EMC Insurance Group Inc., a 53.6 percent owned subsidiary of Employers Mutual Casualty Company (Employers Mutual), is an insurance holding company with operations in property and casualty insurance and reinsurance. Property and casualty insurance is the most significant segment, representing 78.7 percent of consolidated premiums earned in the first quarter of 2005. For purposes of this discussion, the term "Company" is used interchangeably to describe EMC Insurance Group Inc. (Parent Company only) and EMC Insurance Group Inc. and its subsidiaries. Employers Mutual and all of its subsidiaries (including the Company) and an affiliate are referred to as the "EMC Insurance Companies."
An insurance company's underwriting results reflect the profitability of its insurance operations, excluding investment income. Underwriting results are calculated by subtracting losses and expenses incurred from premiums earned. An underwriting profit indicates that a sufficient amount of premium income was received to cover the risks insured. An underwriting loss indicates that premium income was not adequate. The combined ratio is a measure utilized by insurance companies to gauge underwriting profitability and is calculated by dividing losses and expenses incurred by premiums earned. A number less than 100 generally indicates an underwriting gain; a number greater than 100 generally indicates an underwriting loss.
Additional information regarding issues affecting the insurance industry is presented in the Management's Discussion and Analysis of Financial Condition and Results of Operations section of the Company's 2004 Form 10-K.
During the first quarter of 2005 management focused its attention on three primary issues affecting the Company. These issues include establishing and maintaining adequate loss and settlement expense reserves, balancing profitability and production as the insurance marketplace becomes increasingly competitive and preparing to comply with the requirements of Section 404 of the Sarbanes-Oxley Act of 2002. These issues are discussed further in the following paragraphs. A discussion of other issues affecting the Company is presented in the Management's Discussion and Analysis of Financial Condition and Results of Operations section of the Company's 2004 Form 10-K.
In addition to recent actions taken to improve reserve adequacy, effective March 1, 2005, Richard K. Schulz, an employee of Employers Mutual, became the senior claims executive officer. Mr. Schulz was the claims manager at the Chicago branch office for the last five years and has over ten years of prior insurance industry experience. Mr. Schulz reports to William A. Murray, Executive Vice President and Chief Operating Officer.
The Company, which is not currently an accelerated filer, has completed the majority of the documentation of its work flow and internal controls over financial reporting as required by Section 404 of the Sarbanes-Oxley Act of 2002. Efforts during the first quarter of 2005 focused on the remediation of identified gaps in existing controls and the verification of controls at the various branch offices. Efforts for the remainder of 2005 will include testing of the documented controls, remediation of any controls that are found to be not working as designed and the establishment of a maintenance process. Management expects to complete its initial assessment of the Company's internal control over financial reporting by mid July, which will allow sufficient time for the Company's independent auditors to perform their analysis and testing procedures and issue their report on the Company's internal control over financial reporting as of December 31, 2005.
The accounting policies considered by management to be critically important in the preparation and understanding of the Company's financial statements and related disclosures are presented in the Management's Discussion and Analysis of Financial Condition and Results of Operations section of the Company's 2004 Form 10-K.
Segment information and consolidated net income for the three months ended March 31, 2005 and 2004 is as follows: Three months ended March 31, -------------------- ($ in thousands) 2005 2004 -------- -------- Property and Casualty Insurance Premiums earned ...................................... $ 79,718 $ 61,360 Losses and settlement expenses ....................... 47,131 36,395 Acquisition and other expenses ....................... 27,383 20,925 -------- -------- Underwriting gain .................................... $ 5,204 $ 4,040 ======== ========
Loss and settlement expense ratio .................... 59.1% 59.3% Acquisition expense ratio ............................ 34.4 34.1 -------- -------- Combined ratio ....................................... 93.5% 93.4% ======== ========
Losses and settlement expenses: Insured events of current year ................... $ 53,724 $ 39,820 Decrease in provision for insured events of prior years .......................... (6,593) (3,425) -------- -------- Total losses and settlement expenses ......... $ 47,131 $ 36,395 ======== ======== Catastrophe and storm losses ......................... $ 1,764 $ 870 ======== ========
(Unaudited) Three months ended March 31, -------------------- ($ in thousands) 2005 2004 -------- -------- Reinsurance Premiums earned ...................................... $ 21,576 $ 22,098 Losses and settlement expenses ....................... 15,712 14,566 Acquisition and other expenses ....................... 5,555 6,358 -------- -------- Underwriting gain .................................... $ 309 $ 1,174 ======== ========
Loss and settlement expense ratio .................... 72.8% 65.9% Acquisition expense ratio ............................ 25.8 28.8 -------- -------- Combined ratio ....................................... 98.6% 94.7% ======== ========
Losses and settlement expenses: Insured events of current year ................... $ 15,005 $ 14,931 Increase (decrease) in provision for insured events of prior years .................. 707 (365) -------- -------- Total losses and settlement expenses ......... $ 15,712 $ 14,566 ======== ========
Consolidated REVENUES Premiums earned ...................................... $101,294 $ 83,458 Net investment income ................................ 8,932 7,274 Realized investment gains ............................ 728 401 Other income ......................................... 96 76 -------- -------- 111,050 91,209 -------- -------- LOSSES AND EXPENSES Losses and settlement expenses ....................... 62,843 50,961 Acquisition and other expenses ....................... 32,938 27,283 Interest expense ..................................... 278 278 Other expense ........................................ 406 324 -------- -------- 96,465 78,846 -------- --------
Income before income tax expense ..................... 14,585 12,363 Income tax expense ................................... 4,082 4,014 -------- -------- Net income ........................................... $ 10,503 $ 8,349 ======== ========
Net income per share ................................. $ 0.77 $ 0.72 ======== ========
Net income increased 25.8 percent to a record $10,503,000 ($0.77 per share) in the first quarter of 2005 from the previous record of $8,349,000 ($0.72 per share) reported in the first quarter of 2004. This increase is primarily attributed to an increase in investment income stemming from a large increase in invested assets. The Company's invested assets increased as a result of $34,890,000 of net proceeds received from the follow-on stock offering completed in October 2004 and the receipt of $107,801,000 in cash in February 2005 in connection with the change in the pooling agreement. Also contributing to the increase in net income was a lower effective tax rate and a moderate increase in underwriting profits to $5,513,000 in the first quarter of 2005 from $5,214,000 in 2004. There have been indications of increased rate competition during the first quarter of 2005, but management continues to emphasize its goal of achieving profitability over production. Achieving an underwriting profit is always stressed, but has become even more critical in this lingering low interest rate environment.
Premiums written for the property and casualty insurance segment increased 75.9 percent to 105,853,000 in the first quarter of 2005 from $60,184,000 in the first quarter of 2004. This large increase is attributed to the change in the pooling agreement and includes a portfolio adjustment of $29,631,000, which serves as an offset to the increase in the unearned premium reserve. Excluding this portfolio adjustment, premiums written increased 26.6 percent in 2005. Looking at the net pool numbers, which are not impacted by the pool change, premiums written increased 0.3 percent in the first quarter of 2005. This slight increase reflects a decline in new business and a decline in the number of rate increases implemented due to increased competition in the marketplace and the current level of rate adequacy. The overall rate level on new and renewal policies increased approximately 0.5 percent for the first quarter of 2005 compared to approximately 4.0 percent in 2004, which is consistent with the marketplace. Commercial lines new business premium decreased approximately 3.0 percent during the first quarter of 2005, and personal lines new business premium decreased approximately 18.5 percent. However, policy retention remained at approximately 86.0 percent in commercial lines and 82.0 percent in personal lines. Though the Company will continue to implement rate increases in select lines of business and/or territories, premium rate levels for most lines of business are not expected to change significantly in 2005. In light of the improvements that have been achieved in both the pricing and the quality of the Company's book of business, management has become more receptive to opportunities to write new business, but continues to stress profitability over production.
Losses and settlement expenses increased 23.3 percent to $62,843,000 in the first quarter of 2005 from $50,961,000 in the first quarter of 2004. The majority of this increase is attributed to the Company's increased participation in the pooling agreement. The loss and settlement expense ratio (losses and settlement expenses expressed as a percentage of premiums earned) increased slightly to 62.0 percent in 2005 from 61.1 percent in 2004. The Company benefited from an increase in the amount of favorable development experienced on prior years' reserves; however, this benefit was partially offset by an increase in catastrophe and storm losses.
The loss and settlement expense ratio for the reinsurance segment increased to 72.8 percent in the first quarter of 2005 from 65.9 percent in the first quarter of 2004. This increase reflects adverse development on prior years' reserves reported by the MRB pool and an increase in catastrophe and storm losses, most notably European storm Erwin.
For the property and casualty insurance segment, the expense ratio increased to 34.4 percent in the first quarter of 2005 from 34.1 percent in the first quarter of 2004. This increase is primarily due to an increase in policyholder dividends, which reflects improved underwriting results on eligible accounts, and to a much lesser extent, an increase in agents' profit share expense.
Net investment income increased 22.8 percent to $8,932,000 in the first quarter of 2005 from $7,274,000 in the first quarter of 2004 due to a significant increase in invested assets. As previously discussed, the Company received $34,890,000 of net proceeds from the follow-on stock offering in October 2004 and received $107,801,000 in February 2005 in connection with the change in the pooling agreement. The Company also received $275,000 of interest income from Employers Mutual as the cash settlement for the pooling change did not occur until February 15, 2005. Investment rates of return continue to be negatively impacted by the lingering low interest rate environment. During this prolonged period of low interest rates, many of the Company's higher yielding securities have been called. The proceeds from these called securities, and from maturing securities, have been reinvested at the current lower interest rates, resulting in less investment income. During the second quarter of 2004, interest rates became more attractive and the Company began investing in long-term securities; however, the majority of these purchases were in tax-exempt bonds, which carry a lower interest rate but a higher after-tax rate of return. Realized investment gains totaled $728,000 in the first quarter of 2005 and $401,000 in the first quarter of 2004. The Company did not recognize any other-than-temporary impairment losses in the first quarter of 2005 or 2004.
The Company is a holding company whose principal assets are its investments in its insurance subsidiaries. As a holding company, the Company is dependent upon cash dividends from its insurance company subsidiaries to meet its obligations and to pay cash dividends to its stockholders. State insurance regulations restrict the maximum amount of dividends insurance companies can pay without prior regulatory approval. The maximum amount of dividends that the insurance company subsidiaries can pay to the Company in 2005 without prior regulatory approval is approximately $32.2 million. The Company received $1,357,000 and $1,576,000 of dividends from its insurance company subsidiaries and paid cash dividends to its stockholders totaling $2,039,000 and $1,730,000 in the first quarter of 2005 and 2004, respectively.
The Company considers itself to be a long-term investor and generally purchases fixed maturity investments with the intent to hold them to maturity. Despite this intent, the Company has historically classified a portion of its fixed maturity investments as available-for-sale securities to provide flexibility in the management of the portfolio. Since the third quarter of 1999, all newly acquired fixed maturity investments have been classified as available-for-sale securities to provide increased management flexibility. The Company had unrealized holding gains, net of deferred taxes, on fixed maturity securities available-for-sale totaling $10,685,000 and $15,511,000 at March 31, 2005 and December 31, 2004, respectively. The fluctuation in the market value of these investments is primarily due to changes in the interest rate environment during this time period. Since the Company does not actively trade in the bond market, such fluctuations in the fair value of these investments are not expected to have a material impact on the operations of the Company, as forced liquidations of investments are not anticipated. The Company closely monitors the bond market and makes appropriate adjustments in its portfolio as changing conditions warrant.
The Company held $5,542,000 and $5,550,000 in minority ownership interests in limited partnerships and limited liability companies at March 31, 2005 and December 31, 2004, respectively. The Company does not hold any other unregistered securities.
The Company carried a pension asset of $2,820,000 and $2,684,000 at March 31, 2005 and December 31, 2004, respectively. Postretirement benefit liabilities reflected in the Company's financial statements totaled $12,248,000 and $9,486,000 at March 31, 2005 and December 31, 2004, respectively. Included in these increases is $722,000 of pension assets and $2,518,000 of postretirement benefit liabilities transferred to the Company in connection with the change in the pooling agreement.
Capital resources consist of stockholders' equity and debt, representing funds deployed or available to be deployed to support business operations. For the Company's insurance subsidiaries, capital resources are required to support premium writings. Regulatory guidelines suggest that the ratio of a property and casualty insurer's annual net premiums written to its statutory surplus should not exceed 3 to 1. All of the Company's insurance subsidiaries were well under this guideline at March 31, 2005.
The Company had total cash and invested assets with a carrying value of $901.8 million and $779.4 million as of March 31, 2005 and December 31, 2004, respectively. The following table summarizes the Company's cash and invested assets as of the dates indicated:
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, CONTINUED
During 2004 the Company had one fixed maturity security series (MCI Communications Corporation) that was determined other-than-temporarily impaired. MCI Communications Corporation was owned by WorldCom Inc., whose corporate bonds were downgraded to junk status in May 2002 when it reported the detection of accounting irregularities. On June 30, 2002 the Company recognized $3,821,000 of realized loss when the carrying value of this investment was reduced from an aggregate book value of $5,604,000 to the then current fair value of $1,783,000. The fair value of the MCI bonds then partially recovered, resulting in pre-tax unrealized gains of $1,035,000 recognized during 2002 and $1,811,000 recognized during 2003. During the second quarter of 2004 the Company received three new series of fixed maturity securities (with impaired book values) issued by MCI Communications Corporation in conjunction with a payout award received under a bankruptcy court approved "Plan of Reorganization." This payout was recorded as a tax- free exchange and the new bonds were assigned a book value equal to the book value of the defaulted bonds that were replaced ($5,509,000). The par value of the new bonds reflected the settlement amount of 79.2 cents per dollar ($4,552,000) and the fair value of the new bonds was $4,241,000 at the time of the payout. Based on these facts, a realized investment gain of $3,826,000 was recognized in the second quarter of 2004 to offset the other-than- temporary impairment loss previously recognized in the second quarter of 2002 and an other-than-temporary impairment loss of $1,268,000 was recognized to reduce the book value of the new bonds to fair value at the time of the payout. The new bonds were sold during the third quarter of 2004 for income tax purposes, resulting in an additional realized gain of $187,000.
Description of securities Fair value Unrealized losses - ---------------------------- ---------- ----------------- ($ in thousands) Fixed maturity securities: Less than six months ........ $276,255 $1,894 Six to twelve months ........ 5,946 55 Twelve months or longer ..... 14,703 294 -------- ------ Total fixed maturity securities .............. 296,904 2,243 -------- ------ Equity securities: Less than six months ........ 10,908 609 Six to twelve months ........ 101 10 Twelve months or longer ..... - - -------- ------ Total equity securities ... 11,009 619 -------- ------ Total temporarily impaired securities ... $307,913 $2,862 ======== ======
Following is a schedule of gross realized losses recognized in 2005 along with the associated book values and sales prices aged according to the length of time the underlying securities were in an unrealized loss position. This schedule does not include realized losses stemming from corporate actions such as calls, pay-downs, redemptions, etc. The Company's equity portfolio is managed on a "tax-aware" basis, which generally results in sales of securities at a loss to offset sales of securities at a gain, thus minimizing the Company's income tax expense. Fixed maturity securities were not included in the schedule since no realized losses were recognized on these investments stemming from disposals other than corporate actions. Fixed maturity securities are generally held until maturity.
The participants in the pooling agreement have purchased annuities from life insurance companies, under which the claimant is payee, to fund future payments that are fixed pursuant to specific claim settlement provisions. The Company's share of loss reserves eliminated by the purchase of these annuities was $700,000 at December 31, 2004. Due to the change in the Company's aggregate participation in the pooling agreement, this amount increased to $894,000 effective January 1, 2005, therefore, the Company has a contingent liability of $894,000 should the issuers of these annuities fail to perform under the terms of the annuities. The Company's share of the amount due from any one life insurance company does not equal or exceed one percent of its subsidiaries' policyholders' surplus.
In December 2004, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards (SFAS) No. 123 (revised 2004) "Share-Based Payment," which is a revision of SFAS No. 123 "Accounting for Stock-Based Compensation" and supersedes Accounting Principles Board (APB) Opinion No. 25 "Accounting for Stock Issued to Employees." SFAS 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements based on their grant date fair values. The pro forma disclosures previously allowed under SFAS 123 will no longer be an alternative to financial statement recognition. The transition methods for adoption include the modified-prospective and modified-retroactive methods. The modified-prospective method requires that compensation expense be recorded for all unvested stock options that exist upon the adoption of SFAS 123(R). Under the modified-retroactive method, prior periods may be restated either as of the beginning of the year of adoption or for all periods presented. The effective date for SFAS 123(R) was originally the first interim and annual periods beginning after June 15, 2005, with earlier adoption encouraged. On April 14, 2005, the Securities and Exchange Commission approved a rule which delayed the required effective date of SFAS 123(R) until fiscal years beginning after June 15, 2005. The Company is currently evaluating the requirements of SFAS 123(R), including the adoption method alternatives, but does not expect adoption of this statement to have a material effect on the operating results of the Company.
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
/s/ Bruce G. Kelley -------------------------- Bruce G. Kelley President & Chief Executive Officer
/s/ Mark E. Reese -------------------------- Mark E. Reese Senior Vice President and Chief Financial Officer