Our headquarters are located in a four story, 110,000 square foot building that we own in Blue Bell, Pennsylvania. Through various wholly-owned subsidiaries, we also own and occupy additional office facilities in three other locations and rent additional office space for our insurance operations in 13 other locations. All but one of these facilities are shared by The PMA Insurance Group with PMA Management Corp. We also rent additional office space for Midlands at six other locations in Oklahoma, Texas, California, and New York. One of our offices in Oklahoma is partially subleased to an unaffiliated third party.
Results for 2003 were impacted by $49 million from the recording of a valuation allowance on the Company’s deferred tax asset.
The following is a discussion of the financial condition of PMA Capital Corporation and its consolidated subsidiaries (“PMA Capital” or the “Company,” which also may be referred to as “we” or “us”) as of December 31, 2007, compared with December 31, 2006, and the results of operations of PMA Capital for 2007 and 2006, compared with the immediately preceding year. The balance sheet information is as of December 31 for each respective year. The statement of operations information is for the year ended December 31 for each respective year.
In 2007, we reported the results of our Run-off Operations as discontinued operations. In accordance with Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-lived Assets” (“SFAS 144”), the Balance Sheets have been presented with the gross assets and liabilities of discontinued operations in separate lines and the Statements of Operations have been presented with the net results from discontinued operations, shown after the results from continuing operations. For comparative purposes, we have reclassified our prior period financial presentation to conform to these changes.
We are a holding company whose operating subsidiaries provide insurance and fee-based services. Our insurance products include workers’ compensation and other commercial property and casualty lines of insurance, which are marketed primarily in the eastern part of the United States. These products are written through The PMA Insurance Group business segment. Fee-based services include third party administrator (“TPA”), managing general agent and program administrator services. Our Fee-based Business segment consists of the results of PMA Management Corp. and Midlands Management Corporation (“Midlands”), and is a new reporting segment, resulting from our acquisition of Midlands on October 1, 2007. PMA Management Corp. is a TPA whose results were previously included in The PMA Insurance Group segment. Midlands is an Oklahoma City-based managing general agent, program administrator and provider of TPA services.
uses of holding company cash. In January 2008, we retired the remaining $1.3 million principal amount of our 6.50% Convertible Debt.
The PMA Insurance Group earns revenue and generates cash primarily by writing insurance policies and collecting insurance premiums. We also earn revenues by providing claims adjusting, managed care and risk control services to customers and by placing insurance business with other third party insurance and reinsurance companies. As time normally elapses between the receipt of premiums and the payment of claims and certain related expenses, we are able to invest the available premiums and earn investment income. The types of payments that we make are:
acquisition and operating expenses, which are direct and indirect costs of acquiring both new and renewal business, including commissions paid to agents, brokers and sub-producers and the internal expenses to operate the business segment; and
These items are further described elsewhere in the MD&A and in “Item 1 - Business.”
Losses and LAE are the most significant payment items affecting our insurance business and represent the most significant accounting estimates in our consolidated financial statements. We establish reserves representing estimates of future amounts needed to pay claims with respect to insured events that have occurred, including events that have not been reported to us. We also establish reserves for LAE, which represent the estimated expenses of settling claims, including legal and other fees, and general expenses of administering the claims adjustment process. Reserves are estimates of amounts to be paid in the future for losses and LAE and do not and cannot represent an exact measure of liability. If actual losses and LAE are higher than our loss reserve estimates, if actual claims reported to us exceed our estimate of the number of claims to be reported to us, or if we increase our estimate of the severity of claims previously reported to us, then we have to increase reserve estimates with respect to prior periods. Changes in reserve estimates may be caused by a wide range of factors, including inflation, changes in claims and litigation trends and legislative or regulatory changes. We incur a charge to earnings in the period the reserves are increased. In 2007, we recorded a $22 million pre-tax charge to increase loss reserves for prior years in our discontinued operations, as discussed under “Discontinued Operations” beginning on page 40 of this MD&A.
Income (loss) from continuing operations included the following after-tax net realized gains:
Consolidated revenues were $455.8 million, $432.6 million and $414.4 million in 2007, 2006 and 2005, respectively. The increases in consolidated revenues in 2007 and 2006, compared to the immediately preceding year, primarily reflected premium growth at The PMA Insurance Group and, to a lesser extent, increased claims service revenues at our Fee-based Business.
The following is a reconciliation of our segment operating results to GAAP net income (loss). See Note 16 of our Consolidated Financial Statements for additional information.
Beginning in the fourth quarter of 2007, the results of The PMA Insurance Group no longer include those of PMA Management Corp. The results of PMA Management Corp. are currently included within the segment results of our Fee-based Business. For comparative purposes, the financial results of The PMA Insurance Group and PMA Management Corp. have been reclassified in all prior periods to reflect this change.
As a result of our acquisition of Midlands in 2007, the combined operating results of PMA Management Corp. and Midlands have been reported in a new reporting segment, Fee-based Business.
Effective in the fourth quarter of 2007, we reported the results of our former Run-off Operations segment as discontinued operations. As a result of this change, the Corporate and Other segment was impacted by investment income previously eliminated in the Corporate and Other segment. For comparative purposes, all prior periods have been reclassified to reflect this change.
We provide combined ratios and operating ratios for The PMA Insurance Group below. The “combined ratio” is a measure of property and casualty underwriting performance. The combined ratio computed on a GAAP basis is equal to losses and loss adjustment expenses, plus acquisition and operating expenses and policyholders’ dividends, all divided by net
Beginning in 2007, the results of The PMA Insurance Group no longer include those of PMA Management Corp. The results of PMA Management Corp. are now included within the segment results of our Fee-based Business. For comparative purposes, the financial results of The PMA Insurance Group and PMA Management Corp. have been reclassified in all prior periods to reflect this change.
Direct workers’ compensation premiums written were $457.4 million in 2007, compared to $382.9 million in 2006 and $347.7 million in 2005. New workers’ compensation business was $152.6 million in 2007, compared to $98.3 million for 2006 and $92.7 million for 2005. Included in new business for 2007 was $51.5 million of California workers’ compensation business written under our agreement with Midwest Insurance Companies (“Midwest”), compared to $14.8 million in 2006. Our agreement with Midwest became effective September 1, 2006 and terminated on March 2, 2008. Our renewal retention rate on existing workers’ compensation accounts was 87% for 2007, compared to 85% for 2006 and 76% for 2005. Pricing on our rate-sensitive workers’ compensation business decreased by 4% in 2007, 2% in 2006, and increased by 4% in 2005. In early 2006, we stopped writing integrated disability business.
For workers’ compensation coverages, the premium charged on fixed-cost policies is primarily based upon the manual rates filed with state insurance departments. Workers’ compensation manual rates for business in our principal marketing territories decreased by 4% in 2007 and 3% in 2006, and increased by 2% in 2005. These changes in manual rates generally reflect the effects of average medical and indemnity cost fluctuations in recent years. Manual rate changes directly affect the prices that we can charge for our rate-sensitive workers’ compensation products, which comprised 59% of workers’ compensation premiums written in 2007.
In September 2006, we entered into an agreement with Midwest General Insurance Agency (“MGIA”) under which MGIA underwrites and services workers’ compensation policies in California using our approved forms and rates. Upon inception, we ceded 100% of the direct premiums and related losses on this business to non-affiliated reinsurers selected by us, including Midwest, an affiliate of MGIA. Effective April 1, 2007, we retained 5% of the direct premiums and related losses on this business. Our retention of this business increased to 10%, effective September 1, 2007. All of the participating reinsurers, except for Midwest, have current A.M. Best Company, Inc. (“A.M. Best”) financial strength ratings of “A-” (Excellent) or higher. Midwest does not have an A.M. Best financial strength rating. We mitigated our credit risk with Midwest by requiring them to secure amounts owed to us by holding cash in trust. We earn an administrative fee based upon the actual amount of premiums earned pursuant to the agreement. Total direct premiums written under this agreement were $59.8 million in 2007 and $14.8 million in 2006. Our agreement with Midwest terminated in March 2008. We will continue to earn fees and service the business previously written, but no additional business will be written or renewed after the termination date. We have entered into one fronting arrangement smaller than Midwest in the first quarter of 2008 and believe that we will write more of these programs in the coming year.
In February 2008, the Pennsylvania Compensation Rating Bureau recommended a reduction in loss costs of 10.2%, which was approved by the Pennsylvania Insurance Department and will become effective on April 1, 2008. While this will result in lower filed loss costs in Pennsylvania, we will continue our practice of underwriting our business with a goal of achieving a reasonable level of profitability on each account. We do not expect that the filed loss costs will result in a reduction in premiums in Pennsylvania at the same level of the loss cost reduction, based on our current views of the
experience modification factors and potential future experience of our book of business. We will continue to determine our business pricing through schedule charges/credits that we file and use to limit the effect of filed loss cost changes. We also believe that the loss cost change should not significantly affect the results or the profitability of our loss-sensitive and alternative market books of business, which represent approximately 42% of our Pennsylvania workers’ compensation business.
Premiums ceded increased by $46.7 million in 2007 and by $36.9 million in 2006, compared to the immediately preceding year. Premiums ceded for workers’ compensation increased by $47.0 million in 2007, compared to 2006, primarily due to our agreement with Midwest, under which we ceded $57.3 million in 2007, compared to $14.8 million in 2006. The increase in 2007 was also attributable to an increase in the amount of workers’ compensation business sold to captive accounts, where a substantial portion of the direct premiums are ceded. Premiums ceded for workers’ compensation increased by $27.7 million in 2006, compared to 2005, primarily due to the increase in our captive accounts business and our agreement with Midwest and, to a lesser extent, the increase in direct premiums earned and the additional terrorism coverage purchased in 2006. Premiums ceded for commercial lines slightly declined in 2007, compared to 2006, mainly resulting from changes in the contractual terms of our property quota share treaty. Premiums ceded for commercial lines increased by $9.3 million in 2006, compared to 2005, resulting primarily from the increase in our captive accounts business and changes in our reinsurance program. During 2006, we lowered our retentions on casualty-related business and converted our property reinsurance protection from an excess of loss to a pro rata basis.
Net premiums written and net premiums earned increased by 6% and 3%, respectively, in 2007, compared to 2006, and decreased by 1% and increased by 3%, respectively, in 2006, compared to 2005. Generally, trends in net premiums earned follow patterns similar to net premiums written, adjusted for the customary lag related to the timing of premium writings within the year. In periods of increasing premium writings, the dollar increase in premiums written will typically be greater than the increase in premiums earned, as was the case in 2007. The increase in net premiums earned in 2006, compared to 2005, reflected the effects of higher net premiums written in the last half of 2005, compared to the same period in 2006. Direct premiums are earned principally on a pro rata basis over the terms of the policies. However, with respect to policies that provide for premium adjustments, such as experience-rated or exposure-based adjustments, such premium adjustment may be made subsequent to the end of the policy’s coverage period and will be recorded as earned premium in the period in which the adjustment is made.
The loss and LAE ratio improved 1.3 points in 2006, compared to 2005. The improved loss and LAE ratio primarily reflected a lower current accident year loss and LAE ratio in 2006, compared to 2005. Our loss and LAE ratio benefited from changes in the type of workers’ compensation products selected by insureds, modest changes in our geographic mix and a reduction in our estimate of medical cost inflation. Our medical cost inflation estimate was 8.5% in 2006, compared to 9% in 2005.
Pre-tax operating income for the Fee-based Business was $3.7 million in 2007, compared to $2.8 million in 2006 and $2.5 million in 2005. The increase in pre-tax operating income in 2007, compared to 2006, primarily related to the inclusion of Midlands’ results for the quarter ended December 31, 2007.
Fee-based revenues, excluding net investment income, were $37.2 million in 2007, compared to $27.9 million in 2006. The increase was primarily due to the inclusion of Midlands’ revenues in 2007, and also reflected higher fees for managed care services of $1.4 million and increases in fees of $803,000 and $746,000, respectively, for claims service provided to self-insured clients and large deductible and captive clients. Managed care services include medical bill review services and access to our preferred provider network partnerships.
Fee-based revenues, excluding net investment income, increased by $4.3 million in 2006, compared to 2005. The increase primarily reflected higher fees of $1.9 million for claims, risk management and related services provided to self-insured clients. Also, fees attributable to large deductible and captive clients and managed care services were each higher by $1.2 million.
Operating expenses increased to $34.4 million in 2007, up from $25.7 million in 2006. The increase in operating expenses primarily reflected the inclusion of Midlands’ operating expenses in 2007, which included $1.1 million in commission expense and $167,000 related to the amortization of intangible assets. The increase also reflected higher direct costs of $2.2 million associated with the claims and managed care services provided to self-insured clients, as well as higher direct costs of $746,000 attributable to large deductible and captive clients.
Discontinued operations, formerly reported as our Run-off Operations, include the results of our former reinsurance and excess and surplus lines businesses, from which we withdrew in November 2003 and May 2002, respectively. In February 2008, we announced that we entered into a non-binding letter of intent with a third party and expect to execute a definitive stock purchase agreement in the first quarter of 2008. The transfer of ownership will be subject to regulatory approval. Because of the expected divestiture of these businesses, we have determined that these operations should be reflected as discontinued operations. As such, we recorded an after-tax impairment loss of $40.0 million in the fourth quarter of 2007, as the book value of our Run-off Operations was greater than the estimated net proceeds we expect to receive in a sale.
In 2007, we increased the net loss reserves at our discontinued operations for prior accident years by $22 million. During the third quarter, our actuaries conducted their periodic comprehensive reserve review. Based on the actuarial work performed, our actuaries observed increased loss development from a limited number of ceding companies on our claims-made general liability business, primarily related to professional liability claims. This increase in 2007 loss trends caused management to determine that reserve levels, primarily for accident years 2001 to 2003, needed to be increased by $22 million.
The losses and LAE incurred benefit reported in 2006 was mainly attributable to favorable loss development and the amortization of the deferred gain on retroactive reinsurance. During 2006, we recorded $1.3 million in favorable development, net of discount accretion, largely due to commutations of reinsurance treaties with some of our ceding companies. Amortization of the deferred gain on retroactive reinsurance reduced losses and LAE incurred by $1.8 million in 2007, $1.7 million in 2006 and $2.8 million in 2005.
At December 31, 2007, we recorded an income tax benefit on the impairment loss as we believe we will be able to use the loss to offset future operating earnings.
Net investment income was $2.8 million, $7.7 million and $16.7 million in 2007, 2006 and 2005, respectively. The decreases in net investment income were mainly due to reductions in the average invested asset base of approximately $155 million, or 52%, in 2007, compared to 2006, and approximately $260 million, or 47%, in 2006, compared to 2005. These reductions were largely impacted by continued loss payments as well as the extraordinary dividends of $37.5 million and $73.5 million paid by PMACIC to PMA Capital Corporation in April 2007 and May 2006, respectively. During 2007, the discontinued operations’ insurance liabilities decreased by $143 million, or 30%, since prior year end, despite the $22 million increase to reserves during the third quarter. Included in the 2007 reduction was $30.6 million from commutations with ceding companies.
The following table represents the reserve levels as of December 31, 2007 for The PMA Insurance Group and the significant lines of business within this segment:
on page 63 and “Item 1A - Risk Factors” for a discussion of factors that may adversely impact our losses and LAE in the future.
We perform credit reviews of our reinsurers focusing on, among other things, financial capacity, stability, trends and commitment to the reinsurance business. Reinsurers failing to meet our standards are excluded from our reinsurance programs. In addition, we require collateral, typically assets in trust, letters of credit or funds withheld, to support balances due from certain reinsurers, generally those not authorized to transact business in the applicable jurisdictions. At December 31, 2007 and 2006, our reinsurance receivables were supported by $351.4 million and $342.0 million of collateral, respectively. Of the uncollateralized reinsurance receivables at December 31, 2007, approximately 89% was due from reinsurers rated “A-” or better by A.M. Best and is broken down as follows: “A++” - 2%; “A+” - 36%; “A” - 41% and “A-” - 10%. We believe that our reinsurance receivables, net of the valuation allowance, are fully collectible. The timing of payments and the collectibility of reinsurance receivables have not had a material adverse effect on our liquidity.
The PMA Insurance Group had recorded reinsurance receivables of $13.9 million at December 31, 2006, related to certain umbrella policies covering years prior to 1977. The reinsurer had previously disputed the extent of coverage under these policies. We settled this dispute with the reinsurer in 2007.
The PMA Insurance Group retains an aggregate $13.8 million deductible on the first layer of its workers’ compensation reinsurance, which is $750,000 excess of $250,000. Effective January 1, 2008, the aggregate deductible decreased to $12.9 million.
Certain portions of The PMA Insurance Group’s workers’ compensation reinsurance include coverage for terrorist acts. Effective January 1, 2008, our reinsurance of $129 million excess of $1 million includes coverage for certified and non-certified terrorist acts, except for nuclear, biological, chemical and radiological (“NBCR”) events. In all cases, at least two full limits of coverage are available in the aggregate. For NBCR events, our coverage includes domestic and non-certified events for $5 million excess of $1 million.
acting on behalf of a foreign or domestic person or interest. TRIPRA contains a “make available” provision, which requires insurers subject to the Act to offer coverage for acts of terrorism that does not differ materially from the terms (other than price), amounts and other coverage limitations offered to the policyholder for losses from events other than acts of terrorism. The “make available” provision permits exclusions for certain types of losses, if a state permits exclusions for such losses. TRIPRA requires insurers to pay a deductible equal to 20% of commercial lines (as defined by TRIPRA) direct earned premiums. The federal government covers 85% of the losses above the deductible, while a company retains 15% of the losses. TRIPRA contains an annual limit of $100 billion of covered industry-wide losses. TRIPRA applies to certain commercial lines of property and casualty insurance, including workers’ compensation insurance, offered by The PMA Insurance Group, but does not apply to reinsurance. The PMA Insurance Group would be subject to a deductible of approximately $90 million in 2008 if a covered terrorist act were to occur. Such deductible would be covered by our existing reinsurance program.
The following table represents the reserve levels as of December 31, 2007 for our discontinued operations and the significant types of business within these operations:
Unpaid losses and LAE of our discontinued operations are presented with the gross liabilities of discontinued operations in a separate line on the Balance Sheet. The unpaid losses and LAE for these operations, net of reinsurance, at December 31, 2007 and 2006 were $195.8 million and $193.4 million, respectively, net of discount of $22.1 million and $26.3 million, respectively. Included in the unpaid losses and LAE of these operations were amounts related to our workers’ compensation claims of $48.8 million and $47.8 million, net of discount of $19.5 million and $22.2 million at December 31, 2007 and 2006, respectively. The discount rate used was approximately 5% at December 31, 2007 and 2006.
Reinsurers are dependent on their ceding companies for reporting information regarding incurred losses. The nature and extent of information provided to reinsurers may vary depending on the ceding company as well as the type of reinsurance purchased by the ceding company. Ceding companies may also independently adjust their reserves over time as they receive additional data on claims and go through their own actuarial process for evaluating reserves. For casualty lines of reinsurance, significant periods of time may elapse between when a loss is incurred and reported by the ceding company’s insured, the investigation and recognition of such loss by the ceding insurer, and the reporting of the loss and evaluation of coverage by a reinsurer. As all of our reinsurance business was produced through independent brokers, an additional lag occurs because the ceding companies report their experience to the placing broker, who then reports such information to the reinsurer. Because of these time lags, and because of the variability in reserving and reporting by ceding companies, it takes longer for reinsurers to find out about reported claims than for primary insurers and such claims are subject to more unforeseen development and uncertainty.
We rely on various data in making our estimate of loss reserves for reinsurance. As described above, the reinsurer receives certain information from ceding companies through the reinsurance brokers. We assess the quality and timeliness of claims
reporting by our ceding companies. The reinsurer also may supplement the reported information by requesting additional information and conducting reviews of certain of its ceding companies’ reserving and reporting practices. It also reviews its internal operations to assess its capabilities to timely receive and process reported claims information from ceding companies. It assesses its claims data and loss projections in light of historical trends of claims developments, claims payments, and also as compared to industry data as a means of noticing unusual trends in claims development or payment. Based on the data reported by ceding companies, the results of the reviews and assessments noted above, as well as actuarial analysis and judgment, we will develop our estimate of reinsurance reserves.
At December 31, 2007, 2006 and 2005, our discontinued operations’ gross reserves for asbestos-related losses were $7.5 million, $5.9 million and $4.6 million, respectively ($1.6 million, $825,000 and $560,000, net of reinsurance, respectively). At December 31, 2007, 2006 and 2005, our discontinued operations’ gross reserves for environmental-related losses were $877,000, $1.5 million and $1.3 million, respectively ($364,000, $1.1 million and $900,000, net of reinsurance, respectively).
At December 31, 2007, our assets of discontinued operations included reinsurance receivables due from the following unaffiliated reinsurers in excess of 5% of our shareholders’ equity:
Includes St. Paul Fire and Marine Insurance Company ($40.8 million), Mountain Ridge Insurance Company ($7.9 million) and other affiliated entities ($124,000).
In 2004, we purchased reinsurance covering potential adverse loss development of the loss and LAE reserves of our reinsurance and excess and surplus lines businesses. Upon entering into the agreement, we ceded $100 million in carried loss and LAE reserves and paid $146.5 million in cash. In 2005, we ceded $30 million in losses and LAE under this agreement. In 2007, an additional $22 million in losses and LAE were ceded under this agreement. See Note 4 to our Consolidated Financial Statements for additional information about the prior year loss development at the discontinued operations recorded in 2005 and 2007. Because the coverage was retroactive, we deferred the initial benefit of these cessions, which was being amortized over the estimated settlement period of the losses using the interest method. Accordingly, we had a deferred gain on retroactive reinsurance of $25.4 million at December 31, 2006, which was included in liabilities of discontinued operations on the Balance Sheet. Amortization of the deferred gain reduced our loss from discontinued operations by $1.8 million in 2007, $1.7 million in 2006 and $2.8 million in 2005. As of December 31, 2006, we also had $56.6 million included in assets of discontinued operations for other receivables due under the contract.
In 2007, we commuted the reinsurance agreement covering potential adverse loss development. As a result, we received $171.9 million in cash and our assets of discontinued operations declined by $152.0 million for amounts collected against reinsurance receivables. Assets of discontinued operations also decreased by $65.6 million related to the reduction of prepaid and other assets, and liabilities of discontinued operations declined by $45.6 million related to the reduction of the deferred gain on retroactive reinsurance. The commutation did not have a material impact on our loss from discontinued operations.
Operating cash flows were $86.8 million in 2007 due primarily to positive cash flows generated from the operating activities at The PMA Insurance Group and discontinued operations. The positive operating cash flows at The PMA Insurance Group were reduced by $22.7 million for retroactive reinsurance purchased to cover substantially all of the unpaid losses and LAE related to its integrated disability business. The positive operating cash flows at our discontinued operations were due to cash received of $171.9 million related to the commutation of the reinsurance agreement covering potential adverse loss development, which was partially offset by loss and expense payments. Operating cash flows were negative in 2006 and 2005, primarily due to the run-off of our reinsurance business, including the commutation and novation of certain reinsurance and retrocessional contracts.
We expect that the cash flows generated from the operating activities of The PMA Insurance Group and our Fee-based Business will be positive for the foreseeable future as we anticipate premium and other service revenue collections to exceed losses and LAE and operating expense payments. We intend to invest these positive cash flows and earn investment income.
At the holding company level, our primary sources of liquidity are dividends, tax payments received from subsidiaries and capital raising activities. We utilize cash to pay debt obligations, including interest costs, taxes to the federal government, corporate expenses and dividends to shareholders. At December 31, 2007, we had $38.2 million of cash and short-term investments at the holding company, which we believe combined with our other capital sources, will continue to provide us with sufficient funds to meet our foreseeable ongoing expenses and interest payments. We do not currently pay dividends on our Class A Common Stock.
On May 9, 2007, our Board of Directors authorized us to repurchase shares of our Class A Common Stock in an amount not to exceed $10.0 million. In 2007, we repurchased 986,522 shares of our Class A Common Stock at a cost of $10.0 million under this authorization.
Assumes holders of this debt require us to repurchase all of this debt on the next put date. Holders, at their option, may require us to repurchase all or a portion of their debt on September 30, 2008, 2010, 2012 and 2017. This debt may be converted at any time, at the holder’s option, at a current price of $16.368 per share.
The operating lease obligations referred to in the table above are primarily obligations of our insurance subsidiaries and are net of sublease rentals of $1.8 million in 2008, $1.6 million in 2009 and 2010, $1.7 million in 2011, 2012 and 2013, and $1.1 million thereafter. The operating lease obligations also include amounts for our discontinued operations of $388,000 in 2008, $474,000 in 2009 and $473,000 in 2010 and 2011, respectively.
As of December 31, 2007, our total outstanding debt was $131.3 million, compared to $131.2 million at December 31, 2006. During 2007, we purchased $18.1 million of our 6.50% Convertible Debt in the open market and issued $20.6 million of junior subordinated debt. These transactions extended the average maturity of our debt from 15 years to 20 years.
Our remaining junior subordinated debt of $43.8 million matures in 2033 and is redeemable, in whole or in part, in 2008 at the stated liquidation amount plus accrued and unpaid interest. The weighted average interest rates on this junior subordinated debt equal the three-month LIBOR plus 4.12%, and interest on this debt is also payable on a quarterly basis. At December 31, 2007, the weighted average interest rate on all of our junior subordinated securities was 8.90%.
We had previously entered into interest rate swaps with an aggregated notional amount of $52.5 million that we had designated as cash flow hedges to manage interest costs and cash flows associated with the variable interest rates on our junior subordinated debt and our Floating Rate Surplus Notes due 2035 (“Surplus Notes”). During 2007, we settled these interest rate swaps and received net proceeds of $578,000.
In June 2007, we entered into new interest rate swaps that we have designated as cash flow hedges to manage interest costs and cash flows associated with the variable interest rates on a portion of our junior subordinated debt and our Surplus Notes. There was no consideration paid or received for these swaps. The swaps will effectively convert $10.0 million of the junior subordinated debt and $10.0 million of Surplus Notes to fixed rate debt with interest rates of 9.40% and 9.93%, respectively.
During 2006, we retired $28.7 million principal amount of our 6.50% Convertible Debt. All of the open market purchases were made by the holding company, except for $3.3 million, which was made by one of our consolidated operating companies. We paid $32.3 million for these bond purchases, exclusive of accrued interest. In 2006, we also retired $2.6 million principal amount of our 8.50% Senior Notes through open market purchases. We paid $2.6 million for these bond purchases, exclusive of accrued interest. We have the right to call our 8.50% Senior Notes beginning in June 2008.
In June 2006, we completed the redemption of $35 million principal amount, including $9.6 million held by our consolidated operating companies, of our 6.50% Convertible Debt. The mandatory redemption was triggered by the extraordinary dividend we received from PMACIC. Under the terms of the indenture, we were required to redeem the debt at par plus a premium of $100 per $1,000 of principal amount. The premium was due in cash, or at the election of the holder, in shares of our Class A Common Stock, valued at $8 per share. In conjunction with the redemption, we paid $36.0 million, including $10.6 million to our consolidated operating companies, and issued 307,990 shares of our Class A Common Stock, with a fair value of $3.1 million, from our treasury.
During 2007, 2006 and 2005, we incurred $11.7 million, $13.5 million and $16.1 million of interest expense, and paid interest of $11.8 million, $13.7 million and $13.9 million in each respective year. The reduction in interest expense and interest paid in 2007, compared to 2006, was due to a lower average amount of debt outstanding. The reduction in interest expense and interest paid in 2006, compared to 2005, was due to a lower average amount of debt outstanding, which was partially offset by higher interest rates on our debt. The 2006 decline in interest paid was not as significant as the decline in interest expense due to timing of interest payments and debt retirements.
Our investment objectives are to (i) seek competitive after-tax income and total returns, (ii) maintain high investment grade asset quality and high marketability, (iii) maintain maturity distribution commensurate with our business objectives, (iv) provide portfolio flexibility for changing business and investment climates and (v) provide liquidity to meet operating objectives. Our investment strategy includes setting guidelines for asset quality standards, allocating assets among investment types and issuers, and other relevant criteria for our portfolio. In addition, invested asset cash flows, which include both current interest income received and investment maturities, are structured to consider projected liability cash flows of loss reserve payouts that are based on actuarial models. Property and casualty claim demands are somewhat unpredictable in nature and require liquidity from the underlying invested assets, which are structured to emphasize current investment income while maintaining appropriate portfolio quality and diversity. Liquidity requirements are met primarily through operating cash flows and by maintaining a portfolio with maturities that reflect expected cash flow requirements.
Our investment portfolio includes only fixed maturities, short-term investments and cash. The portfolio is diversified and does not contain any significant concentrations in single issuers other than U.S. Treasury and agency obligations. Our largest exposure to a single corporate issuer is $14.8 million, or 2% of total invested assets. In addition, we do not have a significant concentration of our investments in any single industry segment other than finance companies, which comprised 10% of invested assets at December 31, 2007. Included in this industry segment are diverse financial institutions, including banks and insurance companies, with no single issuer exceeding 2% of the total investment portfolio. All of our investments as of December 31, 2007 are dollar denominated.
The net unrealized gain on our investments at December 31, 2007 was $6.1 million, or 1% of the amortized cost basis. The net unrealized gain included gross unrealized gains of $9.7 million and gross unrealized losses of $3.6 million.
For all but two securities, which were carried at a fair value of $1.5 million at December 31, 2007, we obtained the fair value of fixed income securities from independent pricing services which use prices obtained in the public markets. For one security, a privately placed $1.0 million 18-month construction bridge loan with no secondary market, we considered its current fair value to approximate original cost. The second security, which was carried at a fair value of $545,000 at December 31, 2007, is priced utilizing the services of the investment banking firm that originally underwrote the security. The investment banker determines the fair value of the security by using a discounted present value of the estimated future cash flows (interest and principal repayment).
At December 31, our fixed maturities had an overall average credit quality of AAA-, broken down as follows:
We review the securities in our fixed income portfolio on a periodic basis to specifically identify individual securities for any meaningful decline in fair value below amortized cost. Our analysis includes all securities whose fair value is significantly below amortized cost at the time of the analysis, with additional emphasis placed on securities whose fair value has been below amortized cost for an extended period of time. As part of our periodic review process, we utilize information received from our outside professional asset manager to assess each issuer’s current credit situation. This review contemplates recent issuer activities, such as quarterly earnings announcements or other pertinent financial news for the company, recent developments in a particular industry, economic outlook for a particular industry and rating agency actions. For structured securities, we analyze the quality of the underlying collateral of the security. We do not believe that there are credit related risks associated with our U.S. Treasury and agency securities.
In 2007, we recorded a pre-tax impairment loss of $209,000 on a security issued by a national provider of higher education loans. In 2005, we recorded impairment losses for securities issued by two auto manufacturers, resulting in a pre-tax impairment charge of $773,000. The write-downs were measured based on public market prices at the time we determined the decline in value was other than temporary.
The contractual maturity of securities in an unrealized loss position at December 31, 2007 was as follows:
We had pre-tax net realized investment gains of $563,000 in 2007, compared to investment gains of $1.2 million in 2006 and $372,000 in 2005. During 2007, we recorded gross realized investment gains and losses of $2.0 million and $3.9 million, respectively, on sales from our invested asset portfolio. The gross realized gains and losses primarily related to general duration management trades, which focused on maintaining our bias towards shorter duration and higher credit quality securities in the investment portfolio. Gross realized losses also included an impairment loss of $209,000 on a fixed income security. The change in fair value of trading securities related to a security that was previously held at our discontinued operations and transferred to our holding company as part of the $37.5 million dividend in April 2007.
During 2006, we had gross realized investment gains and losses of $5.6 million and $4.7 million, respectively, on sales from our invested asset portfolio. The gross realized gains and losses resulted primarily from the repositioning of invested assets out of lower yielding sectors, such as corporate bonds, and into higher yielding sectors, such as structured securities, and reducing our overall risk in the portfolio by improving credit quality and shortening duration.
Results for 2005 included gross realized gains and losses of $6.7 million and $2.8 million, respectively, from investment sales. Gross realized losses reflected sales reducing our per issuer exposure, general duration management trades and impairment losses of $773,000 on fixed income securities.
See Note 4 to our Consolidated Financial Statements for additional discussion about investments at our discontinued operations.
The following discussion is intended to provide you with an understanding of our critical accounting estimates, which are those accounting estimates that we believe are most important to the portrayal of our financial condition and results of operations, and that require our most difficult, subjective and complex judgments.
Incurred Loss Development - This method projects ultimate losses based on historical development trends of incurred losses.
Bornhuetter-Ferguson - This method projects future incurred or paid losses based upon expected losses. The expected future paid or incurred losses are added to actual paid or incurred losses to determine ultimate losses.
In estimating our reserves for unpaid losses and LAE, our actuaries also consider the fact that each of our businesses has a different potential for reserve development. We believe that the potential for adverse reserve development is increased at our former reinsurance business because of the nature of the reinsurance business itself and because of the fact that it is in run-off. Reinsurers rely on their ceding companies to provide them with information regarding incurred losses. Therefore, it takes longer for reinsurers to find out about reported claims than for primary insurers and such claims are more subject to unforeseen development and uncertainty. Additionally, the potential for adverse reserve development in our former reinsurance operation has increased because we have ceased ongoing business relationships with most of our ceding companies. As a result, to the extent that there are disputes with its ceding companies over claims coverage or other issues, we believe that it is more likely that we will be required to arbitrate these disputes.
Within the workers’ compensation line of business, we review medical and indemnity costs separately. We undertake this review because we believe that the medical cost component of workers’ compensation claims has a different development pattern than the indemnity payments, and also because we believe that certain assumptions within the medical cost component, such as the rate of medical cost inflation, can lead to more volatility as compared to the indemnity component. For example, a one percentage-point change in current year medical inflation would result in about three tenths of a point change in our overall loss and LAE ratio. At December 31, 2007, our medical loss reserves were approximately 48% of the workers’ compensation loss reserves, with the balance being indemnity costs. We also review the workers’ compensation line of business by state for some of our larger states. We undertake this review because workers’ compensation benefits vary by state and this can cause loss development patterns to vary by state.
After our actuaries complete the analyses described above, management reviews the data along with various industry benchmarks, and using its informed judgment, selects its best estimate of the amounts needed to pay all pending and future claims and related expenses, including those not yet reported to us. This best estimate is recorded as a loss and LAE reserve on our balance sheet. Our practice is to establish reserves for unpaid losses and LAE at a level where we believe it is likely that such unpaid losses and LAE could ultimately settle at similar amounts either above or below management’s
At December 31, 2007, unpaid losses and loss adjustment expenses at the continuing operations were $1,213.0 million, which included case reserves of $598.6 million and IBNR reserves of $614.4 million. At December 31, 2007, unpaid losses and loss adjustment expenses at the discontinued operations were $339.1 million, which included case reserves of $271.4 million and IBNR reserves of $67.7 million.
At our discontinued operations, the components of our (favorable) unfavorable development of reserves for losses and LAE for prior accident years by accident year, excluding accretion of discount, were as follows:
During 2007, the discontinued operations recorded unfavorable prior year loss development of $21.6 million, which included a $22 million charge taken in the third quarter. In the third quarter of 2007, our actuaries conducted their periodic comprehensive reserve review. Based on the actuarial work performed, our actuaries observed increased loss development from a limited number of ceding companies on our claims-made general liability business, primarily related to professional liability claims. Specifically, we experienced higher than expected severity on general liability claims-made losses at our discontinued operations during the third quarter causing our actuaries to increase the average expected size of future loss payments on these types of claims. This increase in 2007 loss trends caused management to determine that reserve levels, primarily for accident years 2001 to 2003, needed to be increased by $22 million.
For additional information about our investments, see Notes 2-B, 4, 5 and 13 to the Consolidated Financial Statements as well as “Investments” beginning on page 51.
We follow the customary insurance industry practice of reinsuring with other insurance and reinsurance companies a portion of the risks under the policies written by our insurance subsidiaries. Our reinsurance receivables total $795.9 million at December 31, 2007. We have estimated that $4.6 million of our reinsurance receivables will be uncollectible, and we have provided a valuation allowance for that amount. Our assets of discontinued operations include $150.1 million for reinsurance receivables at December 31, 2007, and these receivables are recorded net of a valuation allowance of $3.3 million.
Although the contractual obligation of individual reinsurers to pay their reinsurance obligations is determinable from specific contract provisions, the collectibility of such amounts requires significant estimation by management. Many years may pass between the occurrence of a claim, when it is reported to us and when we ultimately settle and pay the claim. As a result, it can be several years before a reinsurer has to actually remit amounts to us. Over this period of time, economic conditions and operational performance of a particular reinsurer may impact their ability to meet these obligations and while they may still acknowledge their contractual obligation to do so, they may not have the financial resources to fully meet their obligation to us. If this occurs, we may have to write-down a reinsurance receivable to its then determined net realizable value and reflect that write-down in earnings in the period such determination is made. We attempt to limit any such exposure to uncollectible reinsurance receivables by performing credit reviews of our reinsurers. In addition, we require collateral, such as assets held in trust or letters of credit, for certain reinsurance receivables. However, if our future
estimate of uncollectible receivables exceeds our current expectations, we may need to increase our allowance for uncollectible reinsurance receivables. The increase in this allowance would result in a charge to earnings in the period recorded. Accordingly, any related charge could have a material adverse effect on our financial condition, results of operations and liquidity.
Prior to 2005, we established a valuation allowance in the amount of $57 million. This was based upon our assessment that it was more likely than not that a portion of the gross deferred tax assets related to the NOL carryforward and all of the deferred tax asset related to the AMT credit carryforward would not be realized. We periodically reassess the valuation allowance previously established against the net deferred tax assets. Factors considered in our reassessment included historical earnings, scheduled reversal of deferred tax liabilities and revised projections of future earnings. Based upon our consideration of these factors in conjunction with the current level of valuation allowance recorded, we increased the valuation allowance with respect to our net deferred tax asset by $3.5 million in 2005. The increase was primarily due to the future earnings projections for our discontinued operations which were revised downward from previous projections.
As a result of the expected sale of our Run-off Operations in 2007, we reported the results of this business as discontinued operations. In conjunction with this change and in accordance with SFAS 144, we recorded a pre-tax impairment loss of $61.5 million to reduce the net assets of this business to estimated fair value less costs to sell. The estimated fair value of the business was based on a non-binding letter of intent that we received from an interested third party. Our estimate reflected amounts anticipated at closing, which are subject to adjustments following the third party’s review of the final purchase price calculation, but excluded future contingent payments that may be received from the third party.
Premiums, including estimates of additional premiums resulting from audits of insureds’ records, are earned principally on a pro rata basis over the terms of the policies. Under The PMA Insurance Group’s loss-sensitive rating plans, we adjust the amount of the insured’s premiums after the policy period expires based, to a large extent, upon the insured’s actual loss experience during the policy period. Retrospectively rated premium adjustments and audit premium adjustments are recorded as earned in the period in which the adjustment is made.
Except for historical information provided in Management’s Discussion and Analysis and otherwise in this report, statements made throughout are forward-looking and contain information about financial results, economic conditions, trends and known uncertainties. Words such as “believe,” “estimate,” “anticipate,” “expect” or similar words are intended to identify forward-looking statements. These forward-looking statements may include estimates, assumptions or projections and are based on currently available financial, competitive and economic data and our current operating plans. Although management believes that our expectations are reasonable, there can be no assurance that our actual results will not differ materially from those expected.
whether state or federal asbestos liability legislation is enacted and the impact of such legislation on us;
competitive conditions that may affect the level of rate adequacy related to the amount of risk undertaken and that may influence the sustainability of adequate rate changes;
uncertainties related to possible terrorist activities or international hostilities and whether TRIPRA is extended beyond its December 31, 2014 termination date; and
Consolidated Statements of Comprehensive Income (Loss) for the years ended December 31, 2007, 2006 and 2005
operations to net cash flows provided by (used in) operating activities:
Includes cash from discontinued operations of $5.7 million, $4.6 million and $12.3 million as of December 31, 2007, 2006 and 2005, respectively.
The accompanying consolidated financial statements include the accounts of PMA Capital Corporation and its subsidiaries (collectively referred to as “PMA Capital” or the “Company”). PMA Capital Corporation is a holding company whose operating subsidiaries provide insurance and fee-based services. Insurance products are underwritten and marketed under the trade name The PMA Insurance Group. Fee-based services include third party administrator (“TPA”), managing general agent and program administrator services. The Company also manages the run-off of its former reinsurance and excess and surplus lines operations, for which the related activity of these businesses has been recorded as discontinued operations.
The PMA Insurance Group - The PMA Insurance Group writes workers’ compensation and other commercial property and casualty lines of insurance, which are marketed primarily in the eastern part of the United States. Approximately 92% of The PMA Insurance Group’s business for 2007 was produced through independent agents and brokers.
B. Investments - All fixed maturities in the Company’s investment portfolio are carried at fair value. Changes in fair value of fixed maturities classified as available for sale, net of income tax effects, are reflected in accumulated other comprehensive income (loss). Changes in fair value of fixed maturities classified as trading are reported in the loss from discontinued operations as realized investment gains (losses). All short-term, highly liquid investments, which have original maturities of one year or less from acquisition date, are treated as short-term investments and are carried at amortized cost, which approximates fair value. Effective January 1, 2007, the Company reclassified securities, which are currently reported as part of discontinued operations, from fixed maturities available for sale to the trading category in conjunction with its adoption of Statement of Financial Accounting Standards No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS 159”).
Certain of the Company’s assumed and ceded reinsurance contracts are funds held arrangements. In a typical funds held arrangement, the ceding company retains the premiums instead of paying them to the reinsurer and losses are offset against these funds in an experience account. Because the reinsurer is not in receipt of the funds, the reinsurer will generally earn interest on the experience fund balance at a predetermined credited rate of interest. The interest earned or credited on funds held arrangements is included in net investment income in the Statement of Operations. In addition, interest on funds held arrangements will continue to be earned or credited until the experience account is fully depleted, which can extend many years beyond the expiration of the coverage period.
L. Intangible Assets - Identifiable intangible assets consist of non-contractual customer relationships, licenses and a trade name. Goodwill represents the excess of the fair value of the net identifiable assets over the purchase price. Goodwill and indefinite-lived intangible assets remain on the balance sheet and are tested for impairment on an annual basis, or when there is a reason to suspect that their values may have been diminished or impaired. Other identifiable intangible assets that are not deemed to have an indefinite useful life are amortized over their estimated useful lives. The identifiable intangible assets and goodwill are reported as Intangible assets on the Balance Sheet.
M. Recent Accounting Pronouncements - Effective January 1, 2007, the Company early adopted Statement of Financial Accounting Standards No. 157, “Fair Value Measurements” (“SFAS 157”), and Statement of Financial Accounting Standards No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS 159”). See Notes 4 and 13 for the impact of the Company’s adoption of these Statements.
Effective January 1, 2007, the Company adopted FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109 (“SFAS 109”)” (“FIN 48”). See Note 14 for the impact of this adoption.
based on the future earnings growth of Midlands, the operating subsidiary of Midlands Holding Corporation, over the next four years. At December 31, 2007, the Company accrued $837,000 for estimated earnings growth payments.
The Company has reclassified the results of operations, including the related tax effects, and the assets and liabilities related to its Run-off Operations to discontinued operations, in accordance with SFAS 144. The following tables provide detailed information regarding the financial statement lines identified as discontinued operations.
SFAS 159 is effective as of the beginning of an entity’s first fiscal year that begins after November 15, 2007. Early adoption is permitted as of the beginning of the previous fiscal year provided that the entity makes that choice within the first 120 days of that fiscal year and also elects to apply the provisions of SFAS 157. The Company early adopted SFAS 159, effective January 1, 2007. Upon adoption of SFAS 159, the Company elected to reclassify all of the fixed income securities in its discontinued operations’ investment portfolio from available for sale to trading. Although the Company’s adoption of this Statement had no net impact on shareholders’ equity, it may result in future volatility in net income as changes in fair value will be recorded through realized gains and losses rather than other comprehensive income. The Company’s discontinued operations recognized pre-tax net realized gains of $1.1 million in 2007 for subsequent changes in fair value on these trading securities.
The Company adopted SFAS 159 because the investment portfolio at the discontinued operations decreased by 50% in the first quarter of 2007, compared to the first quarter of 2006. The Company also considered that, given the unpredictability of cash flows for commutations, combined with the shrinking size of the portfolio, trading activity was expected to increase in 2007. The discontinued operations’ investment portfolio was also reduced significantly during the second quarter as a result of the $37.5 million extraordinary dividend payment to the holding company in April 2007.
During 2005, the discontinued operations recorded unfavorable prior year loss development of $28.8 million, which included a $30 million charge taken in the first quarter. In the first quarter of 2005, the Company’s actuaries identified higher than expected claim frequency and severity on policies covering contractors’ liability for construction defects from accident years 1998 to 2001 written by the Company’s former excess and surplus lines operation and an increase in reported losses and continued volatility in pro rata professional liability reinsurance business written from accident years 1997 to 2001. Information regarding applicable reinsurance coverage is discussed below.
The Company’s discontinued operations’ loss reserves were stated net of salvage and subrogation of $407,000 and $419,000 at December 31, 2007 and 2006, respectively.
At December 31, 2007, 2006 and 2005, the discontinued operations’ gross reserves for asbestos-related losses were $7.5 million, $5.9 million and $4.6 million, respectively ($1.6 million, $825,000 and $560,000, net of reinsurance, respectively). Of the net asbestos reserves, approximately $350,000 at December 31, 2007 and $38,000 at December 31, 2006 and 2005, respectively, related to IBNR losses.
At December 31, 2007, the assets of discontinued operations included reinsurance receivables due from the following unaffiliated reinsurers in excess of 5% of shareholders’ equity:
In 2004, the Company purchased reinsurance covering potential adverse loss development of the loss and LAE reserves of its reinsurance and excess and surplus lines businesses. Upon entering into the agreement, the Company ceded $100 million in carried loss and LAE reserves and paid $146.5 million in cash. In 2005, these businesses ceded $30 million in losses and LAE under this agreement. In 2007, an additional $22 million in losses and LAE were ceded under this agreement. Additional information about the prior year loss development, which resulted in these cessions, is discussed above. Because the coverage was retroactive, these businesses deferred the initial benefit of these cessions, which was being amortized over the estimated settlement period of the losses using the interest method. Accordingly, the Company had a deferred gain on retroactive reinsurance of $25.4 million at December 31, 2006, which was included in liabilities of discontinued operations on the Balance Sheet. Amortization of the deferred gain reduced the Company’s loss from discontinued operations by $1.8 million in 2007, $1.7 million in 2006 and $2.8 million in 2005. As of December 31, 2006, the Company also had $56.6 million included in assets of discontinued operations for other receivables due under the contract. In December 2007, the Company commuted the adverse development cover and received $171.9 million in cash.
The amortized cost and fair value of fixed maturities at December 31, 2007, by contractual maturity, were as follows:
Included in realized losses for 2007 and 2005 were impairment losses of $209,000 and $773,000, respectively. The impairment loss for 2007 was related to a security issued by a national provider of higher education loans. The impairment losses for 2005 were related to securities issued by two auto manufacturers. The write-downs were measured based on public market prices at the time when the Company determined the decline in value was other than temporary.
The change in fair value of trading securities during 2007 related to a security that was previously held at the Company’s discontinued operations and transferred to the holding company as part of the $37.5 million dividend in April 2007. Fixed income securities held at the discontinued operations were selected for the fair value option and reclassified from the
The realized gains (losses) on the change in fair value of debt derivative related to the decrease (increase) in the fair value of the derivative component of the 6.50% Convertible Debt. See Note 8 for additional information and for information regarding the 2006 realized loss on the mandatory debt redemption.
Unpaid losses and LAE reflect management’s best estimate of future amounts needed to pay claims and related settlement costs with respect to insured events which have occurred, including events that have not been reported to the Company. Due to the “long-tail” nature of a significant portion of the Company’s business, in many cases, significant periods of time, ranging up to several years or more, may elapse between the occurrence of an insured loss, the reporting of the loss to the Company and the Company’s payment of that loss. The Company defines long-tail business as those lines of business in which a majority of coverage involves average loss payment lags of several years beyond the expiration of the policy. The Company’s major long-tail lines primarily include its workers’ compensation business. As part of the process for determining the Company’s unpaid losses and LAE, various actuarial models are used that analyze historical data and consider the impact of current developments and trends, such as trends in claims severity and frequency and claims settlement trends. Also considered are legal developments, regulatory trends, legislative developments, changes in social attitudes and economic conditions.
The Company’s loss reserves were stated net of salvage and subrogation of $18.0 million and $21.0 million at December 31, 2007 and 2006, respectively.
At December 31, 2007, 2006 and 2005, gross reserves for asbestos-related losses were $25.7 million, $17.3 million and $22.3 million, respectively ($10.8 million, $9.8 million and $12.6 million, net of reinsurance, respectively). Of the net asbestos reserves, approximately $2.2 million, $6.6 million and $10.1 million related to IBNR losses at December 31, 2007, 2006 and 2005, respectively.
At December 31, 2007, 2006 and 2005, gross reserves for environmental-related losses were $10.3 million, $11.9 million and $14.0 million, respectively ($0, $3.0 million and $4.1 million, net of reinsurance, respectively). Of the net environmental reserves, approximately $1.0 million and $1.6 million related to IBNR losses at December 31, 2006 and 2005, respectively. All incurred asbestos and environmental losses were for accident years 1986 and prior.
In the first quarter of 2006, the Company stopped writing integrated disability business. Effective August 1, 2007, the Company purchased reinsurance covering substantially all unpaid losses and LAE related to its integrated disability business. Under the agreement, the reinsurer also handles the servicing and benefit payments related to this business. Upon entering into this agreement, the Company ceded $25.7 million in carried loss and LAE reserves and paid $22.7 million in cash. Because the coverage is retroactive, the Company deferred the initial benefit of this cession, which is being amortized over the estimated settlement period of the losses using the interest method.
In September 2006, the Company entered into an agreement with Midwest General Insurance Agency (“MGIA”) under which MGIA underwrites and services workers’ compensation policies in California using the Company’s approved forms and rates. Upon inception, the Company ceded 100% of the direct premiums and related losses on this business to non-affiliated reinsurers selected by the Company, including Midwest Insurance Company (“Midwest”), an affiliate of MGIA. Effective April 1, 2007, the Company retained 5% of the direct premiums and related losses on this business. The Company’s retention of this business increased to 10%, effective September 1, 2007. All of the participating reinsurers, except for Midwest, have current A.M. Best Company, Inc. (“A.M. Best”) financial strength ratings of “A-” (Excellent) or higher. Midwest does not have an A.M. Best financial strength rating. The Company mitigated its credit risk with Midwest by requiring Midwest to secure amounts owed by holding cash in trust. The Company earns an administrative fee based upon the actual amount of premiums earned pursuant to the agreement. Total direct premiums written under this agreement were $59.8 million in 2007 and $14.8 million in 2006. The Company’s agreement with Midwest terminated in March 2008.
The Company performs credit reviews of its reinsurers focusing on, among other things, financial capacity, stability, trends and commitment to the reinsurance business. Reinsurers failing to meet the Company’s standards are excluded from the Company’s reinsurance programs. In addition, the Company requires collateral, typically assets in trust, letters of credit or funds withheld, to support balances due from certain reinsurers, generally those not authorized to transact business in the applicable jurisdictions. At December 31, 2007 and 2006, the Company’s reinsurance receivables of $795.9 million and $720.1 million were supported by $351.4 million and $342.0 million of collateral. Of the uncollateralized reinsurance receivables as of December 31, 2007, approximately 89% was recoverable from reinsurers rated “A-” or better by A.M. Best.
In June 2007, the Company issued $20.6 million of 30-year floating rate junior subordinated securities to a wholly-owned statutory trust subsidiary. The junior subordinated debt matures in 2037 and is redeemable, in whole or in part, immediately at 107.5% of par, or in 2012 at par, plus accrued and unpaid interest. The interest rate on the junior subordinated debt equals the three-month London InterBank Offered Rate (“LIBOR”) plus 3.55%, and interest on this debt is payable on a quarterly basis.
The Company has the right to defer interest payments on the junior subordinated securities for up to twenty consecutive quarters but, if so deferred, it may not declare or pay cash dividends or distributions on its Class A Common Stock. The Company has guaranteed the obligations of these statutory trust subsidiaries with respect to distributions and payments on the trust preferred securities issued by these trusts.
In September 2007, the Company entered into a new interest rate swap that it has designated as a cash flow hedge to manage interest costs and cash flows associated with the variable interest rates on a portion of its junior subordinated debt.
There was no consideration paid or received for this swap. The swap will effectively convert $20.0 million of the junior subordinated debt to fixed rate debt with an interest rate of 8.29%.
The Company leases certain facilities, office equipment and automobiles under non-cancelable operating leases. Future minimum net operating lease obligations as of December 31, 2007 are as follows:
Net of sublease rentals of $1.8 million in 2008, $1.6 million in 2009 and 2010, $1.7 million in 2011 and 2012 and $2.8 million thereafter. Also includes discontinued operations’ obligations of $388,000 in 2008, $474,000 in 2009 and $473,000 in 2010 and 2011, respectively.
Total expenses incurred under operating leases were $6.3 million, $6.2 million and $6.9 million for 2007, 2006 and 2005, respectively.
See Note 11 for information regarding shares reissued under stock-based compensation plans.
Prior to 2005, the Company’s Board of Directors suspended dividends on the Company’s Class A Common Stock.
the 2004 Order, PMACIC was permitted to request an “extraordinary” dividend, as defined under Pennsylvania law, in 2006 provided that immediately after giving effect to the dividend or return of capital, PMACIC’s risk-based capital equaled or exceeded 225% of Authorized Control Level Capital, as defined by the National Association of Insurance Commissioners (“NAIC”). In 2006, the Department approved the Company’s request for an “extraordinary” dividend in the amount of $73.5 million from PMACIC. The Company used the proceeds to reduce its debt obligations and to maintain liquidity at the holding company. In 2007, the Department approved the Company’s request for an additional “extraordinary” dividend in the amount of $37.5 million from PMACIC. Given the anticipated sale of PMACIC, the Company does not expect to receive any dividends from this operation in 2008. As of December 31, 2007, the statutory surplus of PMACIC was $47.6 million and its risk-based capital ratio was 241% of Authorized Control Level Capital.
The Pooled Companies, which are not subject to the Department’s 2004 Order, paid dividends of $7.0 million to PMA Capital Corporation in 2005. The Pooled Companies did not pay any dividends to PMA Capital Corporation in 2006 and 2007. As of December 31, 2007, the Pooled Companies had statutory surplus of $335.4 million and can pay a maximum of $29.2 million in dividends to PMA Capital Corporation during 2008 without the prior approval of the Department.
On January 1, 2006, the Company adopted SFAS 123R, “Share-Based Payment,” using the modified-prospective transition method. SFAS 123R requires all share-based payments to employees, including grants of employee stock options, be recognized as compensation expense in the income statement at fair value. Under the modified-prospective transition method, the Company recognized expense over the remaining required service period for stock options granted prior to January 1, 2006 for the portion of those grants for which the requisite service had not yet been rendered. No adjustment was made to prior period amounts nor was any expense recorded for options granted prior to January 1, 2006 for which the requisite service had been rendered by that date. The Company recognized stock-based compensation expense of $1.8 million and $2.4 million for the years ended December 31, 2007 and 2006, respectively. The stock-based compensation expense included amounts related to stock options of $44,000 in 2007 and $602,000 in 2006.
The Company previously accounted for stock-based compensation using the intrinsic value method. Accordingly, compensation cost for stock options was measured as the excess, if any, of the quoted market price of the Company’s Class A Common Stock at grant date or other measurement date over the amount an employee must pay to acquire the Class A Common Stock. In 2005, the Company expensed $24,000 for stock option compensation costs.
The total intrinsic value of stock options exercised was $241,000 in 2007, $843,000 in 2006 and $757,000 in 2005. The Company reissued shares from its treasury for options exercised during 2007, 2006 and 2005.
All options granted in 2005 were granted with an exercise price that equaled or exceeded the market value of the Class A Common Stock on the grant date (“out-of-the-money”). The weighted average fair value of options granted in 2005 was $3.62 per share. The Company did not grant any options in 2007 and 2006.
The fair value of options at date of grant was estimated using an option-pricing model with the following weighted average assumptions:
The Company recognizes compensation expense for restricted stock awards over the vested period of the award. Compensation expense recognized for restricted stock was $771,000 in 2007, $1.3 million in 2006 and $841,000 in 2005. At December 31, 2007, unrecognized compensation expense for non-vested restricted stock was $292,000, which is expected to be recognized over a weighted average period of 6 months.
The effects of 380,000, 426,000 and 2.1 million stock options were excluded from the computations of diluted earnings per share for 2007, 2006 and 2005, respectively, because they were anti-dilutive. The effects of 177,000 shares of restricted stock were also excluded from the computation of diluted earnings per share for 2005 because they were anti-dilutive.
Diluted shares for 2007, 2006 and 2005 do not assume the effects of conversion of the Company’s convertible debt into 736,000, 2.8 million and 5.8 million shares of Class A Common Stock, respectively, because they were anti-dilutive.
In September 2006, the FASB issued SFAS 157. This Statement defines fair value, establishes a framework for measuring fair value in accordance with GAAP and expands disclosures about fair value measurements. SFAS 157 is applicable in conjunction with other accounting pronouncements that require or permit fair value measurements, but does not expand the use of fair value to any new circumstances. More specifically, SFAS 157 emphasizes that fair value is a market-based measurement, not an entity-specific measurement, and sets out a fair value hierarchy with the highest priority given to quoted prices in active markets and the lowest priority to unobservable inputs. Further, SFAS 157 requires tabular disclosures of the fair value measurements by level within the fair value hierarchy. This Statement is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. However, early adoption is permitted as of the beginning of a fiscal year. The Company early adopted SFAS 157, effective January 1, 2007. The Company’s adoption of SFAS 157 did not have an impact on its financial condition or results of operations.
The following table provides the fair value measurements of applicable Company assets and liabilities by level within the fair value hierarchy as of December 31, 2007. These assets and liabilities are measured on a recurring basis.
The following table provides the fair value of assets re-measured on a nonrecurring basis.
The valuation allowance of $60.5 million reserves against $50.9 million of gross deferred tax assets related to the NOL carryforward and all of the projected deferred tax asset related to the AMT credit carryforward because it is more likely than not that this portion of the benefit will not be realized. The Company will continue to periodically assess the realizability of its net deferred tax asset.
The Company adopted the provisions of FIN 48, effective January 1, 2007. FIN 48 clarifies the accounting for uncertainty in income taxes recognized in a company’s financial statements in accordance with SFAS 109. FIN 48 requires that an uncertain tax position should be recognized only if it is “more likely than not” that the position is sustainable based on its technical merits. Recognizable tax positions should then be measured to determine the amount of benefit recognized in the financial statements. The Company’s adoption of FIN 48 did not have a material impact on its financial condition or results of operations.
The Company files income tax returns in the U.S. federal jurisdiction and in various states and foreign jurisdictions. With few exceptions, the Company is no longer subject to U.S. federal, state and local, or non-U.S. income tax examinations by tax authorities for years before 2003. The Company is currently not under examination by any tax authority. The
Company does not anticipate any significant changes to its total unrecognized tax benefits within the next 12 months. The Company will recognize, as applicable, interest and penalties related to unrecognized tax positions as part of income taxes.
The Company also maintains non-qualified unfunded supplemental defined benefit pension plans (the “Non-qualified Pension Plans”) which, prior to January 1, 2006, covered certain key employees. The projected benefit obligation and accumulated benefit obligation for the Non-qualified Pension Plans were $7.1 million and $7.1 million, respectively, as of December 31, 2007.
The decline in Qualified Pension Plan asset performance prior to 2005, combined with historically low interest rates (which are the key assumption in estimating plan liabilities) caused the Company to record a $25.2 million increase in its accrued Qualified Pension Plan liability and record a $16.4 million charge to equity. The Company further increased its pension liability by $5.1 million in 2005 and recorded a charge to equity of $3.3 million. In 2006 and 2007, the Company reversed $5.7 million and $5.4 million of its pension liability and increased equity by $3.7 million and $3.5 million, respectively, due primarily to the increases in interest rates and higher than expected returns on plan assets.
The asset allocation for the Company’s Qualified Pension Plan at the end of 2007 and 2006, and the target allocation for 2008, by asset category, are as follows:
Qualified Pension Plan benefits will be paid from the pension trust assets which have a fair value of $74.1 million at December 31, 2007. Non-qualified Pension Plan and other postretirement benefits will be paid from the general assets of the Company.
B. Defined Contribution Savings Plan - The Company also maintains defined contribution savings plans covering substantially all employees. These plans include a voluntary employee contribution component, in which the Company matches employee contributions, up to 5% of compensation and, effective January 1, 2006, an aged-based company contribution. Contributions expensed under these plans in 2007, 2006 and 2005 were $5.3 million, $4.9 million and $2.3 million, respectively.
The PMA Insurance Group’s operations are concentrated in twelve contiguous states in the eastern part of the U.S. The economic trends in these individual states may not be independent of one another. Also, The PMA Insurance Group’s products are highly regulated by each of these states. For most of The PMA Insurance Group’s products, the insurance departments of the states in which it conducts business must approve rates and policy forms. In addition, workers’ compensation benefits are determined by statutes and regulations in each of these states. While The PMA Insurance Group considers factors such as rate adequacy, regulatory climate and economic factors in its underwriting process, unfavorable developments in these factors could have an adverse impact on the Company’s financial condition and results of operations. Since November 2003, The PMA Insurance Group has been the Company’s sole remaining ongoing insurance segment. In 2007, 2006 and 2005, workers’ compensation net premiums written represented 92%, 90% and 86%, respectively, of The PMA Insurance Group’s net premiums written.
The Company’s statutory financial statements are presented on the basis of accounting practices prescribed or permitted by the Pennsylvania Insurance Department.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of PMA Capital Corporation and subsidiaries as of December 31, 2007 and 2006 and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2007 in conformity with accounting principles generally accepted in the United States of America.
As discussed in Note 2 to the consolidated financial statements, the Company reclassified as trading, certain marketable securities previously designated as available-for-sale and changed the manner in which changes in unrealized gains and losses on these securities get recognized in 2007.
As discussed in Notes 11 and 15, respectively, to the consolidated financial statements, the Company changed its method of accounting for share-based payments and its defined benefit pension and other retirement plans in 2006.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), PMA Capital Corporation'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 10, 2008 expressed an unqualified opinion.
In our opinion, PMA Capital Corporation maintained, in all material respects, effective 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).