The following table sets forth selected consolidated financial data for MIG at and for each of the years in the five year period ended December 31, 2007. You should read this data in conjunction with the Group’s consolidated financial statements and accompanying notes, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and other financial information included elsewhere in this report.
Costs and expenses related to the stock conversion incurred in the year ended December 31, 2003. Stock conversion expenses consist primarily of the costs of engaging independent accounting, valuation, legal and other consultants to advise us and our insurance regulators as to the stock conversion process and related matters, as well as printing and postage costs relating to our communications with our policyholders. These costs and expenses are reported in accordance with the American Institute of Certified Public Accountants Statement of Position (“SOP”) 00-3, “Accounting by Insurance Enterprises for Demutualizations and Formations of Mutual Insurance Holding Companies and for Certain Long-Duration Participating Contracts.”
SOP 00-3 addresses financial statement presentation and accounting for stock conversion expenses and accounting for retained earnings and other comprehensive income at the date of the stock conversion.
Income of the Group attributable to the minority interest in FHC, which interest was acquired by the Group immediately after the Conversion for shares of the Group.
Includes Net Income and the change in Unrealized Gains and Losses of the investment portfolio.
specific adverse events affecting the issuers of debt obligations held by the Group;
Reserves are closely monitored and are recomputed periodically using the most recent information on reported claims and a variety of actuarial techniques. Specifically, on a quarterly basis, we review, by line of business, existing reserves, new claims, changes to existing case reserves, and paid losses with respect to the current and prior accident years. We use historical paid and incurred losses and accident year data to derive expected ultimate loss and loss adjustment expense ratios by line of business. We then apply these expected loss and loss adjustment expense ratios to earned premium to derive a reserve level for each line of business. In connection with the determination of the reserves, we also consider other specific factors such as recent weather-related losses, trends in historical paid losses, and legal and judicial trends with respect to theories of liability. Some of our business relates to coverage for short-term risks, and for these risks loss development is comparatively rapid and historical paid losses, adjusted for known variables, have been a reliable predictive measure of future losses for purposes of our reserving. Some of our business relates to longer-term risks, where the claims are slower to emerge and the estimate of damage is more
We maintain IBNR reserves to provide for already incurred claims that have not yet been reported and developments on reported claims. The IBNR reserve is determined by estimating our insurance companies’ ultimate net liability for both reported and IBNR claims and then subtracting the case reserves and payments made to date for reported claims.
6. Ratios of cumulative average paid loss per claim closed with payment and of average case reserve per pending claim.
The reported loss development method relies on the assumption that, at any given state of maturity, ultimate losses can be predicted by multiplying cumulative reported losses (paid losses plus case reserves) by a cumulative development factor. The validity of the results of this method depends on the stability of claim reporting and settlement rates, as well as the consistency of case reserve levels. Case reserves do not have to be adequately stated for this method to be effective; they only need to have a fairly consistent level of adequacy at comparable stages of maturity. Historical “age-to-age” loss development factors are calculated to measure the relative development of an
The validity of the results from using a loss development approach can be affected by many conditions, such as internal claim department processing changes, a shift between single and multiple claim payments, legal changes, or variations in a company’s mix of business from year to year. Also, since the percentage of losses paid for immature years is often low, development factors are volatile. A small variation in the number of claims paid can have a leveraging effect that can lead to significant changes in estimated ultimates. Therefore, ultimate values for immature accident years are often based on alternative estimation techniques.
Unrealized investment gains or losses on investments carried at fair value, net of applicable income taxes, are reflected directly in Stockholders’ Equity as a component of accumulated other comprehensive income and, accordingly, have no effect on net income. A decline in fair value of an investment below its cost that is deemed other than temporary is charged to earnings as a realized loss. We monitor our investment portfolio and review investments that have experienced a decline in fair value below cost to evaluate whether the decline is other than temporary. These evaluations involve judgment and consider the magnitude and reasons for a decline and the prospects for the fair value to recover in
Many of the reinsurance treaties participated in by the Group prior to 2007 and primarily FPIC treaties have included provisions that establish minimum and maximum cessions and allow limited participation in the profit of the ceded business. Generally, the Group shares on a limited basis in the profitability of our reinsurance treaties through contingent ceding commissions. The Group’s exposure in the loss experience is contractually defined at minimum and
maximum levels. The terms of such contracts are fixed at inception. Since estimating the emergence of claims to the applicable reinsurance layers is subject to significant uncertainty, the net amounts that will ultimately be realized may vary significantly from the estimated amounts presented in the Group’s results of operations.
The key elements of the Group’s business model are the sales of properly priced and underwritten personal and commercial property and casualty insurance through independent agents and the investment of the premiums in a manner designed to assure that claims and expenses can be paid while providing a return on the capital employed. Loss trends and investment performance are critical factors in influencing the success of the business model. These factors are affected by the factors impacting the insurance industry in general and factors unique to the Group as described in the following discussion.
Our growth in premiums, underwriting results and investment income have been, and continue to be, influenced by market conditions, as well as the acquisition of FPIG on October 1, 2005. The Group’s financial statements include FPIG and its results of operations for the entire year of 2007 and 2006 and for the period of October 1, 2005 through December 31, 2005.
Our premiums earned mix reflects the Group’s focus on growing the commercial lines book, while working within our underwriting standards.
Pricing in the property and casualty insurance industry historically has been and remains cyclical. During a soft market cycle, price competition is prevalent, which makes it difficult to write and retain properly priced personal and commercial lines business. Our policy is to maintain disciplined underwriting and pricing standards during soft markets, declining business which is inadequately priced for its level of risk. The current market is highly competitive, with pricing and coverage competition being seen in virtually all classes of commercial accounts, package policies, and commercial automobile policies and in the Pennsylvania personal auto market and Pennsylvania and New Jersey homeowners markets, all of which impacts our ability to retain our accounts on renewal, or to renew a policy at expiring premium. We continue to work with our agents to target classes of business and accounts compatible with our underwriting appetite, which includes certain types of religious institution risks, contracting risks, small business risks and property risks. As a result of what management believes is a soft market, commercial lines direct written premium declined in 2007, as compared to 2006, due in part to increased competition and reduced audit premium on expired business, among other factors discussed more in detail below in the 2007 vs. 2006 Revenue discussion.
The Group does not write homeowners insurance or other personal lines in California, nor does it have significant exposure to commercial risks in the areas affected by the recent wildfires in Southern California. Consequently, the Company expects to have very limited claim activity in connection with such wildfires.
$1.9 million in 2007 and 2006 represents service charges recorded on insurance premiums. Interest expense of $1.2 million in 2007 and 2006 represents interest charges on the trust preferred obligations of FPIG.
In 2007, direct premiums written decreased $2.8 million or 1.5% to $182.9 million in 2007 as compared to $185.7 million in 2006. The decline in direct premiums written is attributed to a more difficult economic environment and competitive market conditions, including a decline in construction related activity and related audit premium in California, increased competition on large accounts as well as the return of a number of competitors to the California contractor market and the East Coast habitational market.
The decline in year-to-date audit premium, as compared to the prior year, relates to a general decline in construction related activity, specifically in California, driven by a slowdown of the residential housing market. Approximately 50% of FPIC’s business (and approximately one-third of the Group’s business in total) is related to artisan contractor liability, primarily in the central valley of California.
Effective January 1, 2006, FPIC restructured its property reinsurance agreement covering the first $2.0 million of loss from an 80% quota share to an $1,650,000 excess of $350,000 excess of loss contract to take advantage of the Group’s combined capital. The restructuring also included the assumption of ceded unearned premium at January 1, 2006 by FPIC from the 2005 property quota share and casualty excess of loss agreements. These assumed premiums were then ceded into the respective 2006 treaties, which due to the reduced ceding rates, resulted in a $5.6 million increase in net written and earned premium for 2006. There was no similar impact in 2007 relating to this restructuring.
Effective, January 1, 2007, the Group consolidated the reinsurance program of all subsidiaries into a single program, and increased its reinsurance retention to $750,000 (from a maximum retention of $500,000 in 2006) on the working layer for all casualty, property and workers’ compensation lines of business. The effect of this change in reinsurance arrangements increased net premiums written for 2007.
The estimated fair value and unrealized loss for securities in a temporary unrealized loss position as of December 31, 2007 are as follows:
Results of our Commercial Lines segment were as follows. In 2007, the Group evaluated its methodology for allocating costs to its lines of business and adopted changes to such methodology in order to more accurately reflect the allocation of joint costs. This resulted in allocating less joint cost to the personal lines of business and more joint cost to the commercial lines of business, but with no net change in cost allocated to personal lines and commercial lines in the aggregate. Related 2006 and 2005 amounts have been reclassified to reflect this change in allocation methodology:
Results of our Personal Lines segment were as follows. In 2007, the Group evaluated its methodology for allocating costs to its lines of business and adopted changes to such methodology in order to more accurately reflect the allocation of joint costs. This resulted in allocating less joint cost to the personal lines of business and more joint cost to the commercial lines of business, but with no net change in cost allocated to personal lines and commercial lines in the aggregate. Related 2006 and 2005 amounts have been reclassified to reflect this change in allocation methodology:
Federal income tax expense was $5.8 million and $4.4 million for 2007 and 2006, respectively. The effective tax rate was 28.8% and 29.5% for 2007 and 2006, respectively. The 2007 effective tax rate was impacted by an unusually high amount of taxable income in the period caused by the retaliatory tax refund, offset by higher tax-advantaged income (municipal bond interest and dividend income, which reduce the effective tax rate).
YEAR ENDED DECEMBER 31, 2006 COMPARED TO YEAR ENDED DECEMBER 31,
The components of income for 2006 and 2005, and the change and percentage change from year to year, are shown in the charts below. The accompanying narrative refers to the statistical information displayed in the chart immediately above the narrative. In 2007, the Group evaluated its methodology for allocating costs to its lines of business and adopted changes to such methodology in order to more accurately reflect the allocation of joint costs. This resulted in allocating less joint cost to the personal lines of business and more joint cost to the commercial lines of business, but with no net change in cost allocated to personal lines and commercial lines in the aggregate. Related 2006 and 2005 amounts have been reclassified to reflect this change in allocation methodology:
The Group’s GAAP combined ratio for 2006 was 97.0%, as compared to a combined ratio for the prior year of 94.9%. The statutory combined ratio for 2006 and 2005 was 95.2% and 94.1%, respectively. Our commercial lines underwriting income benefited from the contribution of FPIC, which was acquired on October 1, 2005. The personal lines performance, while benefiting from rate increases initiated in 2005 on our homeowners line of business and a redirection of our Pennsylvania personal auto book to better performing tiers of business, underperformed the prior year. Frequency and severity of claims on personal lines was within the normal range of expectations during 2006. Frequency of losses reported on our commercial lines was also within a normal range of our expectations and we experienced a slight increase in severity during 2006 as compared to 2005.
Total revenues for 2006 increased $68.7 million or 84.5% to $149.9 million as compared to $81.3 million in 2005. This increase was due primarily to inclusion of the revenue of FPIG for the entire year of 2006 compared to inclusion of revenue of FPIG for only the fourth quarter in 2005. FPIG contributed $84.9 million and $15.9 million in revenue for the year ending December 31, 2006 and fourth quarter ending December 31, 2005, respectively. Net premiums earned totaled $137.7 million in 2006 as compared to $74.8 million in 2005, representing an 84.2% or $62.9 million increase. This increase was due to the FPIG acquisition which contributed $77.3 million and $13.9 million in net premiums earned for the year ending December 31, 2006 and fourth quarter ending December 31, 2005, respectively. Realized investment gains amounted to $151,000 in 2006 as compared to $1.3 million in 2005. The gains in 2005 were the result of sales of mostly equity securities to fund the FPIG acquisition. Net realized gains in 2006 and 2005 also include the mark-to-market fair value adjustment on the interest rate swaps related to the floating-rate trust preferred securities. The mark-to-market on the swaps resulted in a realized (loss)/gain of $(94,000) and $122,000 in 2006 and 2005, respectively.
Investment expenses increased 15.3%, or $0.3 million, to $2.3 million in 2006 from $2.0 million in 2005. Although a full year of expenses are included for FPIG as compared to only a quarter in 2005, investment expenses increased by only 15.3% in 2006 as compared to a 91.0% increase in gross investment income. This reflects cost savings achieved by the Group in consolidating investment strategies, policies and external advisors. As of January 1, 2006, the Group consolidated investment managers and uses only one manager/advisor for all insurance subsidiaries in the Group.
The estimated fair value and unrealized loss for securities in a temporary unrealized loss position as of December 31, 2006 are as follows:
In the commercial lines segment for 2006, we had underwriting income of $4.2 million, a GAAP combined ratio of 96.5%, a GAAP loss and loss adjustment expense ratio of 63.7% and a GAAP underwriting expense ratio of 32.8%, compared to underwriting income of $3.4 million, a GAAP combined ratio of 93.5%, a GAAP loss and loss adjustment expense ratio of 58.3% and a GAAP underwriting expense ratio of 35.2% in 2005. Our commercial lines loss ratio for 2006 reflects a frequency of losses reported within a normal range of our expectations, and includes a slight increase in severity compared to 2005.
lines in the aggregate. Related 2006 and 2005 amounts have been reclassified to reflect this change in allocation methodology:
In the personal lines segment for 2006, we had an underwriting loss of $0.1 million, a GAAP combined ratio of 100.3%, a GAAP loss and loss adjustment expense ratio of 63.8% and a GAAP underwriting expense ratio of 36.5%, compared to underwriting income of $0.4 million, a GAAP combined ratio of 98.1%, a GAAP loss and loss adjustment expense ratio of 57.4% and a GAAP underwriting expense ratio of 40.7% in 2005. The frequency and severity of losses in the personal lines book in 2006 was within the range of our normal expectations.
The principal source of liquidity for the Holding Company (which has modest expenses and does not currently, or for the foreseeable future, need a significant regular source of cash flow to cover these expenses other than its debt service on its indebtedness to MIC and its quarterly dividend to shareholders) is dividend payments and other fees received from the insurance subsidiaries, and payments it receives on the 10-year note it received from the ESOP (see below) when the ESOP purchased shares at the time of the Conversion.
On March 29, 2007, June 29, 2007, September 28, 2007 and December 28, 2007, MIG paid a quarterly shareholder dividend of $0.05 per common share. The amount of dividends paid out on these dates totaled $1.3 million, which amount was funded from the Group’s insurance companies, for which approval was sought and received (where necessary) from each of the insurance companies’ primary regulators.
The Group maintains an Employee Stock Ownership Plan (ESOP), which purchased 626,111 shares from the Group at the time of the Conversion in return for a note bearing interest at 4% on the principal amount of $6,261,110. MIC makes annual contributions to the ESOP sufficient for it to make its required annual payment under the terms of the loan to the Holding Company. It is anticipated that approximately 10% of the original ESOP shares will be allocated annually to employee participants of the ESOP. An expense charge is booked ratably during each year for the shares committed to be allocated to participants that year, determined with reference to the fair
market value of the Group’s stock at the time the commitment to allocate the shares is accrued and recognized. The issuance of the shares to the ESOP was fully recognized in the Additional Paid-in Capital account at Conversion, with a contra account entitled Unearned ESOP Shares established in the Stockholders’ Equity section of the balance sheet for the unallocated shares at an amount equal to their original per-share purchase price. Shareholder dividends received on unallocated ESOP shares are used to pay-down principal and interest owed on the loan to the Holding Company.
The Group adopted a stock-based incentive plan at its 2004 annual meeting of shareholders. Pursuant to that plan, the Group may issue a total of 876,555 shares, which amount will increase automatically each year by 1% of the number of shares outstanding at the end of the preceding year. At December 31, 2007, the shares authorized under the plan have been increased under this provision to 1,075,870 shares. During 2007, the Group made no grants of restricted stock, incentive stock options and non-qualified stock options. A total of 3,000 shares of restricted stock and 19,400 incentive stock options were forfeited during 2007. A total of 14,100 incentive stock options granted under the Plan were exercised during 2007. Upon exercise, new shares were issued to the option holder.
Total assets increased 8%, or $39.5 million, to $546.4 million, at December 31, 2007, from $507.0 million at December 31, 2006. The Group’s total investments increased $44.5 million or 15%, primarily due to net cash provided by operating activities. Prepaid reinsurance premiums decreased $6.9 million or 42%, primarily due to a change in certain of the Group’s reinsurance contracts for 2007, whereby fewer unearned premium reserves are ceded. Deferred policy acquisition costs increased $3.8 million or 23%, reflecting the increase to net unearned premium reserves.
Total liabilities increased 6%, or $21.9 million, to $413.0 million, at December 31, 2007, from $391.1 million at December 31, 2006, primarily a result of the increase in loss and loss adjustment expense reserves of $23.9 million or 10% and the increase in unearned premiums of $6.1 million, or 7%. Other reinsurance balances decreased $9.9 million or 40%, primarily due to a change in certain of the Group’s reinsurance contracts for 2007, whereby less premium is ceded.
Total stockholders’ equity increased 15%, or $17.6 million, to $133.4 million, at December 31, 2007, from $115.8 million at December 31, 2006, primarily due to net income of $14.2 million, unrealized gains on investment securities of $2.3 million, stock compensation plan amortization of $1.0 million and ESOP shares committed of $1.2 million, issuance of common stock of $0.2 million, offset by stockholder dividends of $1.3 million.
The Group was not a party to any unconsolidated arrangement or financial instrument with special purpose entities or other vehicles at December 31, 2007 which would give rise to previously undisclosed market, credit or financing risk.
The Group and its subsidiaries have no significant contractual obligations at December 31, 2007, other than their insurance obligations under their policies of insurance, trust preferred securities, a line of credit obligation, and
We have audited the accompanying consolidated balance sheets of Mercer Insurance Group, Inc. and subsidiaries as of December 31, 2007 and 2006, and the related consolidated statements of earnings, stockholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2007. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
The Company adopted Statement of Financial Accounting Standards No. 123(R), Share Based Payment, effective January 1, 2006.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Mercer Insurance Group, Inc.’s internal control over financial reporting as of December 31, 2007, 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 17, 2008, expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.
Mercer Insurance Group, Inc. (MIG) and subsidiaries (collectively, the Group) includes Mercer Insurance Company (MIC), its subsidiaries Queenstown Holding Company, Inc. (QHC) and its subsidiary Mercer Insurance Company of New Jersey, Inc. (MICNJ), Franklin Holding Company, Inc. (FHC) and its subsidiary Franklin Insurance Company (FIC), and BICUS Services Corporation (BICUS). Effective October 1, 2005, MIG acquired Financial Pacific Insurance Group, Inc. (FPIG) and its subsidiaries Financial Pacific Insurance Company (FPIC) and Financial Pacific Insurance Agency (FPIA), which is currently inactive after having sold the opportunity to solicit renewals to an unrelated agency for a fixed commission for one year, commencing in October, 2006. FPIG also holds an interest in three statutory business trusts that were formed for the purpose of issuing Floating Rate Capital Securities (see note 18).
The companies in the Group are operated under common management. The Group’s operating subsidiaries are licensed collectively in twenty two states, but are currently focused on doing business in seven states; Arizona, California, Nevada, New Jersey, New York, Oregon and Pennsylvania. MIC and MICNJ recently became licensed to write property and casualty insurance in New York. FPIC holds an additional fifteen state licenses outside of the Group’s current focus area. Currently, only direct mail surety is being written in some of these states.
The Group’s business activities are separated into three operating segments, which are commercial lines of insurance, personal lines of insurance and the investment function. The commercial lines of business consist primarily of multi-peril and commercial auto coverage. These two commercial lines represented 64% and 17%, respectively, of the Group’s net premiums written in 2007 and 61% and 14%, respectively, of the Group’s net premiums written in 2006. The personal lines business consists primarily of homeowners insurance in Pennsylvania and New Jersey and private passenger automobile insurance in Pennsylvania. These two personal lines represented 8% and 4%, respectively, of the Group’s net written premiums in 2007 and 10% and 4%, respectively, of the Group’s net written premiums in 2006.
The consolidated financial statements are prepared in accordance with U.S. generally accepted accounting principles (GAAP), which differ in some respects from those followed in reports to insurance regulatory authorities, and include the accounts of each member of the Group since the date of acquisition. The insurance subsidiaries within the Group participate in a reinsurance pooling arrangement (the Pool) whereby each insurance affiliate’s underwriting results are combined and then distributed proportionately to each participant. FPIC joined the Pool effective January 1, 2006, after receiving regulatory approvals. Each insurer’s share in the Pool is based on their respective statutory surplus as of the beginning of each year. The effects of the Pool as well as all other significant intercompany accounts and transactions have been eliminated in consolidation.
Interest on fixed-income securities is credited to income as it accrues on the principal amounts outstanding, adjusted for amortization of premiums and accretion of discounts computed utilizing the effective interest rate method. Premiums and discounts on mortgage-backed securities are amortized/accreted using anticipated prepayments with changes in anticipated prepayments, which are evaluated semi-annually, accounted for prospectively. The model used to determine anticipated prepayment assumptions for mortgage-backed securities uses separate home sale, refinancing, curtailment, and full pay-off components, derived from a variety of industry sources as used by the Group’s fixed income securities manager.
Realized gains and losses are determined on the specific identification basis. When the fair value of any investment is lower than its cost, an assessment is made to determine if the decline is other than temporary. If the decline is deemed to be other than temporary, the investment is written down to fair value and the amount of the write-down is charged to income as a realized loss. The fair value of the investment becomes its new cost basis.
Cash and cash equivalents as of December 31, 2007 and 2006 include restricted cash of $506 and $683, respectively, consisting of funds held for surety bonds.
Investments - The fair values for fixed-income securities available for sale are based on quoted market prices, when available. If not available, fair values are based on values obtained from investment brokers. Fair values for marketable equity securities are based on quoted market prices.
Property and equipment are carried at cost less accumulated depreciation calculated on the straight-line basis. Property is depreciated over useful lives generally ranging from five to forty years. Equipment is depreciated over three to ten years.
The carrying value of property and equipment is reviewed for recoverability including an evaluation of the estimated useful lives of such assets. Impairment is recognized only if the carrying amount of the property and equipment is not recoverable from its undiscounted cash flows and is measured as the difference between the carrying amount and the fair value of the asset. A change in the estimated useful lives of such assets is treated as a change in estimate and is accounted for prospectively.
Estimates of liabilities for losses and loss adjustment are necessarily based on estimates, and the amount of losses and loss adjustment expenses ultimately paid may be more or less than such estimates. Changes in the estimates for losses and loss adjustment expenses are recognized in the period in which they are determined.
Prior to January 1, 2006, the Group accounted for this plan under the provisions of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (APB 25) and related interpretations, as permitted by SFAS No. 123, “Accounting for Stock-Based Compensation”. Under the principles of APB 25, as permitted by SFAS No. 123, stock-based compensation was recognized for grants of restricted stock in the consolidated statement of earnings for the year ended December 31, 2005, but not for grants of stock options because options granted under the plan had an exercise price equal to the market value of the underlying common stock on the date of grant. Effective January 1, 2006, the Group adopted the fair value recognition provisions of SFAS No. 123R, “Share-Based Payment”, using the modified-prospective-transition method. Consolidated statement of earnings for prior periods have not been retrospectively adjusted for SFAS No. 123R.
As of December 31, 2007, the Group has $1.0 of unrecognized total compensation cost related to non-vested stock options and restricted stock, based on the estimated grant date fair value. That cost will be recognized over the remaining weighted-average vesting period of 2.1 years.
Goodwill is tested annually for impairment, and is tested for impairment more frequently if events and circumstances indicate that the asset might be impaired. An impairment loss is recognized to the extent that the carrying amount exceeds the asset’s fair value. This determination is made at the reporting unit level and consists of two steps. First, the Group determines the fair value of a reporting unit and compares it to its carrying amount. Second, if the carrying amount of a reporting unit exceeds its fair value, an impairment loss is recognized for any excess of the carrying amount of the reporting unit’s goodwill over the implied fair value of that goodwill. The implied fair value of goodwill is determined by allocating the fair value of the reporting unit in a manner similar to a purchase price allocation, in accordance with SFAS No. 141, “Business Combinations”. The residual fair value after this allocation is the implied fair value of the reporting unit goodwill. The Group has two reporting units with goodwill as of December 31, 2007 and 2006. The Group performed the annual impairment tests as of December 31, 2007 and 2006, and the results indicated that the fair value of the reporting units exceeded their carrying amounts.
The Group entered into four interest rate swap agreements to hedge against interest rate risk on its floating rate Trust preferred securities. Interest rate swaps are contracts to convert, for a period of time, the floating rate of the Trust preferred securities into a fixed rate without exchanging the instruments themselves.
Earnings per share (EPS) is computed in accordance with SFAS No. 128, “Earnings per Share”. Basic EPS is computed by dividing income available to common shareholders by the weighted average number of common shares outstanding during the period. The computation of Diluted EPS reflects the effect of potentially dilutive securities.
In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements”, which defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. The provisions of SFAS No. 157 are effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The Group does not expect that the adoption of SFAS No. 157 will have a significant effect on operations, financial condition or liquidity.
In June 2006, the FASB issued Interpretation No. 48 (FIN 48), “Accounting for Uncertainty in Income Taxes” which clarifies the accounting for income tax reserves and contingencies recognized in an enterprise’s financial statements in accordance with SFAS No. 109, “Accounting for Income Taxes”. This Interpretation also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. On January 1, 2007, the Group adopted FIN 48. As a result of adoption, the Group recognized a previously unrecognized tax benefit of approximately $0.2 million relating to merger-related expenses for the FPIG acquisition that took place October 1, 2005. The application of FIN 48 for this unrecognized tax benefit resulted in a corresponding reduction to goodwill relating to the FPIG acquisition of $0.2 million. The adoption of FIN 48 did not
result in any adjustments to beginning retained earnings, nor have a significant effect on operations, financial condition or liquidity. As of January 1, 2007, the Group has no unrecognized tax benefits.
Reclassifications have been made in the 2006 and 2005 financial statements and notes to conform them to the presentation of the 2007 financial statements.
Includes approximately $56,142 and $48,840 (cost) and $56,637 and $48,548 (estimated fair value) of mortgage-backed securities backed by the U.S. government and government agencies as of December 31, 2007 and 2006, respectively.
The estimated market value and unrealized loss for securities in a temporary unrealized loss position as of December 31, 2007 are as follows:
Fixed maturity investments with unrealized losses for less than twelve months are primarily due to changes in the interest rate environment. At December 31, 2007 the Group has 74 fixed maturity securities with unrealized losses for more than twelve months. Of the 74 securities with unrealized losses for more than twelve months, 72 of them have fair values of no less than 94% or more of cost, and the other 2 securities have a fair value greater than 89% of cost. The fixed income portfolio is invested 100% in investment grade securities, with the exception of one corporate security held with a market value of $0.4 million, and these unrealized losses primarily reflect the current interest rate environment. The Group does not believe theses declines are other than temporary due to the credit quality of the holdings. The Group currently has the ability and intent to hold these securities until recovery.
The estimated market value and unrealized loss for securities in a temporary unrealized loss position as of December 31, 2006 are as follows:
There are 12 equity securities that are in an unrealized loss position at December 31, 2006. All of these securities have been in an unrealized loss position for less than six months. The Group believes these declines are not other than temporary as a result of reviewing the circumstances of each such security in an unrealized position. The Group currently has the ability and intent to hold these securities until recovery.
Accumulated other comprehensive income was net of deferred income taxes of $2,615 and $1,451 applicable to net unrealized investment gains at December 31, 2007 and 2006, respectively.
As a result of changes in estimates of insured events in prior years, the liabilities for losses and loss adjustment expenses increased by $8.2 million and $8.4 million in 2007 and 2006, respectively and decreased by $0.5 million 2005.
The following table presents the increase (decrease) in the liability for unpaid losses and loss adjustment expenses attributable to insured events of prior years incurred in the year ended December 31, 2007 by line of business. Amounts shown in the 2005 column of the table include all 2005 and prior accident year development for FPIC, which was acquired on October 1, 2005, and accounted for as a purchase business combination.
With $140.0 million of recorded reserves, net of reinsurance, at December 31, 2007, commercial multi-peril is the line of business that carries the largest net loss and loss adjustment expense reserves, representing 73% of the Group’s total carried net loss and loss adjustment expense reserves at December 31, 2007. As a result of changes in estimates of insured events in prior years, the liabilities for prior year losses and loss adjustment expenses for the commercial multi-peril line of business increased by $5.9 million in 2007. The majority of this development relates to loss adjustment reserves for 2005 and prior accident years of our West coast operations.
The strengthening of net loss and loss adjustment expense reserves in the commercial multi-peril line reflects refinement in the assumptions and techniques supporting the reserve estimates, primarily on the contractor liability book of business. Contractor liability claims, particularly construction defect claims, are long-tailed in nature and develop over a period of ten to twelve years, based on the related statute of limitations. The increase in our estimates of insured events of prior years relates primarily to a higher than expected level of claims being reported in 2007 for such prior years. Actuarial methods are used to predict future development which is assumed to follow an expected pattern that is supported by historical data and industry trends. This line of business and related reserving assumptions are inherently uncertain and several factors, including newly observed trends, taken into consideration in the actuarial analysis can cause volatility in the determination of net ultimate losses.
With $16.6 million of recorded reserves, net of reinsurance, at December 31, 2007, commercial automobile is the Group’s second largest reserved line of business, representing 9% of the Group’s total carried net loss and loss adjustment expense reserves at December 31, 2007. As a result of changes in estimates of insured events in prior years, the liabilities for losses and loss adjustment expenses for the commercial automobile line of business decreased by $2.5 million in 2007. The development of net ultimate losses on the commercial automobile line of business was better than expected in 2007, primarily as a result of a reduction in claims frequency and a lower than expected incurred in the West coast business.
With $12.4 million of recorded reserves, net of reinsurance, at December 31, 2007, other liability is the Group’s third largest reserved line of business, representing 6% of the Group’s total carried net loss and loss adjustment expense reserves at December 31, 2007. As a result of changes in estimates of insured events in prior years, the liabilities for losses and loss adjustment expenses for the other liability line of business increased by $4.4 million in 2007. The development of net ultimate losses on the other liability line of business was primarily the result of increased loss reserves and outside litigation expenses on larger East coast claims that are in the process of settlement.
The following table presents the increase (decrease) in the liability for unpaid losses and loss adjustment expenses attributable to insured events of prior years incurred in the year ended December 31, 2006 by line of business. Amounts shown in the 2005 column of the table include all 2005 and prior accident year development for FPIC, which was acquired on October 1, 2005, and accounted for as a purchase business combination.
A discussion of factors contributing to an increase (decrease) in the liability for unpaid losses and loss adjustment expenses for the Group’s two major lines of business, representing 81% of total carried loss and loss adjustment expenses at December 31, 2006, follows:
The strengthening of net loss and loss adjustment expense reserves in the commercial multi-peril line reflects refinement in the assumptions and techniques supporting the reserve estimates, primarily on the contractor liability book of business. Contractor liability claims, particularly construction defect claims, are long-tailed in nature and develop over a period of ten to twelve years, based on the related statute of limitations. The increase in the estimates of insured events of prior years relates primarily to a higher than expected level of claims being reported in 2006 for such prior years. Actuarial methods are used to predict future development which is assumed to follow an expected pattern that is supported by historical data and industry trends. This line of business and related reserving assumptions are inherently uncertain and several factors, including newly observed trends, taken into consideration in the actuarial analysis can cause volatility in the determination of net ultimate losses.
With $13.4 million of recorded reserves, net of reinsurance, at December 31, 2006, commercial automobile is the Group’s second largest reserved line of business, representing 8% of the Group’s total carried net loss and loss adjustment expense reserves at December 31, 2006. As a result of changes in estimates of insured events in prior years, the liabilities for losses and loss adjustment expenses for the commercial automobile line of business decreased by $2.0 million in 2006. The development of net ultimate losses on the commercial automobile line of business was better than expected in 2006, primarily as a result of a reduction in claims frequency and a lower than expected incurred. The Group’s expansion into heavy vehicle programs such as ready mix and aggregate haulers has not translated into the expected increased level of loss activity.
The Group has geographic exposure to catastrophe losses in its operating territories. Catastrophes can be caused by various events including hurricanes, windstorms, earthquakes, hail, explosion, severe weather, and fire. The incidence and severity of catastrophes are inherently unpredictable. The extent of losses from a catastrophe is a function of both the total amount of insured exposure in the area affected by the event and the severity of the event. Most catastrophes are restricted to small geographic areas. However, hurricanes and earthquakes may produce significant damage in large, heavily populated areas. The Group generally seeks to reduce its exposure to catastrophe through individual risk selection and the purchase of catastrophe reinsurance.
The Group maintains a 401(k) qualified retirement savings plan covering substantially all employees. Benefits are based on an employee’s annual compensation, with new employees participating after a six-month waiting period. The Group matches a percentage of each employees’ pre-tax contribution and also contributes an amount equal to 2% of each employee’s annual compensation. Deferral amounts in excess of the qualified plan limitations, as well as Group contributions on such compensation, are funded into nonqualified plans benefiting affected individuals. The cost for these benefits was $510, $469 and $177 for 2007, 2006 and 2005, respectively. In addition, the Group generally makes a discretionary contribution each year, based on Group profitability, to both the qualified 401(k) plan, and, where applicable, to the nonqualified plans. The cost for this portion of the retirement plan was $463, $389 and $201 for 2007, 2006 and 2005, respectively.
The Group also maintains nonqualified deferred compensation plans for its directors and officers. Under the plans, participants may elect to defer receipt of all or a portion of their fees or salary amounts, although there is no match by the Group. Amounts deferred by directors and officers, together with accumulated earnings, are distributed either as a lump sum or in installments over a period of not greater than ten years. Deferred compensation, including accumulated earnings, amounted to $1,438 and $1,222 at December 31, 2007 and 2006, respectively.
The Group has purchased Company-owned life insurance covering key individuals. The Group’s cost, net of increases in cash surrender value, for the Company-owned life insurance was $(208), $(23) and $16 for the years ended December 31, 2007, 2006 and 2005, respectively. The cash surrender value of the Company-owned life insurance totaled $1,548 and $1,003 at December 31, 2007 and 2006, respectively, and is included in other assets.
On December 15, 2003, MIG was formed from the conversion of Mercer Mutual Insurance Company from the mutual to the stock form of ownership (“the Conversion”). The Group established an Employee Stock Ownership Plan (ESOP) and issued 626,111 shares to the ESOP at the Conversion offering price. The ESOP signed a promissory note in the amount of $6,261 to purchase the shares, which is due in 10 equal annual installments with interest at 4%. Shares purchased are held in a suspense account for allocation among participating employees as the loan is repaid, and are allocated to participants based on compensation as described in the plan. During 2007, 2006 and 2005, 62,611 shares were allocated to employee participants. Compensation expense equal to the fair value of the shares allocated is recognized ratably over the period that the shares are committed to be allocated to the employees. In 2007, 2006 and 2005 the Group recognized compensation expense of $1,175, $1,253 and $832, respectively, related to the ESOP. As of December 31, 2007, the cost of the 313,056 shares issued to the ESOP but not yet allocated to its employee participants is classified within equity as unearned ESOP shares.
In 2007, the Group evaluated its methodology for allocating costs to its lines of business and adopted changes to such methodology in order to more accurately reflect the allocation of joint costs. This resulted in allocating less joint cost to the personal lines of business and more joint cost to the commercial lines of business, but with no net change in cost allocated to personal lines and commercial lines in the aggregate. Related 2006 and 2005 amounts have been reclassified to reflect this change in allocation methodology:
All dividends from FPIC to FPIG (wholly owned by MIG) require prior notice to the California Department of Insurance. All “extraordinary” dividends require advance approval. A dividend is deemed “extraordinary” if, when
aggregated with all other dividends paid within the preceding 12 months, the dividend exceeds the greater of (a) statutory net income (excluding unrealized capital gains) for the preceding calendar year or (b) 10% of statutory surplus as of the preceding December 31. As of December 31, 2007, the amount available for payment of dividends from FPIC in 2008, without the prior approval, is approximately $6.0 million.
The following unaudited pro forma information presents the combined results of operations of MIG and FPIG for the twelve months ended December 31, 2005 with pro forma purchase accounting adjustments as if the acquisition had been consummated as of the beginning of the periods presented. This pro forma information is not necessarily indicative of what would have occurred had the acquisition and related transactions been made on the dates indicated, or of future results of the Group.
The goodwill associated with the acquisition of FPIG will not be tax-deductible.
The denominator for diluted earnings per share does not include the effect of outstanding stock options that have an anti-dilutive effect. For the year ended December 31, 2007 and 2006, 40,000 stock options were considered to be anti-dilutive and were excluded from the earnings per share calculation. For the year ended December 31, 2005, there were no stock options that were considered to be anti-dilutive and excluded from the earnings per share calculation.
The Group adopted the Mercer Insurance Group, Inc. 2004 Stock Incentive Plan (the Plan) on June 16, 2004. Awards under the Plan may be made in the form of incentive stock options, nonqualified stock options, restricted stock or any combination to employees and non-employee Directors. At adoption, the Plan initially limited to 250,000 the number of shares that may be awarded as restricted stock, and to 500,000 the number of shares for which incentive stock options may be granted. The total number of shares initially authorized in the Plan was 876,555 shares, with an annual increase equal to 1% of the shares outstanding at the end of each year. As of December 31, 2007, the Plan’s authorization has been increased under this feature to 1,075,870 shares. The Plan provides that stock options and restricted stock awards may include vesting restrictions and performance criteria at the discretion of the Compensation Committee of the Board of Directors. The term of options may not exceed ten years for incentive stock options, and ten years and one month for nonqualified stock options, and the option price may not be less than fair market value on the date of grant. All grants made under the Plan employ graded vesting over vesting periods of 3 or 5 years for restricted stock, incentive stock options, and nonqualified stock option grants, and include only service conditions. During 2007, the Group made no grants of restricted stock, incentive stock options and non-qualified stock options. A total of 3,000 shares of restricted stock and 19,400 incentive stock options were forfeited during 2007. A total of 14,100 incentive stock options granted under the Plan were exercised during 2007. Upon exercise, new shares were issued to the option holder.
In determining the charge to the consolidated statement of earnings for 2007 and 2006 and the pro-forma effect for 2005 described in Note 1(m), the fair value of each option award is estimated on the date of grant using the Black-Scholes-Merton option pricing model. The significant assumptions utilized in applying the Black-Scholes-Merton option pricing model are the risk-free interest rate, expected term, dividend yield, and expected volatility. The risk-free interest rate is the implied yield currently available on U.S. Treasury zero-coupon issues with a remaining term equal to the expected term used as the assumption in the model. The expected term of an option award is based on expected experience of the awards. The dividend yield is determined by dividing the per share-dividend by the grant date stock price. The expected volatility is based on the volatility of the Group’s stock price
Information regarding stock option activity in the Plan is presented below:
Expense, with $3.1 million of that amount recognized in the quarter ended June 30, 2007, and $0.5 million recognized in the quarter ended September 30, 2007.
The Group produces a large percentage of its business through one insurance agent, Davis Insurance Agency (Davis), the owner of which is also a Board member of the Group. In 2007, 2006 and 2005, premiums written through Davis totaled 4%, 4% and 8%, respectively, of the Group’s direct written premiums. Commissions paid to Davis were $1,177, $1,187 and $1,231 in 2007, 2006 and 2005, respectively.
Van Rensselaer, Ltd., which is owned by William V.R. Fogler, a director, has provided equities investment management services to the Group since the year 1980. Fees to Van Rensselaer, Ltd. amounted to $128, $117 and $161 in 2007, 2006 and 2005, respectively.
The Group had the following Trust Preferred Securities outstanding as of December 31, 2007:
The Group is party to interest rate swap agreements to hedge the floating interest rate on the Junior Subordinated Debentures purchased by Trust I, Trust II and Trust III. The variable-rate debt obligations expose
The Group accepts various forms of collateral for issuance of its surety bonds including cash, irrevocable letters of credit and certificates of deposit. The Group’s policy is to record in the accompanying consolidated financial statements only those funds received as cash deposits. The off-balance sheet collateral held by the Group consists solely of irrevocable letters of credit totaling $478 and $1,808 as of December 31, 2007 and 2006, respectively.