------ E. H. Creese, C.P.A. Senior Vice President, Treasurer and Chief Financial Officer
Cash .............................................. 1,258,221 675,203 Indebtedness of related party (note 4) ............ - 12,291,512 Accrued investment income ......................... 5,560,633 4,835,451 Accounts receivable ............................... 1,280,550 415,215 Deferred policy acquisition costs ................. 8,393,635 7,698,864 Deferred income taxes (note 11) ................... 14,190,499 13,040,693 Intangible assets, including goodwill, at cost less accumulated amortization of $1,674,643 and $1,540,130 .................................. 1,883,177 2,017,690 Reinsurance receivables (note 3) .................. 14,935,048 18,477,406 Prepaid reinsurance premiums (note 3) ............. 2,121,033 2,832,184 Other assets ...................................... 1,575,540 2,084,102 ------------ ------------ Total assets ............................... $387,369,878 $368,935,523 ============ ============
CUMULATIVE EFFECT OF CHANGES IN ACCOUNTING PRINCIPLES FOR: Income taxes (note 11) .......... - 5,595,177 - Postretirement benefits (note 13) - (2,165,900) - Unearned premiums (note 1) ...... - (807,933) - ------------ ------------ ------------ Net income ................. $ 13,505,727 $ 9,755,379 $ 215,692 ============ ============ ============
Year ended December 31, ---------------------------------------- 1994 1993 1992 ------------ ------------ ------------ EARNINGS PER COMMON SHARE:
Income before cumulative effect of changes in accounting principles $ 1.29 $ .70 $ .02
Year ended December 31, ------------------------------------- 1994 1993 1992 ----------- ----------- ----------- Common stock, beginning of year ........ $10,325,329 $10,161,760 $10,082,675 Issuance of common stock: Stock option plans ................. 41,694 31,252 79,085 Dividend reinvestment plan ......... 220,606 132,317 - ----------- ----------- ----------- Common stock, end of year .............. 10,587,629 10,325,329 10,161,760 ----------- ----------- -----------
Treasury stock at cost, beginning of year ................. (81,386) (483,344) (341,616) Purchase of shares for the treasury (28,681) (126,948) (315,749) Sale of shares from the treasury .... - 528,906 174,021 ------------ ------------ ------------ Treasury stock at cost, end of year (110,067) (81,386) (483,344) ------------ ------------ ------------ Total stockholders' equity ..... $116,726,689 $109,633,769 $100,910,777 ============ ============ ============
Cash provided by the commutation of outstanding reinsurance balances by the reinsurance subsidiary (note 2) ............ 686,962 - -
Cash used in the commutation of two reinsurance contracts under the reinsurance subsidiary's quota share agreement (note 2) - (20,425,955) - ----------- ----------- ----------- Total adjustment ............. 25,499,823 (18,548,921) 50,610,716 ----------- ----------- ----------- Net cash provided by (used in) operating activities $39,005,550 $(8,793,542) $50,826,408 ----------- ----------- -----------
CASH FLOWS FROM FINANCING ACTIVITIES: Issuance of common stock .......... 491,676 331,568 748,405 Dividends paid to stockholders (note 14(c)) ....... (3,510,555) (3,443,465) (5,103,890) Purchase of treasury stock, net ... (28,681) (118,641) (278,241) ------------- ------------ ------------ Net cash used in financing activities ............... (3,047,560) (3,230,538) (4,633,726) ------------- ------------ ------------ NET INCREASE (DECREASE) IN CASH ..... 583,018 (1,334,309) 1,407,617 Cash at beginning of year ........... 675,203 2,009,512 601,895 ------------- ------------ ------------ Cash at end of year ................. $ 1,258,221 $ 675,203 $ 2,009,512 ============= ============ ============
The consolidated financial statements have been prepared on the basis of generally accepted accounting principles (GAAP) which differ in some respects from those followed in reports to insurance regulatory authorities. All significant intercompany balances and transactions have been eliminated.
Income is derived from fees and commissions which are realized when earned. Costs of doing business are expensed as incurred.
Effective December 31, 1993, the Company adopted Statement of Financial Accounting Standards No. 115 (SFAS 115) "Accounting for Certain Investments in Debt and Equity Securities." SFAS 115 requires that investments in all debt securities and those equity securities with readily determinable market values be classified into one of three categories: held-to-maturity, trading or available-for-sale. Classification of investments is based upon management's current intent. Debt securities which management has a positive intent and ability to hold until maturity are classified as securities held-to-maturity and are carried at amortized cost. Unrealized holding gains and losses on securities held-to-maturity are not reflected in the consolidated financial statements. Debt and equity securities that are held for current resale are classified as trading securities and are carried at market value, with unrealized holding gains and losses included in earnings. All other debt and equity securities not included in the above two categories are classified as securities available-for-sale and are carried at market value, with unrealized holding gains and losses reported as a separate component of stockholders' equity, net of tax. Adoption of this statement had no effect on the income of the Company. Unrealized holding (losses) gains on securities available-for- sale had the effect of (decreasing) increasing stockholders' equity by ($1,316,596) and $2,048,651 at December 31, 1994 and 1993, respectively, net of income taxes of $0 and $1,055,365. At December 31, 1994 and 1993, the Company did not have any investments categorized as trading securities.
The Company's carrying value for investments is reduced to its estimated realizable value if a decline in the market value is deemed other than temporary. Such reductions in carrying value are recognized as realized losses and charged to income. Premiums and discounts on debt securities are amortized over the life of the security as an adjustment to yield using the effective interest method. Realized gains and losses on disposition of investments are included in net income. The cost of investments sold is determined on the first-in, first-out method. Included in investments at December 31, 1994 and 1993 are securities on deposit with various regulatory authorities as required by law amounting to $11,331,550 and $11,329,402, respectively.
Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 106 (SFAS 106), "Employers' Accounting for Postretirement Benefits Other Than Pensions." Under SFAS 106, the cost of postretirement benefits other than pensions must be recognized on an accrual basis as employees perform services to earn the benefits. Prior to 1993, the cost of retiree health care and life insurance benefits were recognized as expenses when paid.
Effective January 1, 1994, the Company adopted Statement of Financial Accounting Standards No. 112 (SFAS 112), "Employers Accounting for Postemployment Benefits." SFAS 112 requires that the cost of certain postemployment benefits that vest or accumulate be accrued over the period of an employee's service. Adoption of this standard had no effect on the income of the Company.
Deferred income taxes are provided for temporary differences between financial statement carrying values of assets and liabilities and their respective tax bases. Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 109 (SFAS 109), "Accounting for Income Taxes." Under SFAS 109, deferred tax assets are recognized for deductible temporary differences and operating loss and tax credit carryforwards, and then a valuation allowance is established to reduce that deferred tax asset if it is "more likely than not" that the related tax benefits will not be realized. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities from a change in tax rates is recognized in income in the period that includes the enactment date. Prior to 1993, the Company computed deferred income taxes in accordance with Statement of Financial Accounting Standards No. 96.
Goodwill, which represents the excess of cost over the fair value of net assets of acquired subsidiaries, is being amortized on a straight-line basis over 25 years. The Company reviews the recoverability of the unamortized balance of goodwill on a periodic basis using discounted cash flows.
The three property and casualty insurance subsidiaries of the Company and two subsidiaries of Employers Mutual are parties to reinsurance pooling agreements with Employers Mutual (collectively the "pooling agreement"). Under the terms of the pooling agreement, each company cedes to Employers Mutual all of its insurance business and assumes from Employers Mutual an amount equal to its participation in the pool. All losses, settlement expenses and other underwriting and administrative expenses, excluding the voluntary reinsurance business assumed by Employers Mutual from unaffiliated insurance companies, are prorated among the parties on the basis of participation in the pool. Operations of the pool give rise to intercompany balances with Employers Mutual, which are settled on a quarterly basis. The investment programs and income tax liabilities of the pool participants are not subject to the pooling agreement.
As noted above, the reinsurance subsidiary assumes a 95 percent quota share portion of Employers Mutual's assumed reinsurance business, exclusive of certain reinsurance contracts. The reinsurance subsidiary receives 95 percent of all premiums and assumes 95 percent of all related losses and settlement expenses of this business. The reinsurance subsidiary does not reinsure any of Employers Mutual's direct insurance business, nor any "involuntary" facility or pool business that Employers Mutual assumes pursuant to state law. In addition, the reinsurance subsidiary is not liable for credit risk in connection with the insolvency of any reinsurers of Employers Mutual.
As of December 31, 1994, deductions for reinsurance ceded to two unaffiliated reinsurers aggregated $10,066,293, which represented a significant portion of the total prepaid reinsurance premiums and reinsurance receivables for losses and settlement expenses. These amounts reflect the property and casualty insurance subsidiaries' pool participation percentage of amounts ceded by Employers Mutual to these organizations in connection with its role as "service carrier". Under these arrangements, Employers Mutual writes business for these organizations on a direct basis and then cedes 100 percent of this business to these organizations. Credit risk associated with these amounts is minimal as all companies participating in these organizations are responsible for the liabilities of such organizations on a pro rata basis.
The effect of reinsurance on premiums written and earned, and losses and settlement expenses incurred for the three years ended December 31, 1994 is presented below. Amounts for the years ended December 31, 1994 and 1993 reflect (1) the change in the property and casualty insurance subsidiaries' pooling agreement whereby effective January 1, 1993, the voluntary assumed reinsurance business written by Employers Mutual is no longer subject to cession to the pool members and (2) the amendment to the reinsurance subsidiary's quota share agreement whereby effective January 1, 1993, losses in excess of $1,000,000 per event are retained by Employers Mutual and the reinsurance subsidiary therefore no longer purchases catastrophe protection (see note 2).
Ceded reserves for losses and settlement expenses, beginning of year .......................... 17,454,679 25,253,507 13,951,033 ------------ ------------ ------------ Net reserves for losses and settlement expenses, beginning of year .......................... 179,667,173 190,135,358 144,863,097 ------------ ------------ ------------ Incurred losses and settlement expenses: ------------------------- Provision for insured events of the current year ............ 123,343,829 119,896,526 116,615,951
(Decrease) increase in provision for insured events of prior years .......................... (6,399,775) 458,773 5,471,882 ------------ ------------ ------------ Total incurred losses and settlement expenses ...... 116,944,054 120,355,299 122,087,833 ------------ ------------ ------------ Payments: --------- Losses and settlement expenses attributable to insured events of the current year ............ 48,771,573 47,600,851 46,436,360
Ceded reserves for losses and settlement expenses, end of year 14,146,874 17,454,679 25,253,507 ------------ ------------ ------------ Gross reserves for losses and settlement expenses, end of year $203,181,615 $197,121,852 $215,388,865 ============ ============ ============
Underwriting results of the Company are significantly influenced by estimates of loss and settlement expense reserves. Changes in reserve estimates are reflected in operating results in the year such changes are recorded. During 1992, the property and casualty insurance subsidiaries and the nonstandard risk automobile insurance subsidiary strengthened prior year reserves on certain lines of business and the reinsurance subsidiary experienced a time lag in the reporting of assumed reinsurance business. During 1993, the property and casualty insurance companies continued to strengthen reserves on certain lines of business while the reinsurance subsidiary experienced adverse development on losses associated with Hurricane Andrew. These reserve increases in 1992 and 1993 were partially offset by reserve decreases on other lines of business, resulting in a net increase in the Company's estimate of prior year reserves of $5,471,882 in 1992 and $458,773 in 1993. During 1994, the reinsurance subsidiary experienced adverse development on certain contracts. These reserve increases were offset by significant reserve decreases in the property and casualty insurance subsidiaries and the nonstandard risk automobile insurance subsidiary. As a result, the net decrease in the Company's estimate of prior year reserves in 1994 amounted to $6,399,775.
Retained earnings of the Company's insurance subsidiaries available for distribution as dividends to EMC Insurance Group Inc. are limited by law to the statutory unassigned surplus of each of the subsidiaries as of the previous December 31, as determined in accordance with accounting practices prescribed by insurance regulatory authorities of the state of domicile of each subsidiary. Subject to this limitation, the maximum dividend that may be paid by Iowa corporations without prior approval of the insurance regulatory authorities is restricted to the greater of 10 percent of statutory surplus as regards policyholders as of the preceding December 31, or net income of the preceding calendar year on a statutory basis. Both Illinois and North Dakota impose restrictions which are similar to those of Iowa on the payment of dividends and distributions. At December 31, 1994, $15,513,214 was available for distribution in 1995 to EMC Insurance Group Inc. without prior approval.
During 1994, the National Association of Insurance Commissioners implemented the Risk-Based Capital (RBC) model. The risk-based capital requirements for property and casualty insurance companies measure three major areas of risk facing property and casualty insurers: asset risk, credit risk and underwriting risk. Companies having less statutory surplus than required by the risk-based capital requirements are subject to varying degrees of regulatory scrutiny and intervention, depending on the severity of the inadequacy. The Company's insurance subsidiaries' ratio of total adjusted capital to risk-based capital at December 31, 1994 is well in excess of the minimum level required.
A reconciliation of net income and surplus from that reported on a statutory basis to that reported in the accompanying consolidated financial statements on a GAAP basis is as follows:
Year ended December 31, ------------------------------------- 1994 1993 1992 ----------- ----------- ----------- Statutory net income (loss) ........... $13,697,482 $ 8,761,472 $(3,118,589) Change in deferred policy acquisition costs ................... 694,771 (413,967) 2,189,375 Change in salvage and subrogation accrual ............................. 5,851 (232,760) 742,233 Change in other policyholders' funds .. (247,816) 840,604 (880,866) Change in pension accrual ............. (298,021) (103,846) 622,177 GAAP postretirement benefit cost in excess of statutory cost ......... (314,583) (216,091) - Deferred income tax benefit ........... 94,441 18,027 1,501,430 Statutory gain on sale of life subsidiary ..................... - - (474,356) Prior year taxes and related interest (180,770) 817 (387,351) GAAP basis amortization of reserve discount on commutation of reinsurance contract ................ 433,979 259,217 - Statutory reserve discount on commutation of reinsurance contract - (1,976,858) - Other, net ............................ (379,607) 197,420 21,639 ----------- ----------- ----------- Income before cumulative effect of changes in accounting principles, GAAP basis .......................... 13,505,727 7,134,035 215,692