Our main office and corporate headquarters is located at 10 North Highway 31, Pennington, New Jersey in a facility of approximately 25,000 square feet owned by Mercer Insurance Company. Mercer Insurance Company completed in 2004 an addition of 11,000 square feet to this structure at a cost of $2.9 million. We also own a tract of land adjacent to our main office property.
Income of the Company attributable to the minority interest in Franklin Holding Company, which interest was acquired by the Company immediately after the Conversion for shares of the Company.
Mercer Insurance Company, a Pennsylvania property and casualty stock insurance company offering insurance coverages to businesses and individuals in New Jersey and Pennsylvania, and New York beginning in 2006,
We manage our business and report our operating results in three operating segments: commercial lines insurance, personal lines insurance and the investment function. See Note 9 of the notes to our consolidated financial statements included in this report. However, we do not allocate assets to segments, and assets are reviewed in the aggregate for decision-making purposes. Our commercial lines insurance business consists primarily of multi-peril and general liability and related coverages. Our personal lines insurance business consists primarily of homeowners (only in New Jersey and Pennsylvania) and private passenger automobile (only in Pennsylvania) insurance coverages. We market both the commercial and personal insurance lines through independent agents.
Our income is principally derived from insurance premiums received from insureds in the commercial lines (businesses insured) and personal lines (individuals insured) segments, less the costs of underwriting the insurance policies, the costs of settling and paying claims reported on the policies, and from investment income reduced by investment expenses, and from gains or losses on holdings in our investment portfolio. Variability in our income is caused by a variety of circumstances, some within the control of our companies and some not within their control. Premium volume is affected by, among other things, the availability of quality, properly-priced underwriting risks being produced by our agents, the ability to retain on renewal existing good-performing accounts, competition from other insurance companies, regulatory rate approvals, our reputation, and other limitations created by the marketplace or regulators. Our underwriting costs are affected by, among other things, the amount of commission and profit-sharing we pay our agents to produce the underwriting risks we receive premiums for, the cost of issuing insurance policies and maintaining our customer and agent relationships, marketing costs, taxes we pay to the states we operate in on the amount of premium we collect, and other assessments and charges imposed on our companies by the regulators in the states in which we do business. Our claim and claim settlement costs are affected by, among other things, the quality of our underwriting accounts, severe weather in our operating region, the nature of the claim, the
regulatory and legal environment in our territories, inflation in underlying medical and property repair costs, and the availability and cost of reinsurance. Our investment income and realized gains and losses are determined by, among other things, market forces, the rates of interest and dividends paid on our portfolio holdings, the credit or investment quality of the issuer and the success of its underlying business, the market perception of the company invested in, and other factors such as ratings by rating agencies and analysts.
We applied the following general methods in projecting loss and loss adjustment expense reserves for the Group:
The Bornhuetter-Ferguson expected loss projection method based on reported loss data relies on the assumption that remaining unreported losses are a function of the total expected losses rather than a function of currently reported losses. The expected losses used in this analysis were selected judgmentally. The expected losses are multiplied by the unreported percentage to produce expected unreported losses. The unreported percentage is calculated as one minus the reciprocal of the selected incurred loss development factors. Finally, the expected unreported losses are added to the current reported losses to produce ultimate losses.
For the property lines of business (special property, personal auto physical, commercial auto physical damage) the results of the reserve calculations were similar and we relied on an average of the four methods utilized.
For the homeowners and commercial multi-peril lines of business (excluding California CMP business for policy years 1996 and prior) we relied on the incurred loss development and incurred Bornhuetter/ Ferguson methods in estimating loss reserves. These two methods yield more consistent results although the two paid methods yielded reserves that were similar in total to the incurred methods.
For the liability lines (general liability, personal auto liability, commercial auto liability, workers’ compensation) the paid loss development method yielded less than reliable results for the immature years and we did not use the method in selecting ultimate losses and reserves. For these lines we relied on the incurred Bornhuetter/ Ferguson method for the most recent accident years and both of the incurred loss development methods for the remaining years.
Reserves are estimates because there are uncertainties inherent in the determination of ultimate losses. Court decisions, regulatory changes and economic conditions can affect the ultimate cost of claims that occurred in the past as well as create uncertainties regarding future loss cost trends. Accordingly, the ultimate liability for unpaid losses and loss settlement expenses will likely differ from the amount recorded at December 31, 2005.
business and applied to loss reserves as a whole. The selected range of changes does not indicate what could be the potential best or worst case or likely scenarios:
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 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 the near term. In the years ended December 31, 2005, 2004 and 2003, we recorded a pre-tax charge to earnings of $517,000, $15,000, and $454,000, respectively. In 2005, these charges related to preferred stocks and fixed income securities, and in 2004 and 2003 these charges are primarily with respect to equity securities that we determined were other than temporarily impaired. Adverse investment market conditions, poor operating performance, or other adversity encountered by companies whose stock or fixed maturity securities we own could result in impairment charges in the future. The Company’s policy on impairment of value of investments is as follows: if a security has a market value below cost it is considered impaired. For any such security a review of the financial condition and prospects of the company will be performed by the Investment Committee to determine if the decline in market value is other than temporary. If it is determined that the decline in market value is “other than temporary”, the carrying value of the security will be written down to “realizable value” and the amount of the write down accounted for as a realized loss. “Realizable value” is defined for this purpose as the market price of the security. Write down to a value other than the market price requires objective evidence in support of that value.
In evaluating the potential impairment of equity securities, the Investment Committee will evaluate certain factors, including but not limited to the following: the relationship of market price per share versus carrying value per share at the date of acquisition and the date of evaluation, the price-to-earnings ratio at the date of acquisition and the date of evaluation, any rating agency announcements, the issuer’s financial
condition and near-term prospects, including any specific events that may influence the issuer’s operations, the independent auditor’s report on the issuer’s financial statements; and any buy/sell/hold recommendations or price projections by outside investment advisors.
Many of the Company’s reinsurance treaties contain provisions that establish minimum and maximum cessions and allow limited participation in the profit of the ceded business. Generally, the Company shares on a limited basis in the profitability of our reinsurance treaties through contingent ceding commissions. The Company’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 Company’s results of operations.
As of December 31, 2005, $6.3 million is due from Alea North America Insurance Company (“Alea”), which previously was rated A- (Excellent), but presently is rated NR-4 (not rated by company request). Alea Group, the parent of Alea is now in voluntary runoff. Some of the Company’s treaties with Alea have contractual provisions that require a trust account to be set up in the event of downgrade. Management is currently working with Alea through its reinsurance intermediary to have Alea fund such a trust, which would cover $3.9 million of the $6.3 million of the loss and loss adjustment expense reserves ceded to Alea as of December 31, 2005. Additionally, to further limit its exposure, the Company terminated its policy year 2005 treaties with Alea on a cut-off basis. At the present time, Alea remains current in the payment of its obligations to the Company.
Our growth in premiums and underwriting results has been, and continue to be, influenced by market conditions, as well as the acquisition of Financial Pacific on October 1, 2005. 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 hard market and related pricing power of the early part of the current decade has given way to a much more competitive market recently, particularly in large commercial accounts, package policies and in the Pennsylvania personal auto market. This has resulted in slower premium growth than the Company has achieved in recent years.
On June 1, 2001, the Group acquired 49% of Franklin Holding and thereafter consolidated the financial condition and results of operations of Franklin Holding with Mercer Insurance Company. From acquisition through December 15, 2003, we allocated a portion of Franklin Holding’s net income to the minority interest in Franklin Holding. This resulted in an allocation of income to minority interest of $131,000 for the year ended December 31, 2003. The minority interest in Franklin Holding was acquired by the Company immediately after the Conversion, through an exchange of shares. Since Franklin Holding Company, Inc. became wholly owned within the group in December, 2003, no further income has been allocated to the minority interest.
On October 1, 2005, the Group acquired Financial Pacific Insurance Group, Inc., including its insurance subsidiary, Financial Pacific Insurance Company. Financial Pacific underwrites commercial lines of business, principally in the states of California, Arizona, Nevada and Oregon. Thus, the financial statements for the year ended December 31, 2005 include Financial Pacific Insurance Group, Inc. and its results of operations from October 1, 2005 through December 31, 2005.
normal range of expectations, and more favorable than the prior year, and large losses in the aggregate were within the normal range of expectations. The Company’s GAAP combined ratio declined in 2005 from 98.8% to 94.9%, and the statutory combined ratio improved to 94.1% in 2005 from 95.4% in 2004.
In 2005, direct premiums written increased 40.2% over 2004 to $92.2 million from $65.8 million, or $26.5 million. Inclusion of Financial Pacific since its acquisition by the Group added $27.9 million in direct written premium, with the balance of the change attributable to a modest decline in personal lines premium as that book continues to be re-directed, and more competitive pricing in the commercial lines marketplace.
Investment expenses increased 34.4% in 2005, or $521,000, to $2.0 million. This increase is largely attributable to the inclusion of Financial Pacific since its acquisition.
Net realized gains for 2005 were $1.3 million, as compared to $484,000 in 2004. As noted above, these gains were taken as part of the process of funding the acquisition of Financial Pacific Insurance Group. In 2005, net realized investment gains of $1.3 million included gains on securities sales of $2.4 million, offset by losses on securities sales of $1.1 million. The losses from securities sales were comprised of $357,000 from the sale of fixed income securities, $245,000 from the sale of equities, and $517,000 from the writedown of securities determined to be other-than-temporarily impaired. These securities were written down to our estimate of fair market value at the time of the writedown.
In 2005, our commercial lines direct premiums written increased by $26.8 million, or 65.6%, to $67.7 million, as compared to the same period in 2004. The acquisition of Financial Pacific added $27.9 million, or 68.3 percentage points of the total. Commercial lines net written premium increased $15.8 million, or 43.3%, to $52.3 million in the same period, of which $16.0 million, or 43.7 percentage points is attributable to the Financial Pacific acquisition. Net premiums earned increased 60.5% in 2005, or $19.6 million, to $52.0 million. Financial Pacific contributed $13.9 million, or 42.9 percentage points of the total increase. In an unusual situation impacting both direct and net written premium, the Group had a large master account with a premium of approximately $2.5 million, which was originally written on a thirteen month policy in December 2004, renew in January, 2006. Although the earned premium relating to this policy in 2005 is reported in the net premium earned above, it is not reflected in the direct and net written premium above because of its renewal date in 2006.
Direct commercial multi-peril premiums written, the largest component of our commercial lines segment, nearly doubled to $44.4 million in 2005, compared to $22.2 million for 2004, and net commercial multi-peril premiums earned increased by 81.4% to $30.0 million in 2005, compared to $16.5 million for 2004. A substantial portion of the increase is as a result of the Financial Pacific acquisition.
Personal lines direct premiums written decreased in 2005 by 1.5% to $24.5 million. Net premiums written was approximately flat with 2004, and net premiums earned decreased by 2.6%, or $610,000, to $22.8 million.
Underwriting expenses increased by $589,000, or 2.2%, to $27.6 million in 2005, as compared to 2004. This increase was principally attributable to an increase in other underwriting expenses, growth in commissions resulting from higher earned premium volume, and increased charges relating to corporate expenses and compensation expenses, including bonuses and agents profit-sharing, which were at higher levels than in 2004. In 2005, the Company had pre-tax external expense associated with Sarbanes - Oxley compliance of $693,000, and pre-tax expense of $693,000 associated with grants of restricted stock, for which expenses were $832,000 and $383,000, respectively, in 2004.
The components of income for 2004 and 2003, 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.
Charts and discussion relating to each of our segments (commercial lines underwriting, personal lines underwriting, and the investments segment) follow below.
Total revenues for 2004, were $59.5 million, which was 17.4% greater than 2003 revenues. This increase was due primarily to a $7.9 million increase in net premiums earned in 2004, and an increase in net investment income of $1.1 million.
securities portfolio to be more heavily weighted in tax-exempt securities, industrial and miscellaneous fixed income securities, and mortgage-backed securities, and less heavily weighted towards U.S government and government agencies fixed income securities. The fixed income portfolio remains invested 100% in investment grade fixed income securities, with, as of December 31, 2004, an average rating of AAA, an average duration of 3.7 years (excluding mortgage-backed securities), and average tax equivalent yield of 4.17%. Our average portfolio duration exceeds that of our insurance liabilities, however the portfolio maturities are laddered to ensure adequate liquidity.
The following table summarizes the length of time equity securities with unrealized losses at December 31, 2004 have been in an unrealized loss position:
Consistent with our goal of increasing commercial business, we increased commercial lines direct premiums written by $5.1 million, or 14.2 % in 2004. With our increased reinsurance retentions in 2004, our commercial lines net premiums written increased by 20.4%, or $6.2 million. Direct commercial multi-peril premiums written, the largest component of our commercial lines segment, increased 19.7% to $22.2 million in 2004, compared to $18.6 million for 2003, and commercial multi-peril net premiums earned increased by 30.4% to $16.5 million in 2004, compared to $12.7 million for 2003. Our largest increase in policy count was within our Religious Institutions sector, where our increasing market presence is helping us add new premium, and in our Special Contractors sector. We expect this trend of increasing commercial writings to continue by targeting selected types of risks with selected producers.
In the personal lines segment for 2004, we had an underwriting loss of $4.9 million, a GAAP combined ratio of 121.0%, a GAAP loss and loss adjustment expense ratio of 76.1% and a GAAP underwriting expense ratio of 44.9%, compared to an underwriting loss of $5.0 million, a GAAP combined ratio of 122.6%, a GAAP loss and loss adjustment expense ratio of 80.3% and a GAAP underwriting expense ratio of 42.3% for 2003.
The personal lines losses in 2004 were slightly better than in 2003, with the losses in both years heavier than usual and attributable to harsh weather conditions. After a number of winters with relatively mild weather conditions in our operating region, our first quarter of 2004, and our first and fourth quarters of 2003 suffered from unusually cold weather conditions. These conditions lead to a high frequency of losses from frozen pipes, structural collapses, and more frequent automobile losses and accidents. The homeowners loss and loss expense ratio was 82.8% in 2004 and 74.3% for 2003, and the personal automobile loss and loss expense ratio was 77.0% for 2004 and 94.5% for 2003.
Personal automobile direct written premiums, written exclusively in Pennsylvania, decreased 2.9% to $7.7 million in 2004, compared to $7.9 million for 2003. Net earned premiums for personal automobile increased by 4.4% to $7.2 million for 2004, from $6.9 million for 2003. The slight decrease in personal automobile direct premiums is attributable to a change in our underwriting guidelines, with a planned decrease in less attractive lower-tier business being replaced by more attractive higher-tier business in 2004, a trend we expect to continue with the result of overall growth in this line. Despite the increase in personal lines net premiums earned, we will continue to focus principally on our commercial lines growth.
The principal source of liquidity for Mercer Insurance Group, Inc. (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) has, up to the Financial Pacific acquisition, been the net proceeds it retained from the Conversion stock offering, as well as dividend payments and other fees received from Mercer Insurance Company or other 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.
For a period of three years after the Conversion (which took place on December 15, 2003), Mercer Insurance Company may not declare or pay any dividend to Mercer Insurance Group without the approval of the Pennsylvania Insurance Department. After this three-year period, Mercer Insurance Company will be limited by the insurance laws of Pennsylvania as to the amount of dividends or other distributions it may pay to its holding company. Under Pennsylvania law, there is a maximum amount that may be paid by Mercer Insurance Company during any twelve-month period after notice to, but without prior approval of, the Pennsylvania Insurance Department. This limit is the greater of 10% of Mercer Insurance Company’s statutory surplus as reported on its most recent annual statement filed with the Pennsylvania Insurance Department, or the net income of Mercer Insurance Company for the period covered by such annual statement. Similarly, Financial Pacific is limited by the insurance laws of California as to how much it may issue as dividends to Mercer Insurance Group, using a formula similar to that described for Pennsylvania.
If the dividend restrictions imposed on Mercer Insurance Company related to the Conversion were not in effect, then as of December 31, 2005, the amounts available for payment of dividends from Mercer Insurance Company in 2006, without the prior approval of the Pennsylvania Insurance Department would have been approximately $5.6 million.
Prior to its payment of any dividends, Mercer Insurance Company of New Jersey, Inc. is required to provide notice of the intended dividends to the New Jersey Department of Banking and Insurance. New Jersey law sets the maximum amount of dividends that may be paid, which amount cannot exceed the greater of 10% of Mercer Insurance Company of New Jersey, Inc.’s statutory surplus as reported on the most recent annual statement filed with New Jersey, or the net income, not including realized capital gains, for the period covered by the annual statement. The New Jersey Department has the power to limit or prohibit dividend payments if certain conditions exist. These restrictions or any subsequently imposed restrictions may affect our future liquidity. As of December 31, 2005, the amount available for payment of dividends by Mercer Insurance Company of New Jersey, Inc. to Mercer Insurance Company in 2006 without the prior approval of New Jersey Department of Banking and Insurance is approximately $1.7 million.
As a Pennsylvania domiciled insurance company, dividends payable by Franklin Insurance Company are subject to the same formula limitation described above for Mercer Insurance Company. As of December 31, 2005, the amount available for payment of dividends from Franklin Insurance Company in 2006, without the prior approval of the Pennsylvania Insurance Department, is approximately $800,000.
In connection with the acquisition of Financial Pacific Insurance Group for approximately $40.4 million in cash on October 1, 2005, all of the securities of Mercer Insurance Group, Inc. (which were purchased with proceeds of the Conversion) were converted into cash, with all but approximately $300,000 of this balance used to fund the acquisition. The remaining liquid assets in Mercer Insurance Group, as well as its other sources of revenue, are adequate to fund its current expenses for the foreseeable future.
As part of the funding of the acquisition, Mercer Insurance Company, with the approval of the Pennsylvania Department of Insurance, paid an extraordinary dividend of $10 million on September 30, 2005, to Mercer Insurance Group, Inc. Mercer Insurance Company also entered into a loan agreement with Mercer Insurance Group, Inc., by which it advanced on September 30, 2005, a loan of $10 million with a 20-year note and a fixed interest rate of 4.75%, repayable in 20 equal annual installments. After the acquisition, Mercer Insurance Group has no special limitations on its ability to take periodic dividends from Financial Pacific Insurance Group, but Financial Pacific Insurance Group will be subject to normal dividend restrictions administered by the California Department of Insurance similar to those described above for Mercer Insurance Company, and by a covenant in Financial Pacific’s line of credit that prohibits dividends while that facility is in use. The Company believes that the resources available to Mercer Insurance Group, Inc., will be adequate for it to meet its obligation under the note to Mercer Insurance Company and its other expenses.
On October 20, 2004, the Company’s Board of Directors authorized the repurchase of up to 250,000 additional shares of its common stock (in addition to the 250,000 share repurchase authorized June 16, 2004 and previously completed). The repurchase of the additional 250,000 shares was completed on March 2, 2005. The repurchased shares will be held as treasury shares available for issuance in connection with Mercer
The Company was not a party to any unconsolidated arrangement or financial instrument with special purpose entities or other vehicles at December 31, 2005 which would give rise to previously undisclosed market, credit or financing risk.
The Company and its subsidiaries have no significant contractual obligations at December 31, 2005, other than its insurance obligations under its policies of insurance, and Trust preferred securities, a line of credit
We have audited the accompanying consolidated balance sheets of Mercer Insurance Group, Inc. and subsidiaries as of December 31, 2005 and 2004, 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, 2005. 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.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Mercer Insurance Group, Inc. and subsidiaries as of December 31, 2005 and 2004, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2005, in conformity with U.S. generally accepted accounting principles.
Mercer Insurance Group, Inc. (MIG) is a holding company which resulted from the conversion of Mercer Mutual Insurance Company from the mutual to the stock form of ownership on December 15, 2003 (“the Conversion”). Mercer Insurance Group, Inc. and subsidiaries (collectively, the Group) includes Mercer Insurance Company (MIC), its subsidiaries Queenstown Holding Company, Inc. (QHC) and BICUS Services Corporation (BICUS), QHC’s subsidiary Mercer Insurance Company of New Jersey, Inc. (MICNJ), and Franklin Holding Company, Inc. (FHC) and its subsidiary Franklin Insurance Company (FIC), and, effective October 1, 2005, Financial Pacific Insurance Group, Inc. (FPIG), and its subsidiaries Financial Pacific Insurance Company (FPIC) and Financial Pacific Insurance Agency (FPIA).
On October 1, 2005, FPIG and its subsidiaries became wholly-owned members of the Group in an acquisition for cash (see note 12). FPIG also holds an interest in three business trusts that were formed for the purpose of issuing Floating Rate Capital Securities (see note 18).
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 insurer affiliates within the Group, other than FPIC, participate in a reinsurance pooling arrangement (the Pool) whereby each insurance affiliate’s underwriting results are combined and then distributed proportionately to each participant. Each insurer’s share in the Pool is based on their respective statutory surplus as of the beginning of each year. It is anticipated that FPIC will join the pool in 2006, pending regulatory approvals and other requirements. The effects of the Pool as well as all other significant intercompany accounts and transactions have been eliminated in consolidation.
The preparation of the accompanying financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the
reporting period. Significant items subject to such estimates include liabilities for losses and loss adjustment expenses, deferred policy acquisition costs, reinsurance, deferred income tax assets and other than temporary impairment of investments. Actual results could differ from those estimates.
Interest on fixed maturities 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 using anticipated prepayments with significant changes in anticipated prepayments accounted for prospectively.
The fair value of an equity security the Group holds in a reinsurance company is estimated based on statutory book value because the security is not traded and because of restrictions placed on the investors.
After receipt of a bona fide offer to purchase this security, the stock must first be offered to the investee or its other shareholders at the lower of statutory book value or the offered price. The investee also has the ability to determine that the potential purchaser is not appropriate and void such an offer. The carrying value of this investment was $1,134 and $1,116 at December 31, 2005 and 2004, respectively.
Trust preferred securities and line of credit obligations - The carrying amounts reported in the consolidated balance sheets for these instruments approximate their fair values.
Acquisition costs such as commissions, premium taxes, and certain other expenses which vary with and are primarily related to the production of business, are deferred and amortized over the effective period of the related insurance policies. The method followed in computing deferred policy acquisition costs limits the amount of such deferred costs to their estimated realizable value, which gives effect to premiums to be earned, anticipated investment income, loss and loss adjustment expenses, and certain other maintenance costs expected to be incurred as the premiums are earned. To the extent that deferred policy acquisition costs are not realizable, the deficiency is charged to income currently.
The Group applies the provisions of Statement of Position (SOP) 98-1, “Accounting for the Costs of Computer Software Developed or Obtained for Internal Use” to account for internally developed computer software costs. In accordance with SOP 98-1, the Company has capitalized $718,000, $916,000, and $790,000 in software development costs, respectively, in 2005, 2004 and 2003.
more likely than not that some portion of the deferred tax asset will not be realized. The effect of a change in tax rates is recognized in the period of the enactment date.
The Group accounts for its interest rate swaps in accordance with SFAS 133, Accounting for Derivative Instruments and Hedging Activities, as amended by SFAS 138, Accounting for Certain Derivative Instruments and Certain Hedging Activities. The Group has designated the interest rate swaps as non-hedge instruments. Accordingly, the Group recognizes the fair value of the interest rate swaps as assets or liabilities on the consolidated balance sheets with the changes in fair value recognized in the consolidated statements of earnings. The estimated fair value of the interest rate swaps is based on valuations received from the financial institution counterparties.
In January 2003, the FASB issued Interpretation No. 46, Consolidation of Variable Rate Interest Entities (FIN 46), which was replaced in December 2003 by FIN 46R. FIN 46R addresses consolidation issues surrounding special purpose entities and certain other entities, collectively termed variable interest entities (VIE). A VIE is an entity in which equity investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN 46R requires VIEs to be consolidated by their primary beneficiaries. FIN 46R was effective immediately for new VIEs formed subsequent to December 31, 2003. For VIEs that were formed prior to January 1, 2004, the effective date is January 1, 2005. The Group is not
party to any VIEs created subsequent to December 31, 2003. The Group adopted FIN 46R on January 1, 2005, and as a result Financial Pacific Statutory Trust I, Financial Pacific Statutory Trust II, and Financial Pacific Statutory Trust III are not consolidated with the Group. The adoption of FIN 46R did not have a material effect on the Group’s statements of earnings, financial condition or results of operations.
Investment expenses include salaries, advisory fees, and other miscellaneous expenses attributable to the maintenance of investment activities.
The cost and estimated fair value of available-for-sale investment securities at December 31, 2005 and 2004 are shown below.
Fixed maturity investments with unrealized losses for less than twelve months are primarily due to changes in the interest rate environment. At December 31, 2005 the Group has 53 fixed maturity securities with unrealized losses for more than twelve months. Of the 53 securities with unrealized losses for more than twelve months, 46 of them have fair values of no less than 96% or more of cost, and the other 7 securities have a fair value greater than 92% of cost. The Group believes these declines are temporary.
The estimated fair value and unrealized loss for securities in a temporary unrealized loss position as of December 31, 2004 are as follows:
for more than twelve months, thirteen of them have fair values of no less than 96% of cost, and the other three securities have a fair value greater than 94% of cost. The Group believes these declines are temporary.
Proceeds from the sales of securities were $66,537, $30,548, and $34,919 in 2005, 2004, and 2003, respectively.
Accumulated other comprehensive income was net of deferred income taxes of $1,469 and $2,671 applicable to net unrealized investment gains at December 31, 2005 and 2004, respectively.
The amortized cost of invested securities on deposit with regulatory authorities at December 31, 2005 and 2004 was $4,675 and $201, respectively.
The revisions in ceded reserve estimates resulted in $3.6 million of adverse loss development (out of the total $4.7 million prior year development for Financial Pacific). The revisions in ceded reserves estimates were due both to an increase in ceded reserves on policy years for which Financial Pacific had assumed reinsurance coverage based on a commutation with one of their reinsurers, Gerling Global Reinsurance, as well as the impact of reducing ceded reserves related to a casualty quota share reinsurance agreement with Berkley Insurance Company, which was terminated in 2004. Both of these changes in ceded reserve estimates increased net reserves and resulted in net prior year development.
The effect of reinsurance on unearned premiums as of December 31, 2005 and 2004 is as follows:
cover $3.9 million of the $6.3 million of the loss and loss adjustment expense reserves ceded to Alea as of December 31, 2005. Additionally, to further limit its exposure, the Company terminated its policy year 2005 treaties with Alea on a cut-off basis. At the present time, Alea remains current in the payment of its obligations to the Company.
The Group sponsored the FPIG 401(k) Plan for employees of FPIG effective with the acquisition of FPIG on October 1, 2005 (see note 12). All employees of FPIC, as defined in the FPIG 401(k) Plan, who have completed six months of service were eligible for participation in the Plan. The Group matched 100% of the employee’s pre-tax contribution up to $2,000, on an annual basis. In the fourth quarter of 2005, the Group recognized a cost of $19 for the FPIG 401(k) Plan. Effective in 2006, the FPIG 401(k) Plan was terminated and all eligible employees were rolled into the Group’s 401(k) Plan described in the preceding paragraph.
The Group also maintains a nonqualified unfunded retirement plan for its directors. The plan provides for monthly payments for life upon retirement, with a minimum payment period of ten years. The expense for this plan amounted to $115, $111, and $102 for 2005, 2004, and 2003 respectively. Costs accrued under this plan amounted to $786 and $704 at December 31, 2005 and 2004, respectively.
The Group also maintains a nonqualified deferred compensation plan for its directors and officers. Under the plan, 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 $974 and $888 at December 31, 2005 and 2004, 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 $16, $5, and $32 for the years ended December 31, 2005, 2004, and 2003, respectively. The cash surrender value of the Company-owned life insurance totaled $865 and $767 at December 31, 2005 and 2004, respectively, and is included in other assets.
In conjunction with the Conversion described in note 1, 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 both 2005 and 2004, 62,611 shares were allocated to employee participants, with an equal number of shares allocated to employee participants in the period December 16, 2003 to December 31, 2003. 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 2005, 2004 and 2003 the Group recognized compensation expense of $832, $779 and $778, respectively, related to the ESOP. As of December 31, 2005, the cost of the 438,278 shares issued to the ESOP but not yet allocated to its employee participants is classified within equity as unearned ESOP shares.
The tax effect of significant temporary differences that give rise to the Group’s net deferred tax asset (liability) as of December 31, is as follows:
In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management believes it is more likely than not the Group will realize the benefits of the deferred tax assets at December 31, 2005 and 2004.
The Group’s insurance companies are required by law to maintain a certain minimum surplus on a statutory basis, and are subject to risk-based capital requirements and to regulations under which payment of a dividend from statutory surplus is restricted and may require prior approval of regulatory authorities. A condition imposed in connection with the approval by the Pennsylvania Department of Insurance of the Conversion is that for a period of three years after the Conversion, Mercer Insurance Company may not declare or pay any dividend to Mercer Insurance Group, Inc. without the approval of the Pennsylvania Insurance Department. In 2005, Mercer Insurance Company applied for, and received, approval to pay an extraordinary dividend of $10 million, which was used in connection with the acquisition of Financial Pacific Insurance Group, Inc. (see note 12). After the expiration of this initial three-year period, Mercer Insurance Company will be restricted by the insurance laws of Pennsylvania as to the amount of dividends or other distributions it may pay to its holding company. Under Pennsylvania law, there is a maximum amount that may be paid by Mercer Insurance Company during any twelve-month period after notice to, but without prior approval of, the Pennsylvania Insurance Department. This limit is the greater of 10% of Mercer Insurance
Company’s statutory surplus as reported on its most recent annual statement filed with the Pennsylvania Insurance Department, or the net income of Mercer Insurance Company for the period covered by such annual statement. If the dividend restrictions imposed on Mercer Insurance Company related to the Conversion were not in effect, then as of December 31, 2005, the amounts available for payment of dividends from Mercer Insurance Company in 2006, without the prior approval of the Pennsylvania Insurance Department would have been approximately $5.6 million.
All dividends from Financial Pacific Insurance Company to Financial Pacific Insurance Group, Inc. (wholly owned by Mercer Insurance Group, Inc.) require prior notice to the California Department of Insurance. All “extraordinary” dividends require advance approval, and the payment of ordinary dividends made for the purpose of servicing debt of the Group has been restricted and requires prior written consent. 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 surplus in regards to the policyholders as of the preceding December 31. Additionally, dividends may not be paid except from unassigned funds or earned surplus without prior approval, and the payment of any dividend can be prohibited if the payment would in any way violate the California Department of Insurance regulations or be hazardous to policyholders, creditors, or the public.
On December 15, 2003, MIC converted from a mutual form of ownership to the stock form of ownership. The Group incurred expenses of $66 in 2003 in the mutual to stock conversion.
On October 1, 2005, the Group acquired all of the outstanding common stock of Financial Pacific Insurance Group, Inc. for $41.1 million in cash (including related transaction costs), and its results of operations have been included in the consolidated financial statements of the Group since that date (see note 1(a)). The acquisition was made through a merger whereby FPIG Acquisition Corp, a Delaware corporation wholly owned by the Group, merged with and into Financial Pacific Insurance Group, Inc., which then became the surviving entity operating under the Certificate of Incorporation and Bylaws of FPIG Acquisition Corp. as a wholly owned subsidiary of the Group. Accordingly, this transaction has been accounted for as a purchase business combination by applying fair value estimates to the acquired assets, liabilities and commitments of Financial Pacific Insurance Group, Inc. as of October 1, 2005. A holdback of 11% of the purchase price is being held in escrow for a period of one year relating to the terms of the acquisition agreement.
As described in Note 1, the Conversion resulted in the initial issuance of common shares of the Group on December 15, 2003. Earnings per share for 2003 are computed by dividing net income for the period subsequent to the Conversion (December 16, 2003 to December 31, 2003) by the weighted average number of common shares outstanding for the period. There were no dilutive potential common shares outstanding during this 2003 period.
The Company 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. The Plan limits 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 authorized in the plan is 876,555 shares, with an annual increase equal to 1% of the shares outstanding at the end of the previous year, with a corresponding proportional annual increase in the number of shares that can be issued as restricted stock. 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 1 month for nonqualified stock options, and the option price may not be less than fair market value on the date of grant. The 2005 and 2004 grants have vesting periods of 3 or 5 years on restricted stock, incentive stock options, and nonqualified stock options.
Rental expenses of approximately $117 for the quarter ended December 31, 2005 has been charged to income in the accompanying consolidated statement of earnings.
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 2000. Fees to Van Rensselaer, Ltd. amounted to $161 in 2005, $166 in 2004, and $141 in 2003.
As of December 31, 2005, the Group owed $3,000 under a $4,000 bank line of credit. The line of credit matures July 17, 2006 and bears interest at the bank’s base rate. The effective annual interest rate as of December 31, 2005 was 7.25%. The line of credit requires the Group to maintain certain financial requirements including a minimum A.M. Best rating and minimum statutory surplus. The Group was in compliance with all covenants as of December 31, 2005.
Financial Pacific Statutory Trust I (Trust I) is a Connecticut statutory business trust. The Trust issued 5,000 shares of the Trust preferred securities at a price of $1,000 per share for $5,000. The Trust purchased $5,155 in Junior Subordinated Debentures from the Group that mature on December 4, 2032. The annual effective rate of interest at December 31, 2005 is 8.44%.
Financial Pacific Statutory Trust II (Trust II) is a Connecticut statutory business trust. The Trust issued 3,000 shares of the Trust preferred securities at a price of $1,000 per share for $3,000. The Trust purchased $3,093 in Junior Subordinated Debentures from the Group that mature on May 15, 2033. The annual effective rate of interest at December 31, 2005 is 7.35%.
Financial Pacific Statutory Trust III (Trust III) is a Delaware statutory business trust. The Trust issued 7,500 shares of the Trust preferred securities at a price of $1,000 per share for $7,500. The Trust purchased $7,740 in Junior Subordinated Debentures from the Group that mature on September 30, 2033. The annual effective rate of interest at December 31, 2005 is 8.07%.
The Group had the following Interest Rate Swaps outstanding as of December 31, 2005:
Market risk is the adverse effect on the value of a financial instrument that results from a change in interest rates. The market risk associated with interest-rate contracts is managed by establishing and monitoring parameters that limit the types and degree of market risk that may be undertaken.