In 1999, the Company adopted SOP 97-3, "Accounting by Insurance and Other Enterprises for Insurance-Related Assessments." As a result of adopting SOP 97-3, the Company recorded a liability of $4.3 million pre-tax and a resulting charge to earnings of $2.8 million, net of tax effect.
Policyholders’ dividend ratio 0.1 % 1.8 % 4.1 % 7.5 % 8.6 %
Operating ratio(9) 97.0 % 94.5 % 94.1 % 92.7 % 92.7 %
Loss and LAE ratio 88.0 % 79.6 % 87.4 % 91.6 % 70.4 %
Expense Ratio(7) 29.9 % 26.8 % 26.8 % 31.7 % 32.1 %
Combined ratio(8) 117.9 % 106.4 % 114.2 % 123.3 % 102.5 %
Operating ratio(9) 112.7 % 97.6 % 100.9 % 102.9 % 82.9 %
In addition to providing consolidated net income (loss), we also provide segment operating income (loss) because we believe that it is a meaningful measure of the profit or loss generated by our operating segments. Operating income (loss), which is GAAP net income (loss) excluding net realized investment gains and losses, is the financial performance measure used by our management and Board of Directors to evaluate and assess the results of our insurance businesses. Accordingly, we report operating income by segment in Note 16 to our Consolidated Financial Statements as required by SFAS No. 131, "Disclosures About Segments of an Enterprise and Related Information." Our management and Board of Directors use operating income as the measure of financial performance because (i) net realized investment gains and losses are unpredictable and not necessarily indicative of current operating fundamentals or future performance of the business segments and (ii) in many instances, decisions to buy and sell securities are made at the holding company level, and such decisions result in net realized gains and losses that do not relate to the operations of the individual segments. Operating income (loss) does not replace net income (loss) as the GAAP measure of our consolidated results of operations.
On November 6, 2003, we announced our decision to withdraw from the reinsurance business previously served by PMA Re. This segment is currently in run-off. Therefore, PMA Re's results for 2003 will not be indicative of results for future periods.
In May 2002, we exited the excess and surplus lines business and placed this business, formerly known as Caliber One, into run-off.
The expense ratio equals the sum of acquisition and insurance-related operating expenses divided by net premiums earned. Acquisition and insurance-related expenses for The PMA Insurance Group were $142.7 million, $108.6 million, $92.3 million, $72.5 million and $69.1 million for 2003, 2002, 2001, 2000 and 1999.
We are a property and casualty insurance holding company, which during the three year period ended December 31, 2003 offered through our subsidiaries standard commercial lines of insurance, excess of loss and pro rata property and casualty reinsurance and excess and surplus lines insurance. In May 2002, we announced our intention to cease writing excess and surplus lines insurance, and since that time, the results of this business have been classified as Run-off Operations. On November 6, 2003, we announced our intention to cease writing excess of loss and pro rata property and casualty reinsurance. The results of this business, which had been offered though our PMA Re business segment, will be included in Run-off Operations effective in 2004. Since November 6, 2003, our subsidiaries offer workers’ compensation, integrated disability and, to a lesser extent, other standard lines of commercial insurance, primarily in the eastern part of the United States. These products are written through The PMA Insurance Group business segment.
The PMA Insurance Group earns revenue and generates cash primarily by writing insurance policies and collecting insurance premiums. The PMA Insurance Group also earns other revenues by providing risk control and claims adjusting services to customers. Because time normally elapses between the receipt of premiums and the payment of claims and certain related expenses, we invest the available premiums and earn investment income at The PMA Insurance Group and PMA Re. From our revenues are deducted:
• loss adjustment expenses ("LAE"), which are the expenses of settling claims;
• acquisition and operating expenses, which are direct and indirect costs of acquiring both new and renewal business, including commissions paid to agents and brokers, and the internal expenses to operate the business segment; and
• dividends that are paid to policyholders of certain of our insurance products.
These items are further described in the MD&A and in “Item 1 - Business”.
Another significant challenge for 2004 is ensuring that we maintain sufficient cash at the holding company level to pay corporate overhead, including debt service and operating expenses. See "Liquidity and Capital Resources" beginning on page 51 for additional information. In December 2003, we entered into a voluntary agreement with our lead regulator, the Pennsylvania Insurance Department, whereby, among other things, we would seek the Department’s prior approval for any dividends paid from our insurance subsidiaries. See "Item 1 - Business-Regulatory Matters" for additional information about this voluntary agreement. As these dividends are a significant source of cash to the holding company, we will continue to work cooperatively with the Department to demonstrate to them our belief that our insurance subsidiaries have adequate statutory capital to support their expected level of business production, the satisfaction of their existing liabilities and the servicing of the holding company debt and overhead obligations.
We recorded a net loss of $93.6 million in 2003, compared to a net loss of $48.0 million in 2002 and net income of $7.1 million in 2001.
Results for 2002 were impacted by approximately $42 million after-tax ($64 million pre-tax) due to unfavorable prior year loss development at PMA Re and by approximately $34 million after-tax ($52 million pre-tax) due to unfavorable prior year loss development at the Run-off Operations. Additionally, results for 2002 include a charge of $28 million after-tax ($43 million pre-tax) associated with our decision to exit from and run off our excess and surplus lines business.
Results for 2001 were adversely impacted by approximately $20 million after-tax ($30 million pre-tax) as a result of losses incurred at PMA Re from the September 11th terrorist attack on the World Trade Center and by unfavorable prior year development of $14 million after-tax ($22 million pre-tax) at the Run-off Operations.
In this MD&A, in addition to providing consolidated net income (loss), we also provide segment operating income (loss) because we believe that it is a meaningful measure of the profit or loss generated by our operating segments. Operating income (loss), which is GAAP net income (loss) excluding net realized investment gains and losses, is the financial performance measure used by our management and Board of Directors to evaluate and assess the results of our insurance businesses. Accordingly, we report operating income by segment in Note 16 to the Consolidated Financial Statements as required by SFAS No. 131, “Disclosures About Segments of an Enterprise and Related Information.” Our management and Board of Directors use operating income as the measure of financial performance because (i) net realized investment gains and losses are unpredictable and not necessarily indicative of current operating fundamentals or future performance of the business segments and (ii) in many instances, decisions to buy and sell securities are made at the holding company level, and such decisions result in net realized gains and losses that do not relate to the operations of the individual segments. Operating income (loss) does not replace net income (loss) as the GAAP measure of our consolidated results of operations.
Following is a reconciliation of our segment operating results to GAAP net income (loss). See Note 16 to our Consolidated Financial Statements for additional information.
Net income (loss) $ (93,569 ) $ (48,024 ) $ 7,103
On November 4, 2003, we announced that we had recorded a pre-tax charge of $150 million at September 30, 2003 to strengthen loss reserves at PMA Re. Since that time, the principal nationally recognized ratings agencies that rate the financial strength of our principal insurance subsidiaries and the debt of PMA Capital Corporation have taken the following actions on our ratings:
On November 6, 2003, we announced our decision to withdraw from the reinsurance business previously served by PMA Re, and we are no longer writing new reinsurance business. On December 22, 2003, PMA Capital Insurance Company entered into a voluntary agreement with the Pennsylvania Insurance Department. Pursuant to this agreement, PMA Capital
Direct workers’ compensation and integrated disability premiums written increased 37% in 2003 and 26% in 2002, compared to the immediately preceding year, primarily due to an increase in the volume of risks underwritten, and to a lesser extent, pricing increases. In addition, the increase in direct workers’ compensation premiums written for 2003 includes $35 million of retrospectively rated premiums recorded in the fourth quarter under loss-sensitive policies that are attributable to the higher than expected losses from accident years 2001 and 2002. See "Losses and Expenses" beginning on page 41 for additional information. Pricing increased approximately 10% in 2003 and 17% in 2002 on workers’ compensation business. In recent years, The PMA Insurance Group increased its writings of workers’ compensation premiums through focused marketing efforts in its principal marketing territories covering the eastern part of the United States.
Direct writings of commercial lines of business other than workers’ compensation, such as commercial auto, general liability, umbrella, multi-peril and commercial property lines (collectively, “Commercial Lines”), increased by $3.5 million and $10.8 million in 2003 and 2002, compared to the immediately preceding year, primarily due to weighted average price increases of approximately 17% in 2003 and 28% in 2002.
Premiums assumed increased $11.2 million and $5.8 million in 2003 and 2002, respectively, compared to the immediately preceding year, primarily due to an increase in the amount of residual market business in The PMA Insurance Group’s principal marketing territories. Companies which write premiums in certain states generally must share in the risk of insuring entities that cannot obtain insurance in the voluntary market. Typically, an insurer’s share of this residual market business is dependent upon its market share in terms of direct premiums in the voluntary market, and the assignments are accomplished either by direct assignment or by assumption from pools of residual market business.
Net premiums written increased 33% in 2003 and 27% in 2002, compared to the immediately preceding year, mainly reflecting the trends discussed above for gross premiums written. Net premiums earned increased 39% in 2003 and 18% in 2002. 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. 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. We made such an adjustment in the fourth quarter of 2003 as described above.
The operating expense ratio equals insurance-related operating expenses divided by net premiums earned. Insurance-related operating expenses were $52.2 million, $36.7 million and $31.4 million for 2003, 2002 and 2001, respectively.
This unfavorable prior year loss development and resulting premium and policyholders’ dividend adjustments in 2003 increased the loss and LAE ratio by approximately 4 points and decreased the total expense ratio and policyholder’s dividend ratio each by approximately 1.5 points. The total impact to the combined ratio was approximately 1 point. Overall, the loss and LAE ratio increased by 2.6 points in 2003 compared to 2002, reflecting the effects of prior year loss development described above, partially offset by an improved current accident year loss and LAE ratio. Our current accident year loss and LAE ratio improved 5.3 points in 2003, compared to 2002, including 4.5 points due to the premium adjustment of $35 million recorded in the fourth quarter for policies of loss-sensitive plans. The remainder of the improvement is primarily due to price increases that have outpaced increasing loss costs. Medical cost inflation, which has contributed to increased severity of workers’ compensation losses, was the primary reason for the increasing loss costs in 2003. We estimate our medical cost inflation for 2003 to be approximately 11%. We expect medical cost inflation to remain a significant component of loss costs in 2004.
On November 6, 2003, we announced our decision to withdraw from the reinsurance business. We are no longer writing new reinsurance business. See "Recent Developments" beginning on page 38 for additional information. Because of our decision to withdraw from the reinsurance business, we expect that PMA Re’s premiums written and earned, losses and LAE, and operating expenses will decline materially in 2004. Therefore, PMA Re’s results for 2003 will not be indicative of results for future periods. PMA Re’s results will be included in Run-off Operations beginning in the first quarter of 2004.
Less: net investment income ratio 5.2 % 8.8 % 13.3 %
PMA Re’s gross premiums written by business unit and major lines of business are as follows:
PMA Re’s net premiums written by business unit and major lines of business are as follows:
Gross premiums written were $750.9 million for 2003, compared to $776.8 million for 2002, primarily reflecting lower premiums from our Traditional-Treaty unit, partially offset by higher premiums from our Finite Risk and Financial Products unit. In addition, gross premiums written for 2002 included an additional $58.1 million of gross premiums written ($44.2 million of net premiums written) recorded in the second quarter of 2002 as a result of a change in our estimate of ultimate premiums written. Because premiums from ceding companies are typically reported on a delayed basis, we monitor and update, as appropriate, the estimated ultimate premiums written. Our periodic review of estimated ultimate premiums written, comparing actual reported premiums to originally estimated premiums based on ceding company estimates, indicated that premiums written in recent years, primarily for 2001 and 2000 in the Traditional- and Specialty-Treaty units, were higher than originally estimated. The increase in net premiums earned of $39.9 million in 2002 caused by this adjustment was offset by corresponding losses and LAE and acquisition expenses.
Net premiums written decreased approximately 7% and net premiums earned increased by approximately 13% in 2003. In 2002, net premiums written and earned increased approximately 77% and 62%, respectively, compared to the immediately preceding year. Traditionally, trends in net premiums earned follow patterns similar to net premiums written. Generally, in periods of decreasing premium writings, the decrease in net premiums written will be greater than the decrease in net premiums earned, as was the case in 2003. Generally, in periods of premium growth, the increase in net premiums written will be greater than the increase in net premiums earned, as was the case in 2002. Premiums are earned principally on a pro rata basis over the coverage periods of the underlying policies. However, with respect to
policies that provide for premium adjustments, such as experience-rated or exposure-based adjustments, such premium adjustments 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.
PMA Re’s analysis was enhanced by an extensive review of specific accounts, comprising about 40% of carried reserves for accident years 1997 to 2000. Our actuaries visited a number of former ceding company clients, which collectively comprised about 25% of PMA Re’s total gross loss and LAE reserves from accident years 1997 to 2000, to discuss reserving and reporting experience with these ceding companies. Our actuaries separately evaluated an additional number of other ceding companies, representing approximately 15% of PMA Re’s total gross loss and LAE reserves from accident years 1997 to 2000, to understand and examine data trends.
PMA Re’s loss and LAE ratio for 2002 reflects a $64 million increase in net loss reserves for prior accident years in the fourth quarter of 2002. In the fourth quarter, PMA Re’s actuarial department conducted its routine year-end reserve study to determine the impact of any emerging data on anticipated loss development trends and recorded unpaid losses and LAE reserves. During the fourth quarter, our actuaries observed a higher than expected increase in the frequency and, to a lesser extent, severity of reported claims by our ceding companies. Based on the actuarial work performed, which included analyzing recent trends in the levels of the reported and paid claims, an updated selection of actuarially determined loss reserve estimates was developed by accident year for each major line of business written by PMA Re. Management’s selection of the ultimate losses indicated that net loss and LAE reserves for prior accident years needed to be increased by approximately $64 million in the fourth quarter of 2002, primarily for excess of loss and pro rata general liability occurrence contracts and, to a lesser extent, excess of loss general liability claims-made contracts, from accident years 1998, 1999 and 2000.
In May 2002, we announced our decision to withdraw from the excess and surplus lines marketplace previously served by the Caliber One operating segment. In January 2003, we closed on the sale of the capital stock of Caliber One Indemnity Company. Pursuant to the agreement of sale, we retained all assets and liabilities related to the in-force policies and outstanding claim obligations relating to Caliber One’s business written prior to closing on the sale. As a result of our decision to exit this business, the results of this segment are reported as Run-off Operations.
In 2002, the Run-off Operations recorded a pre-tax operating loss of $87.5 million. As a result of our decision to exit from and run off this business, the Run-off Operations recorded a charge of $43 million pre-tax. Components of the pre-tax charge include approximately $16 million to write-down assets to their estimated net realizable value, including non-cash charges of approximately $6 million for leasehold improvements and other fixed assets and $1.3 million for goodwill. In addition, the $43 million pre-tax charge includes expenses associated with the recognition of liabilities of approximately $27
Pre-tax operating results for 2002 also include net unfavorable prior year loss development of $51.8 million. During 2002, company actuaries conducted reserve reviews to determine the impact of any emerging data on anticipated loss development trends and recorded unpaid losses and LAE reserves. Based on the actuarial work performed, which included analyzing recent trends in the levels of the reported and paid claims, an updated selection of actuarially determined loss reserve estimates was developed by accident year for each major line of business written by this segment. Management’s selection of the ultimate losses resulting from their reviews indicated that net loss reserves for prior accident years, mainly 1999 and 2000, needed to be increased by $51.8 million. This unfavorable prior year development reflects the impact of higher than expected claim severity and, to a lesser extent, frequency, that emerged in 2002 on casualty lines of business, primarily professional liability policies for the nursing homes class of business; general liability, including policies covering contractors’ liability for construction defects; and commercial automobile, mainly for accident years 1999 and 2000.
Our consolidated unpaid losses and LAE, net of reinsurance, at December 31, 2003 and 2002 were $1,346.3 million and $1,184.3 million, net of discount of $67.0 million and $97.8 million, respectively. Included in the consolidated unpaid losses and LAE are amounts related to our workers’ compensation claims of $433.8 million and $326.7 million, net of discount of $54.6 million and $76.7 million at December 31, 2003 and 2002, respectively. The discount rate used was approximately 5% at December 31, 2003 and 2002.
Management believes that its unpaid losses and LAE are fairly stated at December 31, 2003. However, estimating the ultimate claims liability is necessarily a complex and judgmental process inasmuch as the amounts are based on management’s informed estimates and judgments using data currently available. As additional experience and data become available regarding claims payment and reporting patterns, legal and legislative developments, judicial theories of liability, the impact of regulatory trends on benefit levels for both medical and indemnity payments, changes in social attitudes and economic conditions, the estimates are revised accordingly. If our ultimate losses, net of reinsurance, prove
At December 31, 2003, 2002 and 2001, our gross reserves for asbestos-related losses were $37.8 million, $42.1 million and $59.9 million, respectively ($17.8 million, $25.8 million and $28.6 million, net of reinsurance, respectively). At December 31, 2003, 2002 and 2001, our gross reserves for environmental-related losses were $14.2 million, $18.2 million and $29.6 million, respectively ($8.8 million, $14.3 million and $16.0 million, net of reinsurance, respectively).
Under our reinsurance and retrocessional coverages in place during 2003, 2002 and 2001, we ceded premiums totaling $228.6 million, $300.6 million and $243.4 million, and we ceded losses and LAE of $243.1 million, $223.2 million and $359.6 million to reinsurers and retrocessionaires. Ceded losses for 2001 include approximately $110 million resulting from the September 11th terrorist attack on the World Trade Center.
At December 31, 2003 and 2002, we had amounts receivable from our reinsurers and retrocessionaires totaling $1,220.3 million and $1,295.1 million, respectively. Approximately $39 million and $37 million, or 3%, of these amounts are due to us on losses we have already paid at December 31, 2003 and 2002. The remainder of the reinsurance receivables relate to unpaid claims.
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, 2003 and 2002, our reinsurance receivables were supported by $644.1 million and $666.9 million of collateral. Of the uncollateralized reinsurance receivables at December 31, 2003, approximately 91% were due from reinsurers rated “A-” or better by A.M. Best and is broken down as follows: “A++” - 11%; “A+” - 33%; “A” - 40% and “A-” - 7%. We believe that the amounts receivable from reinsurers are fully collectible and that the allowance for uncollectible items is adequate to cover any disputes about amounts owed by reinsurers to us. In the last three years combined, we have written off $6.5 million of reinsurance receivables, substantially all from the Run-off Operations. The timing and collectibility of reinsurance receivables have not had, and are not expected to have, a material adverse effect on our liquidity. See "Critical Accounting Estimates - Reinsurance Receivables" beginning on page 60 and Note 6 to our Consolidated Financial Statements for additional information.
With respect to the reinsurance and retrocessional protection shown in the table above, our treaties that renewed effective January 1, 2004 do not cover us for losses sustained from terrorist activities. Further, for treaties that renew later in 2004 it is possible that losses due to terrorist attacks may be excluded. Therefore, future terrorist attacks may result in losses that have a material adverse effect on our financial condition, results of operations and liquidity.
At the holding company level, our primary sources of liquidity are dividends and net tax payments received from subsidiaries, and capital raising activities. We utilize cash to pay debt obligations, including interest costs; dividends to shareholders; taxes to the Federal government; and corporate expenses. In addition, we periodically use cash resources to capitalize subsidiaries and to repurchase shares of our common stock.
As of December 31, 2003, we had $15.0 million in cash and short-term investments at the holding company. Management currently believes that our available sources of funds will provide sufficient liquidity to meet our short-term obligations without receiving dividends from our insurance subsidiaries. Our ability to meet our long-term obligations will depend on our ability to receive dividends from our insurance subsidiaries. As a result, unless the Pennsylvania Insurance Department permits such dividends, we may not be able to receive dividends from our operating subsidiaries in sufficient amounts to pay these long-term obligations. Further, any event that would have a material adverse effect on the $15.0 million of holding company cash and short-term investments or the results of operations of our insurance subsidiaries could affect our liquidity and ability to meet our contractual obligations and operating needs.
Holders of the Convertible Debt, at their option, may require the Company to repurchase all or a portion of their debentures on September 30, 2006, 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.
See discussion below for the variable interest rates on the Trust Preferred Debt. The obligations related to the Trust Preferred Debt have been calculated using the interest rates in effect at December 31, 2003.
In June 2003, we issued $57.5 million of 8.50% monthly income senior notes (“Senior Notes”) due June 15, 2018, from which we realized net proceeds of $55.1 million. We used the proceeds from the offering to repay the remaining balance outstanding under our prior bank credit facility, to increase the statutory capital and surplus of our insurance subsidiaries, and for general corporate purposes. We have the right to call these securities beginning in June 2008.
In May 2003, we issued $18.0 million (“Trust Preferred 1”) and $15.5 million (“Trust Preferred 2”) of 30-year floating rate subordinated debentures to two wholly owned statutory trust subsidiaries. We used all of the $31.5 million of net proceeds to pay down a portion of our then outstanding bank credit facility. During September 2003, we issued $10.3 million (“Trust Preferred 3”) of 30-year floating rate subordinated debentures to a third wholly owned statutory trust subsidiary. We realized net proceeds of $9.7 million, which we used for general corporate purposes. Each of Trust Preferred 1, 2 and 3 has a 30-year maturity and is redeemable, in whole or in part, after five years from issuance at their stated liquidation amount plus accrued and unpaid interest. The interest rates on Trust Preferred 1, 2 and 3 equal the three-month London InterBank Offered Rate (“LIBOR”) plus 4.10%, 4.20% and 4.05%, respectively, and are payable on a quarterly basis. At December 31, 2003, the interest rates on Trust Preferred 1, 2 and 3 were 5.28%, 5.37% and 5.21%, respectively.
In October 2002, we issued $86.25 million of 4.25% convertible senior debentures (“Convertible Debt”) due September 30, 2022 from which we received net proceeds of $83.7 million. We used the proceeds from this offering primarily to increase the capital and surplus of our reinsurance and insurance subsidiaries. See Note 7 to our Consolidated Financial Statements for additional information. In December 2001, we issued 9,775,000 shares of Class A Common stock for net proceeds of $157.9 million. We used the net proceeds from this issuance to contribute additional capital to our reinsurance subsidiary and to repay $62.5 million of our outstanding debt maturing at year-end 2001 under our bank credit facility. Because of the debt rating assigned to the Company’s 4.25% Senior Convertible Debentures (“Convertible Debt”), holders of the Convertible Debt may currently convert their debentures at a conversion price of $16.368 per share, subject to adjustment upon certain events.
At December 31, 2002, we had $65 million of short-term debt under our bank credit facility (“Credit Facility”) and $86.25 million aggregate principal amount of 4.25% Convertible Debt. We repaid and retired the Credit Facility in the first half of 2003 as discussed above.
During 2003, 2002 and 2001, we incurred $9.9 million, $3.3 million and $6.5 million of interest expense, and paid interest of $8.4 million, $2.1 million and $7.1 million in each respective year. As of December 31, 2003, we had $12.0 million outstanding in letters of credit, which we utilize primarily for securing reinsurance obligations of our insurance subsidiaries. The letters of credit were issued under our letter of credit facility, which was terminated during 2003. The lender agreed to waive certain defaults under the letter of credit facility and renewed the letters of credit for one year.
Our ability to refinance our existing debt obligations or raise additional capital is dependent upon several factors, including conditions with respect to both the equity and debt markets and the ratings of any securities that we may issue as established by the principal rating agencies. Because of our current debt ratings downgrades, it is unlikely that we would be able to refinance our outstanding debt obligations with the same terms and conditions as presently exist. See Recent Developments beginning on page 38 for additional discussion regarding ratings downgrades.
In 2002 and 2001, we contributed $16.5 million and $9.0 million, respectively, to our qualified pension plan in order to ensure that the plan assets were at least equal to our accumulated benefit obligation at the end of each year. We did not make a contribution to our qualified pension plan in 2003. Our accumulated benefit obligation was greater than the fair value of plan assets by approximately $3 million at December 31, 2003, largely due to a reduction in the discount rate used to measure the benefit obligation. As a result, we recorded a minimum pension liability of $25.3 million, and reduced accumulated other comprehensive income by $15.6 million after-tax. In 2003, the Company was not required to make any contribution to the pension plan under the minimum funding requirements of the Employee Retirement Income Security Act (“ERISA”) of 1974, and we are not required to make such a contribution in 2004. We made the contributions in 2002 and 2001 due to a significant decline in the market value of our plan assets, stemming from the broad market declines in the bond and equity markets over the past three years. Our plan assets are composed of 35% fixed maturities and 65% equities at December 31, 2003. We currently estimate that the pension plan’s assets will generate a long-term rate of return of 9%, which we believe is a reasonable long-term rate of return, in part, because of the historical performance of the broad financial markets. Pension expense in 2003, 2002 and 2001 was $4.4 million, $3.0 million and $1.9 million, respectively.
We have an interest in a real estate partnership that leases office space for which we have provided a guaranty of $7.0 million related to loans on properties of the partnership. This guaranty shall continue to be in force until the related loan has been satisfied. The loan is scheduled to be repaid on November 1, 2004.
Until December 31, 2003, we had an executive loan program, through which a financial institution provided personal demand loans to our officers. We had provided collateral and agreed to purchase any loan in default. In November 2003, the financial institution sold the collateral partially securing the loans of two of our former officers in satisfaction of their loans in the aggregate amount of $2.0 million. We are seeking repayment of the loans from the former officers and are accruing interest on these loans at a rate of 3.3% as of December 31, 2003. These loans are included in other assets on the Balance Sheet at December 31, 2003.
Mortgage-backed and other asset-backed securities in the table above include collateralized mortgage obligations (“CMOs”) of $209.2 million and $181.2 million carried at fair value as of December 31, 2003 and 2002. CMO holdings are concentrated in securities with limited prepayment, extension and default risk, such as planned amortization class bonds.
The net unrealized gain on our investment assets at December 31, 2003 was $48.5 million, or 2.4% of the amortized cost basis. The net unrealized gain included gross unrealized gains of $60.5 million and gross unrealized losses of $12.0 million.
For all but one security, which was carried at its fair value of $14.9 million at December 31, 2003, we determine the market value of each fixed income security using prices obtained in the public markets. For this security, whose fair value is not reliably determined from these public market sources, we utilize the services of our outside professional investment asset manager to determine the fair value. The asset manager determines the fair value of the security by using a discounted present value of the estimated future cash flows (interest and principal repayment).
Gross investment income less investment expenses and before interest credited on funds held treaties of $10.4 million, $2.9 million and $12.0 million in 2003, 2002 and 2001, respectively. Excludes net realized investment gains and losses and amounts related to securities lending activities.
Of the 5 securities that have been in an unrealized loss position for more than 12 months, 4 securities have an unrealized loss of less than $1 million each and/or less than 20% of each security’s amortized cost. These 4 securities have fair values at December 31, 2003 that are 90% or more of the amortized cost basis, and the average unrealized loss per security is approximately $276,000. There is only one security out of the 5 with an unrealized loss in excess of $1 million at December 31, 2003, and it has a market value of $14.9 million and a cost of $20.0 million. The security is a structured security backed by a U.S. Treasury Strip, and is rated AAA. This security matures in 2011 at a value of $20.0 million, and we have both the ability and intent to hold this security until it matures.
At December 31, 2003, 99% of our fixed income investments were publicly traded and all were rated by at least one nationally recognized credit rating agency. In addition, at December 31, 2003, $15.6 million, or 0.8%, of our total investments were below investment grade. Of these below investment grade investments, $2.2 million were in an unrealized loss position, which totaled $13,000.
During 2003, we determined there were other than temporary declines in market value of securities issued by 4 companies, resulting in impairment charges of $2.6 million pre-tax in 2003. The impairment losses for 2003 primarily related to securities issued by airline companies and one asset-backed security. The write-downs were measured based on public market prices and our expectation of the future realizable value for the security at the time we determined the decline in value was other than temporary.
We recorded pre-tax net realized investment gains of $13.8 million in 2003, compared to pre-tax net realized investment losses of $16.1 million in 2002 and net realized gains of $8.0 million in 2001. During 2003, there were gross realized gains and losses of $18.7 million and $4.9 million, respectively. Included in the gross losses of $4.9 million were $2.6 million of impairment losses on fixed income securities, primarily securities issued by airline companies and one asset-backed security and $800,000 of realized losses on sales of securities where we reduced and/or eliminated our positions in certain issuers due to credit concerns. Realized losses also include sales reducing our per issuer exposure and general duration management trades.
In January 2003, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 46, “Consolidation of Variable Interest Entities” (“FIN 46”), which requires a company to assess if consolidation of an entity is appropriate based upon its variable economic interests in a variable interest entity (“VIE”). The initial determination of whether an entity is a VIE is required to be made on the date at which we become involved with the entity. A VIE is an entity in which the equity investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. A company must consolidate a VIE if the company has a variable interest that will absorb a majority of the VIE’s expected losses if they occur, receive a majority of the entity’s expected residual returns if they occur or both. FIN 46 also requires the disclosure of certain information related to VIEs in which a company holds a significant variable interest.
Adoption of FIN 46 and its current interpretations did not have a material impact on our financial condition, results of operations or liquidity. At December 31, 2003, we applied the provisions of FIN 46 and its current interpretations to our reporting for three wholly owned statutory trusts, which issued $42.5 million of trust preferred securities in 2003. As a result of application of the provisions of FIN 46, we deconsolidated these wholly owned statutory trusts, resulting in an increase of $1.3 million in other assets and debt on the Balance Sheet.
Effective December 31, 2002, we adopted the disclosure provisions of SFAS No. 148, “Accounting for Stock-Based Compensation - Transition and Disclosure.” SFAS No. 148 amended SFAS No. 123, “Accounting for Stock-Based Compensation,” to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, SFAS No. 148 amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. We account for stock-based employee compensation using the intrinsic value method prescribed in Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees.” Accordingly, we have applied the disclosure provisions of SFAS No. 148.
Effective January 1, 2003, we adopted the recognition provisions of FASB Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others” (“FIN 45”). We had previously applied the disclosure provisions of FIN 45 to our year end 2002 financial statements. FIN 45 requires certain guarantees to be recorded at fair value and also requires a guarantor to make certain disclosures, even when the likelihood of making payments under the guarantee is remote. Generally, FIN 45 applies to contracts or indemnification agreements that contingently require the guarantor to make payments to the guaranteed party. Adoption of FIN 45 did not have an impact on our financial condition, results of operations or liquidity.
In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” This statement establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances). This statement is effective for instruments entered into or modified after May 31, 2003 and the disclosure requirements were effective beginning with the third quarter of 2003. Adoption of this statement did not have an impact on our financial statements.
At December 31, 2003, we estimated that under all insurance policies and reinsurance contracts issued by our insurance businesses our liability for all events that occurred as of December 31, 2003 is $2,541.3 million. This amount includes estimated losses from claims plus estimated expenses to settle claims. Our estimate also includes amounts for losses occurring prior to December 31, 2003 whether or not these claims have been reported to us.
In arriving at the estimate of unpaid claims, our actuaries performed detailed studies of historical data for incurred claims, reported claims and paid claims for each major line of business and by accident year. The review of this data results in patterns and trends that are analyzed using various actuarial models that assume that historical development patterns will be predictive of future patterns. Along with this historical data, our actuaries consider the impact of legal and legislative developments, regulatory trends, changes in social attitudes and economic conditions. From this assessment, we develop various sets of assumptions that we believe are reasonable, valid and can be relied upon to help us predict future claim trends. These assumptions are then applied to various actuarially accepted methods and techniques, which provide us with a range of possible outcomes of the ultimate claims to be paid by us in the future. Management uses its judgment to select the best estimate of the amounts needed to pay all future claims and related expenses from this range of possible outcomes. Under GAAP, we record a liability on our balance sheet equal to our best estimate of the ultimate claims liability.
As outlined above, our loss and LAE reserves at December 31, 2003 have been established using generally accepted actuarial techniques and are based on numerous critical assumptions and informed judgments about reported and paid claim trends and their implication on our estimate of the ultimate loss for reported and incurred but unreported claims at the balance sheet date. We have established a loss and LAE reserve for unpaid claims at December 31, 2003 that we believe is a reasonable and adequate provision based on the information available to us. If we revised our assessment of loss reporting and claims payment patterns because of changes in those patterns, such that it resulted in a 1% change in our net loss and LAE reserves, then our pre-tax operating income would change by approximately $13 million.
As part of determining the market value for each specific investment that we hold, we evaluate each issuer’s ability to fully meet their obligation to pay all amounts, both interest and principal, due in the future. Because we have invested in fixed income obligations with an overall average credit quality of AA, and all of our investments are currently meeting their obligations with respect to scheduled interest income and principal payments, we believe that we will fully realize the value of our investments. However, future general economic conditions and/or specific company performance issues may cause a particular issuer, or group of issuers in the same industry segment, to become unable to meet their obligation to pay principal and interest as it comes due. If such events were to occur, then we would evaluate our ability to fully recover the recorded value of our investment. Ultimately, we may have to write down an investment to its then determined net realizable value and reflect that write-down in earnings in the period such determination is made.
Based on our evaluation of securities with an unrealized loss at December 31, 2003, we do not believe that any additional other-than-temporary impairment losses, other than those already reflected in the financial statements, is necessary at the balance sheet date. However, if we were to have determined that all securities that were in an unrealized loss position at December 31, 2003 should have been written down to their fair value, we would have recorded an additional other-than-temporary impairment loss of $12.0 million pre-tax.
For additional information about our investments, see Notes 2-B, 4 and 12 of the Consolidated Financial Statements as well as "Investments" beginning on page 54.
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 and reinsurance subsidiaries. Our reinsurance receivables total $1,220.3 million at December 31, 2003. We have also estimated that $6.8 million of reinsurance receivables will be uncollectible, and we have provided a valuation allowance for that amount.
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.
For additional information about reinsurance receivables, see Note 5 to the Consolidated Financial Statements as well as "Reinsurance" beginning on page 48.
We record deferred tax assets and liabilities to the extent of the tax effect of differences between the financial statement carrying values and tax bases of assets and liabilities. The recoverability of deferred tax assets is evaluated based upon management’s estimates of the future profitability of our taxable entities based on current forecasts. We establish a valuation allowance for deferred tax assets where it appears more likely than not that we will not be able to recover the deferred tax asset. At December 31, 2003, PMA Capital has a net deferred tax asset of $77.0 million, resulting from $191.4 million of gross deferred tax assets reduced by a deferred tax asset valuation allowance of $49.0 million and by $65.4 million of deferred tax liabilities. In establishing the appropriate value of this asset, management must make judgments about our ability to utilize the net tax benefit from the reversal of temporary differences and the utilization of operating loss carryforwards that expire mainly from 2018 through 2023.
50% of ceded losses or reinstatement premiums in the event that losses of a significant magnitude are ceded under such contracts. Under accounting rules, we are not permitted to establish reserves for potential additional premiums or record such amounts until a loss occurs that would obligate us to pay such additional or reinstatement premiums. As a result, the net benefit to our results from ceding losses to our retrocessionaires in the event of a loss may be reduced by the payment of additional premiums and reinstatement premiums to our retrocessionaires. For example, in 2001, PMA Re assumed losses of $135 million due to the September 11th terrorist attack on the World Trade Center and ceded $110 million of these losses to our retrocessionaires. Under the terms of the retrocessional coverage to which we ceded these losses, we were required to pay $30 million of additional ceded premiums to our retrocessionaires, which reduced the net benefit of the loss cessions from $110 million to $80 million. For additional information, see Notes 5 and 6 to our Consolidated Financial Statements.
• our ability to effect an efficient withdrawal from the reinsurance business, including the commutation of reinsurance business with certain large ceding companies;
• regulatory or tax changes in risk-based capital or other regulatory standards that affect the cost of, or demand for, our products or otherwise affect our ability to conduct business, including any future action with respect to our business taken by the Pennsylvania Insurance Department or any other state insurance department;
• the ability of the Company to have sufficient cash at the holding company to meet its debt service and other obligations, including any restrictions such as in our letter agreement with the Pennsylvania Insurance Department on receiving dividends from its insurance subsidiaries in an amount sufficient to meet such obligations;
• the outcome of any litigation against the Company, including the outcome of the purported class action lawsuits;
• 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;
• our ability to predict and effectively manage claims related to insurance and reinsurance policies;
• the uncertain nature of damage theories and loss amounts and the development of additional facts related to the attack on the World Trade Center;
• uncertainty as to the price and availability of reinsurance on business we intend to write in the future, including reinsurance for terrorist acts;
• changes in general economic conditions, including the performance of financial markets, interest rates and the level of unemployment;
• uncertainties related to possible terrorist activities or international hostilities; and
• other factors disclosed from time to time in this Form 10-K and our most recent 10-Q and 8-K filed with the Securities and Exchange Commission.
Consolidated Statements of Comprehensive Income (Loss) for the years ended December 31, 2003, 2002
Net cash flows used in investing activities (185,990 ) (123,845 ) (19,668 )
Balance at end of year (52,426 ) (52,535 ) (55,797 )
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 is an insurance holding company that operates the following businesses:
PMA Re - Prior to November 6, 2003, the Company’s reinsurance operations offered excess of loss and pro rata property and casualty reinsurance protection mainly through reinsurance brokers. Effective November 6, 2003, the Company decided to withdraw from the reinsurance business. See Note 3 for additional information. The results of this business, which had been offered though our PMA Re business segment, will be included in Run-off Operations effective in 2004.
The Company participates in a securities lending program through which securities are lent from the Company’s portfolio for short periods of time to qualifying third parties via a lending agent. Borrowers of these securities must provide collateral equal to a minimum of 102% of the market value including accrued interest of the lent securities. Acceptable collateral may be in the form of either cash or securities. Cash received as collateral is invested in short-term investments, and is recorded as such on the Balance Sheet, along with a corresponding liability included in payable under securities loan agreements. All
securities received as collateral are of similar quality to those securities lent by the Company. The Company is not permitted by contract to sell or repledge the securities received as collateral. Additionally, the Company limits securities lending to 40% of statutory admitted assets of its insurance subsidiaries, with a 2% limit on statutory admitted assets to any individual borrower. The Company either receives a fee from the borrower or retains a portion of the income earned on the collateral. Under the terms of the securities lending program, the Company is indemnified against borrower default, with the lending agent responsible to the Company for any deficiency between the cost of replacing a security that was not returned and the amount of collateral held by the Company.
C. Premiums - Premiums, including estimates of additional premiums resulting from audits of insureds’ records, and premiums from ceding companies which are typically reported on a delayed basis, are earned principally on a pro rata basis over the terms of the policies. For reinsurance premiums assumed, management must estimate the subject premiums associated with the treaties in order to determine the level of written and earned premiums for a reporting period. Such estimates are based on information from brokers and ceding companies, which can be subject to change as new information becomes available. Any changes occurring or reported to the Company after the policy term are recorded as earned premiums in the period in which the adjustment is made. See Note 5 for additional information. With respect to policies that provide for premium adjustments, such as experience-rated or exposure-based adjustments, such premium adjustments may be made subsequent to the end of the policy’s coverage period and will be recorded as earned premiums in the period in which the adjustment is made. Premiums applicable to the unexpired terms of policies in force are reported as unearned premiums. The estimated premiums receivable on retrospectively rated policies are reported as a component of premiums receivable.
D. Unpaid Losses and Loss Adjustment Expenses - Unpaid losses and loss adjustment expenses (“LAE”), which are stated net of estimated salvage and subrogation, are estimates of losses and LAE on known claims and estimates of losses and LAE incurred but not reported (“IBNR”). IBNR reserves are calculated utilizing various actuarial methods. Unpaid losses on certain workers’ compensation claims are discounted to present value using the Company’s payment experience and mortality and interest assumptions in accordance with statutory accounting practices prescribed by the Pennsylvania Insurance Department. The Company also discounts unpaid losses and LAE for certain other claims at rates permitted by domiciliary regulators or if the timing and amount of such claims are fixed and determinable. The methods of making such estimates and establishing the resulting reserves are continually reviewed and updated and any adjustments resulting therefrom are reflected in earnings in the period identified. See Note 5 for additional information.
E. Reinsurance - In the ordinary course of business, PMA Capital’s reinsurance and insurance subsidiaries assume and cede premiums with other insurance companies and are members of various insurance pools and associations. The Company’s insurance and reinsurance subsidiaries cede business in order to limit the maximum net loss and limit the accumulation of many smaller losses from a catastrophic event. The insurance and reinsurance subsidiaries remain primarily liable to their clients in the event their reinsurers are unable to meet their financial obligations. Reinsurance receivables include claims paid by the Company and estimates of unpaid losses and LAE that are subject to reimbursement under reinsurance and retrocessional contracts. The method for determining the reinsurance receivable for unpaid losses and LAE involves reviewing actuarial estimates of unpaid losses and LAE to determine the Company’s ability to cede unpaid losses and LAE under its existing reinsurance contracts. This method is continually reviewed and updated and any adjustments resulting therefrom are reflected in earnings in the period identified. Under certain of the Company’s reinsurance and retrocessional contracts, additional premium and interest may be required if predetermined loss and LAE thresholds are exceeded.
Certain of the Company’s assumed and ceded reinsurance contracts are funds held arrangements. In a 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 Company generally earns an interest rate of between 6% and 8% on its assumed funds held arrangements and generally pays interest at a rate of between 6% and 8% on its ceded funds held arrangements. 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.
H. Income Taxes - The Company records deferred tax assets and liabilities to the extent of the tax effect of differences between the financial statement carrying values and tax bases of assets and liabilities. A valuation allowance is recorded for deferred tax assets where it appears more likely than not that the Company will not be able to recover the deferred tax asset. See Note 13 for additional information.
I. Stock-Based Compensation - The Company accounts for stock-based compensation using the intrinsic value method prescribed in Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. Accordingly, compensation cost for stock options is 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. The following table illustrates the effect on net income (loss) if the fair value based method had been applied:
Basic - as reported $ (2.99 ) $ (1.53 ) $ 0.33
Diluted - as reported $ (2.99 ) $ (1.53 ) $ 0.32
J. Other Revenues - Other revenues include service revenues related to unbundled claims, risk management and related services provided by The PMA Insurance Group, which are earned over the term of the related contracts in proportion to the actual services rendered, and other miscellaneous revenues. During 2001, other revenues included a $9.8 million gain on the sale of certain real estate properties.
K. Recent Accounting Pronouncements - In January 2003, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 46, “Consolidation of Variable Interest Entities” (“FIN 46”), which requires a company to assess if consolidation of an entity is appropriate based upon its variable economic interests in a variable interest entity (“VIE”). The initial determination of whether an entity is a VIE is required to be made on the date at which a company becomes involved with the entity. A VIE is an entity in which the equity investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. A company must consolidate a VIE if the company has a variable interest that will absorb a majority of the VIE’s expected losses if they occur, receive a majority of the entity’s expected residual returns if they occur or both. FIN 46 also requires the disclosure of certain information related to VIEs in which a company holds a significant variable interest.
In December 2003, the FASB revised Statement of Financial Accounting Standards (“SFAS”) No. 132, “Employers’ Disclosures About Pensions and Other Postretirement Benefits,” to require additional disclosures regarding defined benefit pension plans and other defined benefit postretirement plans. The Company has applied the disclosure provisions of SFAS No. 132 to its Consolidated Financial Statements for 2003.
Effective December 31, 2002, the Company adopted the disclosure provisions of SFAS No. 148, “Accounting for Stock-Based Compensation - Transition and Disclosure.” SFAS No. 148 amended SFAS No. 123, “Accounting for Stock-Based Compensation,” to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, SFAS No. 148 amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The Company accounts for stock-based employee compensation using the intrinsic value method prescribed in Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees.” Accordingly, the Company has applied the disclosure provisions of SFAS No. 148.
Effective January 1, 2003, the Company adopted the recognition provisions of FASB Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others” (“FIN 45”). The Company had previously applied the disclosure provisions of FIN 45 to its year end 2002 financial statements. FIN 45 requires certain guarantees to be recorded at fair value and also requires a guarantor to make certain disclosures, even when the likelihood of making payments under the guarantee is remote. Generally, FIN 45 applies to contracts or indemnification agreements that contingently require the guarantor to make payments to the guaranteed party. Adoption of FIN 45 did not have an impact on the Company’s financial condition, results of operations or liquidity.
Effective July 1, 2003, the Company adopted SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities.” This statement amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts (collectively referred to as derivatives) and for hedging activities under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities.” Adoption of this statement did not have an impact on the Company’s financial condition, results of operations or liquidity.
Re expects to record expenses of approximately $2 million in 2004, which includes retention bonuses and severance. The Company expects to pay the majority of these costs in 2004 and 2005.
The Company’s investment portfolio is diversified and does not contain any significant concentrations in single issuers other than U.S. Treasury and agency obligations. In addition, the Company does not have a significant concentration of investments in any single industry segment other than finance companies, which comprise 14% of invested assets at December 31, 2003. Included in this industry segment are diverse financial institutions, including the financing subsidiaries of automotive manufacturers.
U.S. Treasury securities and obligations of U.S. Government agencies $ 340,483
Interest on funds held, net (10,408 ) (2,889 ) (11,985 )
Included in realized losses for 2003, 2002 and 2001 were impairment losses of $2.6 million, $23.8 million and $1.6 million, respectively. The impairment losses for 2003 primarily related to securities issued by airline companies and an asset-backed security. The impairment losses for 2002 primarily related to corporate bonds issued by telecommunications and energy companies, including $14.2 million for WorldCom. The write-downs were measured based on public market prices and the Company’s expectation of the future realizable value for the security at the time when the Company determined the decline in value was other than temporary.
The increase (decrease) in net unrealized gains on investments for 2003, 2002 and 2001 was $(3.5) million, $43.6 million and $30.7 million, respectively, attributable to fixed maturities.
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. 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. In addition, because reinsurers rely on their ceding companies to provide them with information regarding incurred losses, reported claims for reinsurers become known more slowly than for primary insurers and are subject to more unforeseen development and uncertainty. 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 components of the Company’s unfavorable (favorable) development of reserves for losses and LAE for prior accident years, excluding accretion of discount, are as follows:
PMA Re’s analysis was enhanced by an extensive review of specific accounts, comprising about 40% of carried reserves for accident years 1997 to 2000. The Company’s actuaries visited a number of former ceding company clients, which collectively comprised about 25% of PMA Re’s total gross loss and LAE reserves from accident years 1997 to 2000, to discuss reserving and reporting experience with these ceding companies. The Company’s actuaries separately evaluated an additional number of other ceding companies, representing approximately 15% of PMA Re’s total gross loss and LAE reserves from accident years 1997 to 2000, to understand and examine data trends.
The remaining $43 million of unfavorable prior year development at PMA Re in 2002 primarily reflects the recording of losses and LAE on additional earned premiums recorded during 2002 as a result of a change in our estimate of ultimate premiums written from prior years. Because premiums from ceding companies are typically reported on a delayed basis, we monitor and update as appropriate the estimated ultimate premiums written. PMA Re’s periodic reviews of estimated ultimate premiums written, which compared actual reported premiums and originally estimated premiums based on ceding company estimates, indicated that premiums written in recent years, primarily in the Traditional- and Specialty-Treaty units for 2001 and 2000, were higher than originally estimated. As a result, PMA Re recorded additional net premiums earned during 2002, including $39.9 million in the second quarter, which were completely offset by losses and LAE and acquisition expenses.
Losses and LAE incurred in 2001 were impacted by the September 11th terrorist attack on the World Trade Center. The Company incurred $30 million of pre-tax net losses from this catastrophe. Gross losses of approximately $145 million resulted from this catastrophe, which is before (1) reinsurance recoveries ($120 million), (2) additional premiums due to PMA Re’s retrocessionaires ($30 million) and (3) additional premiums due to PMA Re on its assumed business ($25 million). The Company’s estimate of net loss from the September 11th terrorist attack on the World Trade Center continues to be approximately $30 million pre-tax and is based on its analysis to date of known exposures. However, it is difficult to fully estimate the Company’s loss from the attack given the uncertain nature of damage theories and loss amounts, and the development of additional facts related to the attack. As more information becomes available, the Company’s estimate of these losses may need to be increased.
At December 31, 2003, 2002 and 2001, gross reserves for asbestos-related losses were $37.8 million, $42.1 million and $59.9 million, respectively ($17.8 million, $25.8 million and $28.6 million, net of reinsurance, respectively). Of the net asbestos reserves, approximately $14.9 million, $22.9 million and $26.6 million related to IBNR losses at December 31, 2003, 2002 and 2001, respectively.
Estimating reserves for asbestos and environmental exposures continues to be difficult because of several factors, including: (i) evolving methodologies for the estimation of the liabilities; (ii) lack of reliable historical claim data; (iii) uncertainties with respect to insurance and reinsurance coverage related to these obligations; (iv) changing judicial interpretations; and (v) changing government standards. Management believes that its reserves for asbestos and environmental claims are appropriately established based upon known facts, existing case law and generally accepted actuarial methodologies. However, due to changing interpretations by courts involving coverage issues, the potential for changes in federal and state standards for clean-up and liability, as well as issues involving policy provisions, allocation of liability and damages among participating insurers, and proof of coverage, the Company’s ultimate exposure for these claims may vary significantly from the amounts currently recorded, resulting in a potential future adjustment that could be material to the Company’s financial condition, results of operations and liquidity.
The components of net premiums written and earned, and losses and LAE incurred are as follows:
Losses and LAE ceded for 2001 included approximately $120 million related to the September 11th terrorist attack on the World Trade Center.
At December 31, 2003, the Company had reinsurance receivables due from the following unaffiliated reinsurers in excess of 5% of shareholders’ equity:
Includes Trabaja Reinsurance Company ($288.7 million), London Life & General Reinsurance Company ($44.3 million) and London Life & Casualty Reinsurance Corporation ($1.0 million).
Includes United States Fidelity & Guaranty Insurance Company ($89.7 million) and Mountain Ridge Insurance Company ($44.3 million).
In January 2002, the Company supplemented its in-force reinsurance programs for PMA Re and The PMA Insurance Group with retroactive reinsurance contracts with Trabaja that provide coverage for adverse loss development on certain lines of business for accident years prior to 2002. These contracts provide coverage of up to $125 million in losses in return for $55 million of funding, which included $50 million of assets and $5 million in ceded premiums. Under the terms of the contracts, PMA Re’s losses and LAE ceded to Trabaja for accident years 1996 through 2001 are recoverable as they are incurred by the Company. In 2002, PMA Re recognized a benefit of $25 million for losses ceded to these reinsurance contracts. Any future cession of losses under these contracts may require the Company to cede additional premiums ranging from 40% to 50% of ceded losses depending on the level of such losses.
In June 2003, the Company issued $57.5 million of 8.50% monthly income senior notes (“Senior Notes”) due June 15, 2018, from which it realized net proceeds of $55.1 million. The Company used the proceeds from the offering to repay the remaining balance outstanding under its prior bank credit facility, to increase the statutory capital and surplus of its insurance subsidiaries, and for general corporate purposes. The Company has the right to call these securities beginning in June 2008.
Total rent expense was $4.0 million, $4.1 million and $3.9 million for 2003, 2002 and 2001, respectively. At December 31, 2003, the Company was obligated under noncancelable operating leases for office space with aggregate minimum annual net rentals of $4.0 million in 2004 and 2005, $3.9 million in 2006 and 2007, $3.4 million in 2008 and $22.0 million thereafter, net of sublease rentals of $1.4 million in 2004, $1.5 million in 2005 and 2006, $1.6 million in 2007 and 2008 and $9.3 million thereafter. In addition, the Company was obligated under noncancelable operating leases for office computers, equipment and other items of $3.1 million in 2004, $2.3 million in 2005, $1.5 million in 2006, $425,000 in 2007 and $32,000 in 2008.
expected to result in recoveries that differ from recorded receivables by amounts that would be material to the Company’s financial condition, results of operations or liquidity.
On November 6, 2003, several purported class action lawsuits were filed against PMA Capital Corporation and certain other defendants. A purported class action lawsuit captioned Pitt v. PMA Capital Corporation, John W. Smithson, and William E. Hitselberger (initiated November 6, 2003) has been filed in the Eastern District of Pennsylvania by alleged shareholders of PMA Capital who seek to represent a class of purchasers of PMA Capital securities from May 7, 2003 to November 3, 2003. The complaints allege, among other things, that the defendants violated Rule 10b-5 of the Securities Exchange Act of 1934, as amended, by making materially false and misleading public statements and material omissions during the class period regarding the Company’s loss reserves.
Reissuance of treasury shares under employee benefit plans (5,481 ) (252,101 ) (117,990 )
The Company repurchased 90,185 shares of its Class A Common stock at a cost of $1.7 million in 2002 and 299,300 shares at a cost of $5.3 million in 2001. No shares were repurchased in 2003. The Company’s remaining share repurchase authorization at December 31, 2003 is $15.4 million. Decisions regarding share repurchases are subject to prevailing market conditions and an evaluation of the costs and benefits associated with alternative uses of capital.
The Company’s domestic insurance subsidiaries’ ability to pay dividends to the holding company is limited by the insurance laws and regulations of the Commonwealth of Pennsylvania. All of PMA Capital’s domestic insurance entities are owned by PMA Capital Insurance Company. As a result, dividends from The PMA Insurance Group’s Pooled Companies may not be paid directly to PMA Capital. Instead, only PMA Capital Insurance Company, a Pennsylvania domiciled company, may pay dividends directly to PMA Capital. Under Pennsylvania law, approximately $17 million of dividends would have been available to be paid by PMA Capital Insurance Company to the holding company in 2004 without the prior approval of the Pennsylvania Insurance Department as of December 31, 2003. However, PMA Capital Insurance Company has agreed with the Pennsylvania Insurance Department that PMA Capital Insurance Company will not pay dividends to the holding company without the prior approval of the Pennsylvania Insurance Department. As of December 31, 2003, The PMA Insurance Group’s Pooled Companies can pay up to $23.2 million in dividends to PMA Capital Insurance Company during 2004. Dividends received from subsidiaries were $24.0 million, $28.0 million and $29.6 million in 2003, 2002 and 2001, respectively.
The Company currently has stock option plans in place for stock options granted to officers and other key employees for the purchase of the Company’s Class A Common stock, under which 4,928,673 Class A Common shares were reserved for issuance at December 31, 2003. The stock options were granted under terms and conditions determined by the Stock Option Committee of the Board of Directors. Stock options granted have a maximum term of ten years, generally vest over periods ranging between two and four years, and are typically granted with an exercise price at least equal to the fair market value of the Class A Common stock on the date the options are granted. Information regarding these option plans is as follows:
Options available for grant at end of year 2,057,054 305,158 48,466
Included in the options outstanding at December 31, 2002 and 2001 are 260,000 and 420,000 options (“Target Price Options”), respectively, with an exercise price of $17.00. Because the stock did not reach the necessary price, the Target Price Options expired as unvested options in February 2003.
All options granted in 2003 were granted with an exercise price that exceeded the market value of the Class A Common stock on the grant date (“out-of-the-money”), and such options had a weighted average exercise price of $9.21 per share and a weighted average fair value of $4.91 per share. Of the total options granted in 2002, 225,000 were granted with an exercise price that was lower than the market value of the Class A Common stock on the grant date, and such options had a weighted average exercise price of $19.50 per share and a weighted average fair value of $14.61 per share. The remaining 215,500 options were granted out-of-the-money, and such options had an exercise price of $19.50 per share and a weighted average fair value of $7.66 per share. In 2001, all options were granted out-of-the-money at an exercise price of $20.00 per share and a fair value of $6.39 per share.
The Company accounts for stock-based compensation using the intrinsic value method prescribed in Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. Included in the Company’s net loss for 2003 and 2002 were pre-tax compensation costs of $239,000 and $215,000, respectively. No compensation cost was recognized in 2001.
The 2003 diluted shares do not assume the conversion of the Company’s 4.25% convertible debentures into 5.3 million shares of Class A Common stock because they would have been anti-dilutive. The 2002 diluted shares do not assume the conversion of the Company’s 4.25% convertible debentures into 5.3 million shares of Class A Common stock because, under the terms of the Convertible Debt agreement, the debentures did not meet the conditions for convertibility. See Note 7 for additional information.
The tax effects of significant temporary differences between the financial statement carrying amounts and tax bases of assets and liabilities that represent the net deferred tax asset are as follows:
Pension Benefits - The Company sponsors a qualified non-contributory defined benefit pension plan (the “Qualified Pension Plan”) covering substantially all employees. After meeting certain requirements under the Qualified Pension Plan, an employee acquires a vested right to future benefits. The benefits payable under the plan are generally determined on the basis of an employee’s length of employment and salary during employment. The Company’s policy is to fund pension costs in accordance with the Employee Retirement Income Security Act of 1974.
The Company also maintains non-qualified unfunded supplemental defined benefit pension plans (the “Non-qualified Pension Plans”) for the benefit of certain key employees. The projected benefit obligation and accumulated benefit obligation for the Non-qualified Pension Plans were $7.0 million and $6.6 million, respectively, as of December 31, 2003.
The following tables set forth the amounts recognized in the Company’s financial statements with respect to Pension Benefits and Other Postretirement Benefits:
Fair value of plan assets at beginning of year $ 57,118
Fair value of plan assets at end of year $ 62,401
Expected return on plan assets (5,032 ) (4,333 ) (3,983 ) -
Expected return on plan assets 9.00 % 9.00 % 9.00 % -
Employer contributions and benefits paid in the table above include only those amounts contributed directly to, or paid directly from, plan assets.
The projected benefit obligation, accumulated benefit obligation and fair value of plan assets for the Qualified Pension Plan were $70.5 million, $65.3 million and $62.4 million, respectively, at December 31, 2003 and $60.7 million, $56.4 million and $57.1 million, respectively, at December 31, 2002.
Qualified Pension Plan benefits will be paid from the pension trust assets which have a fair value of $62.4 million at December 31, 2003. Non-qualified Pension Plan benefits will be paid from the general assets of the Company.
B. Defined Contribution Savings Plan - The Company also maintains a voluntary defined contribution savings plan covering substantially all employees. The Company matches employee contributions up to 5% of compensation. Contributions under such plans expensed in 2003, 2002 and 2001 were $3.3 million, $3.4 million and $2.9 million, respectively.
In May 2002, the Company announced its decision to withdraw from the excess and surplus lines marketplace previously served by the Caliber One operating segment. In January 2003, the Company closed on the sale of the capital stock of Caliber One Indemnity Company. The sale generated gross proceeds of approximately $31 million and resulted in a pre-tax gain of $2.5 million, which is included in other revenues in the Statement of Operations for 2003. Pursuant to the agreement of sale, the Company has retained all assets and liabilities related to the in-force policies and outstanding claim obligations relating to Caliber One’s business written prior to closing. As a result of the Company’s decision to exit this business, the results of this segment are reported as Run-off Operations. During 2003, the Company recognized an additional $2.5 million writedown of assets, made up of approximately $2 million for reinsurance receivables and $500,000 for premiums receivable, reflecting an assessment of their estimated net realizable value. The writedown is included in operating expenses in the Statement of Operations for 2003.
The Company’s amortization and depreciation expense by principal business segment were as follows:
The Company’s total assets(1) by principal business segment were as follows:
Equity investments in subsidiaries, which eliminate in consolidation, are excluded from total assets for each segment.
The PMA Insurance Group’s operations are concentrated in nine contiguous states in the eastern part of the U.S. As such, economic trends in 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 many 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. In 2003, 2002 and 2001, workers’ compensation net premiums written by The PMA Insurance Group represented 41%, 32% and 36%, respectively, of the Company’s net premiums written.
Although the Company believes that it has adequate reinsurance to protect against the estimated probable maximum gross loss from a catastrophe, an especially severe catastrophe or series of catastrophes could exceed the Company’s reinsurance and/or retrocessional protection and may have a material adverse impact on the Company’s financial condition, results of operations and liquidity. In 2001, the Company’s results reflect approximately $30 million pre-tax ($20 million after-tax) of losses due to the attack on the World Trade Center. See Note 5 for additional information. In 2003 and 2002, the Company’s loss and LAE ratios were not significantly impacted by catastrophes.
The Company incurred legal and consulting expenses aggregating approximately $3.7 million, $3.9 million and $4.8 million in 2003, 2002 and 2001, respectively, from firms in which directors of the Company are partners or principals.
At December 31, 2003, 2002 and 2001, the Company had notes receivable from officers totaling $65,000, $62,000 and $158,000, respectively, that are accounted for as a reduction of shareholders’ equity. At December 31, 2003, the interest rate on these notes was 4.0%.
These consolidated financial statements vary in certain respects from financial statements prepared using statutory accounting practices that are prescribed or permitted by the Pennsylvania Insurance Department and the Delaware Insurance Department, (collectively, “SAP”). Prescribed SAP includes state laws, regulations and general administrative rules, as well as a variety of National Association of Insurance Commissioners (“NAIC”) publications. Permitted SAP encompasses all accounting practices that are not prescribed. The Codification of Statutory Accounting Principles (“Codification”) guidance is the NAIC’s primary guidance on statutory accounting. The principal differences between GAAP and SAP are in the treatment of reinsurance, acquisition expenses, deferred income taxes, fixed assets and investments.
Net income (loss) (Basic) $ (0.55 ) $ (0.95 )(2) $ 0.30
Includes approximately $43 million pre-tax ($28 million after-tax or $0.90 per basic and diluted share) for costs associated with the exit from and run off of Caliber One, our former excess and surplus lines business.