The Company’s subsidiaries that do not participate in the pooling agreement (EMC Reinsurance Company and EMC Underwriters, LLC), as well as subsidiaries of Employers Mutual that do not participate in the pooling agreement, are allocated rent expense based on the square footage occupied by the respective operations. The remaining rent expense is attributed to the pool and is allocated among the pool participants based on their respective participation interests.
The following discussion and analysis of EMC Insurance Group Inc. and Subsidiaries’ financial condition and results of operations should be read in conjunction with the Consolidated Financial Statements and Notes to Consolidated Financial Statements included elsewhere herein.
EMC Insurance Group Inc., a 56.6 percent owned subsidiary of Employers Mutual Casualty Company (Employers Mutual), is an insurance holding company with operations in property and casualty insurance and reinsurance. Property and casualty insurance is the most significant segment, representing 81.3 percent of consolidated premiums earned in 2006. For purposes of this discussion, the term “Company” is used interchangeably to describe EMC Insurance Group Inc. (Parent Company only) and EMC Insurance Group Inc. and its subsidiaries. Employers Mutual and all of its subsidiaries (including the Company) and an affiliate are referred to as the “EMC Insurance Companies.”
The Company’s reinsurance subsidiary is a party to a quota share reinsurance retrocessional agreement with Employers Mutual (the “quota share agreement”). Under the terms of the quota share agreement, the reinsurance subsidiary assumes a 100 percent quota share portion of Employers Mutual’s assumed reinsurance business, exclusive of certain reinsurance contracts. This includes all premiums and related losses, settlement expenses, and other underwriting and administrative expenses of this business, subject to a maximum loss of $2,000,000 per event ($1,500,000 in 2005 and 2004). The reinsurance subsidiary does not directly reinsure any of the insurance business written by Employers Mutual or the other pool participants; however, the reinsurance subsidiary assumes reinsurance business from the Mutual Reinsurance Bureau (MRB) pool and this pool provides a small amount of reinsurance protection to the EMC Insurance Companies. As a result, the reinsurance subsidiary’s assumed exposures include a small portion of the EMC Insurance Companies’ direct business, after ceded reinsurance protections purchased by the MRB pool are applied. In addition, the reinsurance subsidiary does not reinsure any “involuntary” facility or pool business that Employers Mutual assumes pursuant to state law. Operations of the quota share agreement give rise to inter-company balances with Employers Mutual, which are settled on a quarterly basis. The investment and income tax activities of the reinsurance subsidiary are not subject to the quota share agreement.
Insurance companies collect cash in the form of insurance premiums and pay out cash in the form of loss and settlement expense payments. Additional cash outflows occur through the payment of acquisition and underwriting costs such as commissions, premium taxes, salaries and general overhead. During the loss settlement period, which varies by line of business and by the circumstances surrounding each claim and may cover several years, insurance companies invest the cash premiums; thereby earning interest and dividend income. This investment income supplements underwriting results and contributes to net earnings. The weak economy during the period 2000 through 2002 prompted the Federal Reserve Bank to reduce interest rates several times. As a result, funds from called and matured fixed maturity securities have been reinvested at much lower interest rates, which has had a negative impact on the insurance industry’s investment income.
Insurance pricing has historically been cyclical in nature. Periods of excess capital and increased competition encourage price cutting and liberal underwriting practices (referred to as a soft market) as insurance companies compete for market share, while attempting to cover the inevitable underwriting losses from these actions with investment income. A prolonged soft market generally leads to a reduction in the adequacy of capital in the insurance industry. To cure this condition, underwriting practices are tightened, premium pricing rises and competition subsides as companies strive to strengthen their balance sheets (referred to as a hard market). During the late 1990’s, the insurance industry had hit the depths of an extremely long soft market. High interest rates and a strong stock market had allowed insurers to cover ever growing underwriting losses with investment income. As the year 2000 approached, declining interest rates and a weakening stock market prompted the insurance industry to begin a movement toward increased pricing. This movement was dramatically accelerated by the terrorist attacks of September 11, 2001, pushing the industry toward a hard market. The ensuing plunge in the stock market, a further decline in interest rates, high profile bankruptcies and rising concerns about reserve deficiencies lead the insurance industry to implement large premium rate increases in an effort to improve capitalization. This hard market continued through 2002, but began to level off somewhat during 2003 as premium rate increases slowed, or even flattened, in most lines of business. Premium rates were fairly stable during 2004, but moderated slightly in certain lines of business and select territories due to an increase in price competition. During 2005, the insurance industry entered into a soft market with premium rate reductions accelerating in most areas of the country, with the notable exception of rate increases in the Gulf States and other hurricane exposed areas due to the severe 2005 hurricane season. The soft market continued during 2006 and market conditions are expected to remain competitive during 2007 as insurance companies continue to compete for good business, which will likely result in additional premium rate reductions.
The United States Congress is currently studying, or has placed on its agenda, several issues of critical importance to the Company and the insurance industry. These issues include Federal regulation on top of, or in place of, current state regulation, tort and class-action reform, the federal government’s role in terrorism insurance, and asbestos liability determination and funding. The United States Congress is also considering legislation (referred to as the Insurance Industry Competition Act) that would amend the McCarran-Ferguson Act and permit the Federal Trade Commission and United States Department of Justice to enforce federal antitrust laws and regulations on the insurance industry. The Company is closely monitoring activities by the United States Congress on these issues through its membership in various organizations.
The Company’s net premiums written increased significantly in 2005 due to the property and casualty insurance subsidiaries’ increased participation in the pooling agreement; however, net premiums written for the EMC Insurance Companies’ pool declined 1.1 percent in 2005 and an additional 0.2 percent in 2006 due to increased premium rate competition and higher reinsurance costs. The increase in premium rate competition has been driven by the high capitalization levels and profitable underwriting results that have been generated by the property and casualty insurance industry during the last two years. As a result of this increased competition, the Company has experienced a moderate reduction in implemented premium rates, most notably in personal lines. With the exception of the workers’ compensation line of business, all lines of business have experienced a decline in premium rates of varying magnitudes over the last two years. Policy retention has remained at high levels, but policy count has declined as a result of increased competition for good business and Company initiatives to exit unprofitable business. On an overall basis, premium rate levels declined approximately 3.7 percent in 2006 after falling approximately 0.9 percent in 2005; however, premium rates are still considered adequate in most lines of business and in most territories.
To properly address the marketing challenges facing the Company in this increasingly competitive environment, management determined that a more formalized process for commercial lines product development was needed. Increased competition in the insurance marketplace has made it increasingly important to provide the Company’s 16 branch offices with an effective and efficient means of product development that can respond quickly to changing market conditions. Management also determined that the sales effectiveness skills of the branch marketing and underwriting personnel needed to improve so that the branch offices could take greater advantage of new product opportunities. To achieve these goals, management hired an outside consulting firm to facilitate the implementation of project “Fusion”, which was a three phase project designed to improve both product development and sales effectiveness, and establish a metrics measurement process to analyze the potential of new products and gauge the success of product rollouts. The implementation of Project Fusion was completed as planned during the third quarter of 2006. Improved processes for the development of commercial lines products have been implemented, including enhanced project management methodologies and the creation of a Project Management Office to monitor and guide the successful completion of large projects. Sales effectiveness skills training began during the second quarter of 2006 and will continue into 2007.
Effective January 1, 2006, Employers Mutual’s participation in the MRB pool was reduced because of the addition of two new assuming companies to that pool. The increase in the number of assuming companies had a negative impact on the reinsurance subsidiary’s premiums earned in 2006 as the pool business was divided between more participants; however, the addition of the new assuming companies has strengthened MRB’s surplus base and should favorably impact future marketing efforts. For calendar year 2006, the reinsurance subsidiary’s premiums earned from the MRB pool totaled approximately $25 million, compared to approximately $40 million in 2005. In addition, effective January 1, 2006, Employers Mutual is no longer participating in a Lloyd’s of London marine syndicate account due to a restructuring of that program. The loss of this account reduced the reinsurance subsidiary’s premiums earned by approximately $2.5 million in 2006, with an additional reduction of approximately $2.0 million expected in 2007. Improved pricing and the addition of some new accounts during 2006 helped to partially offset the loss of this business; however, the MRB pool is not producing much new business at this time, and it is therefore unlikely that the reinsurance subsidiary’s premium volume will increase significantly in the near future.
Acquisition Expense Ratio. The acquisition expense ratio is the ratio (expressed as a percentage) of net acquisition and other expenses to premiums earned and measures a company’s operational efficiency in producing, underwriting and administering its insurance business. For statutory accounting purposes, acquisition and other expenses of an insurance company exclude investment expenses. There is no such industry definition for determining an acquisition expense ratio for GAAP purposes. As a result, management applies the statutory definition to calculate the Company’s acquisition expense ratio on a GAAP basis. The net acquisition expense ratio is meaningful in evaluating the Company’s financial results, which are net of ceded reinsurance, as reflected in the consolidated financial statements.
GAAP Combined Ratio. The combined ratio (expressed as a percentage) is the sum of the loss and settlement expense ratio and the acquisition expense ratio and measures a company’s overall underwriting profit. If the combined ratio is at or above 100, an insurance company cannot be profitable without investment income (and may not be profitable if investment income is insufficient). Management uses the GAAP combined ratio in evaluating the Company’s overall underwriting profitability and as a measure for comparison of the Company’s profitability relative to the profitability of its competitors who prepare GAAP-basis financial statements.
The Company has implemented specific line-of-business guidelines that are used to establish the individual case loss reserve estimates. These guidelines, which are used for both short-tail and long-tail claims, require the claims department personnel to reserve for the probable (most likely) exposure for each claim. Probable exposure is defined as what is likely to be awarded if the case were to be decided by a civil court in the applicable venue or, in the case of a workers’ compensation case, by that state’s Workers’ Compensation Commission. This evaluation process is repeated throughout the life of the claim at regular intervals, and as additional information becomes available. While performing these regular reviews, the branch claims personnel are able to make adjustments to the case loss reserves for location and time specific factors, such as legal venue, severity of claim, inflation, and changes in applicable laws.
As of December 31, 2006, IBNR loss reserves accounted for $77,328,000, or 18.9 percent, of the property and casualty insurance segment’s total loss and settlement expense reserves, compared to $71,664,000, or 17.5 percent at December 31, 2005. IBNR loss reserves are, by nature, less precise than case loss reserves. A five percent change in IBNR loss reserves at December 31, 2006 would equate to $2,513,000 net of tax, which represents 4.7 percent of net income and 0.8 percent of stockholders’ equity.
Internal actuarial evaluations of overall loss reserve levels are performed quarterly for all direct lines of business. There is a certain amount of random variation in loss development patterns, which results in some uncertainty regarding projected ultimate losses, particularly for longer-tail lines such as workers’ compensation, other liability and commercial auto liability. Therefore, the reasonability of the actuarial projections is regularly monitored through an examination of loss ratio and claims severity trends implied by these projections. Following is a discussion of the major assumptions underlying the quarterly internal actuarial reserve evaluations.
After-tax impact on earnings from a five percent variance in case reserve adequacy
One of the variables impacting the estimation of IBNR loss reserves is the assumption that the vast majority of future construction defect losses will continue to occur in those states in which most construction defect claims have historically arisen. Since the vast majority of these losses have been confined to a relatively small number of states, which is consistent with industry experience, there is no provision in the IBNR loss reserve for a significant spread of construction defect claims to other states. It is also assumed that various underwriting initiatives implemented in recent years will gradually mitigate the amount of construction defect losses experienced. These initiatives include exclusionary endorsements, increased care regarding additional insured endorsements, a general reduction in the amount of contractor business written relative to the total commercial lines book of business, and underwriting restrictions on the writing of residential contractors. The estimation of the Company’s IBNR loss reserves also does not contemplate substantial losses from potential mass torts such as Methyl Tertiary Butyl Ether (a gasoline additive that reduces emissions, but causes pollution), tobacco, silicosis, cell phones and lead. Further, consistent with general industry practice, the IBNR loss reserve for all liability lines does not provide for any significant retroactive expansion of coverage through judicial interpretation. If these assumptions prove to be incorrect, ultimate paid amounts on emerged IBNR claims may differ substantially from the carried IBNR loss reserves.
Carried reserves established in addition to those reported by the ceding companies totaled approximately $56,280,000 at December 31, 2006. Since many ceding companies in the HORAD book of business do not report IBNR loss reserves, Employers Mutual establishes a bulk IBNR loss reserve to cover the lag in reporting. For the few ceding companies that do report IBNR loss reserves, Employers Mutual carries them as reported. These reported IBNR loss reserves are subtracted from the total IBNR loss reserve calculated by Employers Mutual’s actuaries, with the difference carried as bulk IBNR loss reserves. Except for a small IBNR loss reserve established to cover a one-month lag in reporting, the MRB IBNR loss reserve is established by the management of MRB. Employers Mutual rarely records additional case loss reserves.
To ensure the accuracy and completeness of the information received from the ceding companies, Employers Mutual’s actuarial department carefully reviews the latest five HORAD policy years on a quarterly basis, and all policy years on an annual basis. Any significant unexplained departures from historical reporting patterns are brought to the attention of the reinsurance department’s staff, who contact the ceding company or broker for clarification.
Since 1989, the Company has included an asbestos exclusion in liability policies issued for most lines of business. The exclusion prohibits liability coverage for “bodily injury”, “personal injury” or “property damage” (including any associated clean-up obligations) arising out of the installation, existence, removal or disposal of asbestos or any substance containing asbestos fibers. Therefore, the Company’s current asbestos exposures are primarily limited to commercial policies issued prior to 1989. At present, the Company is defending approximately 600 asbestos bodily injury lawsuits, some of which involve multiple plaintiffs. Most of these defenses are subject to express reservation of rights based upon the lack of an injury within the Company’s policy periods, because many asbestos lawsuits do not specifically allege dates of asbestos exposure or dates of injury. The Company’s policyholders that have been named as defendants in these asbestos lawsuits are peripheral defendants who have had little or no exposure and are routinely dismissed from asbestos litigation with nominal, or no, payment (i.e., small contractors, insulators, electrical welding supply, furnace manufacturers, gasket, and building supply companies).
During 2003, as a direct result of proposed federal legislation in the areas of asbestos and class action reform, the Company was presented with several hundred additional lawsuits filed against three former policyholders representing approximately 66,500 claims related to exposure to asbestos or products containing asbestos. These claims are based upon nonspecific asbestos exposure and nonspecific injuries. As a result, management did not establish a significant amount of case loss reserves associated with these claims. The vast majority of the 66,500 claims were multi-plaintiff suits filed in Mississippi. During 2006 the Company received notice that another former insured was a named defendant in approximately 33,000 claims nationwide. At the end of 2006 approximately 58,000 asbestos cases remain pending including approximately 22,000 of the original filings. While the projected expense of handling these lawsuits is higher than what the Company has averaged in the past, it is not proportional to the number of plaintiffs, and is mitigated to some extent through cost sharing agreements reached with other insurance companies. The Company believes its settlement expense reserve adequately provides for these projected expenses.
During 2006 several of the multiple plaintiff lawsuits (including the vast majority of those associated with one former policyholder) were either voluntarily dismissed or dismissed during motion practice. Minimal expense payments have been made to date on the lawsuits related to the other two former policyholders, and no payments have been made for either defense or indemnity. Four former policyholders and one current policyholder dominate the Company’s asbestos claims. To date, actual losses paid have been minimal due to the plaintiffs’ failure to identify an exposure to any asbestos-containing product associated with the Company’s policyholders. Defense costs, on the other hand, have increased due to the large number of parties involved in the litigation and the length of time required to obtain a favorable judgment. Whenever possible, the Company has participated in cost sharing agreements with other insurance companies to reduce overall asbestos claim expenses.
Proposed federal asbestos legislation initially introduced in 2004 was defeated once again in 2006. While this legislation was being debated, asbestos plaintiffs’ attorneys began pleading “silica” and “pneumoconiosis dust” exposure for new clients, as well as former asbestos plaintiffs. The Company is defending approximately 75 such claims in Texas and Mississippi jurisdictions, some of which involve multiple plaintiffs. The plaintiffs allege employment exposure to “airborne respirable silica dust,” causing “serious and permanent lung injuries” (i.e., silicosis). Silicosis injuries are identified in the upper lobes of the lungs, while asbestos injuries are localized in the lower lobes.
In 2004, the Company developed, filed and attached a “pneumoconiosis dust” exclusion to its commercial lines liability policies in the majority of jurisdictions where such action was warranted. This exclusion precludes liability coverage for “any injury, damage, expense, cost, loss, liability, defense or legal obligation arising out of, resulting from, or in any way related to, in whole or in part, “mixed dust” pneumoconiosis, pleural plaques, pleural effusion, mesothelioma, lung cancer, emphysema, bronchitis, tuberculosis or pleural thickening, or other pneumoconiosis-related ailments such as arthritis, cancer (other than lung), lupus, heart, kidney or gallbladder disease. “Mixed dust” is defined as dust, or a mixture of dusts, composed of one or more of the following: asbestos, silica, fiberglass, iron, tin, coal, cement, cadminium, carbon, mica, cobalt, barium, tungsten, kaolin, graphite, clay, ceramic, talc, vitallium, beryllium, zinc, cotton, hemp, flax or grain. It is anticipated that this mixed dust exclusion will further limit the Company’s exposure in silica claims, and may be broad enough to limit exposure in other dust claims.
In 2004, the Company was presented with eight contamination claims filed against four of its petroleum marketers in Iowa and Indiana. These claims arise out of alleged contamination of municipal public water systems by the gasoline additive Methyl Tertiary Butyl Ether (“MTBE”). All MTBE lawsuits initiated in the states of California, Connecticut, Florida, Indiana, Iowa, Massachusetts, New Hampshire, New Jersey and New York were moved to their respective federal courts and were then transferred to the United States District Court for the Southern District of New York, where they were consolidated under the caption, In re: Methyl Tertiary Butyl Ether (“MTBE”) Products Liability Litigation. The Company is defending these claims under commercial auto policies which afford broadened pollution liability coverage for overfills. These claims are subject to express reservations of rights based upon the lack of property damage within the policy periods, because these lawsuits do not specifically allege dates of property damage or contamination, or any contamination that is the result of an overfill.
The Company’s exposure to asbestos and environmental claims through assumed reinsurance is very limited due to the fact that the Company’s reinsurance subsidiary entered into the reinsurance marketplace in the early 1980’s, after much attention had already been brought to these issues. The Company commuted one reinsurance contract during the first quarter of 2003 that had some asbestos and environmental reserves associated with it.
The Company has exposure to construction defect claims arising from general liability policies issued to contractors. Most of the Company’s construction defect claims are concentrated in a limited number of states, and the Company has taken steps to mitigate this exposure. Construction defect is a highly uncertain exposure due to such issues as whether coverage exists, definition of an occurrence, determination of ultimate damages, and allocation of such damages to financially responsible parties. The Company has recently implemented additional coding to identify and monitor construction defect claims. Newly reported construction defect claims numbered 410, 394, and 685 in 2006, 2005, and 2004, respectively, and produced incurred losses and paid settlement expenses of approximately $3,315,000, $3,515,000, and $2,498,000 in each respective period. Incurred losses and paid settlement expenses on all construction defect claims totaled approximately $4,352,000 in 2006. At December 31, 2006, the Company carried case loss reserves of approximately $6,389,000 on 657 open construction defect claims.
The Company does not determine a range of estimates for all components of the loss and settlement expense reserves at the time those reserves are established. At each year-end, however, an actuarially determined range of estimates is developed for the major components of the loss and settlement expense reserves. All reserves are reviewed, except for the involuntary workers’ compensation pools, for which reliance is placed on a reserve opinion received from the National Council on Compensation Insurance certifying the reasonableness of those reserves. Shown below are the actuarially determined ranges of reserve estimates as of December 31, 2006, along with the net carried reserves. The last two columns display the estimated after-tax impact on earnings if the reserves were moved to the high end-point or low end-point of the ranges.
For the property and casualty insurance segment, total carried reserves for direct business equal the individual case loss reserves established primarily by the claims adjusters in the sixteen branch offices, with assistance of the home office claims department, plus IBNR loss reserves and settlement expense reserves established by home office management. The precise location of total carried reserves within the actuarial range is unknown at the time reserves are established because the final actuarial evaluation of reserve adequacy is conducted after the establishment of the reserves. However, IBNR and settlement expense reserves are carried at levels near the midpoint of preliminary actuarial ranges. The fact that carried property and casualty insurance segment reserves at December 31, 2006 were in the upper quarter of the range of actuarial estimates is attributable primarily to the estimated adequacy of the individual case loss reserves, and not to the existence of a specific targeted total reserve adequacy level.
As previously noted, assumed reinsurance business carries a higher risk of volatility and uncertainty which, in management’s opinion, warrants a higher degree of conservatism. Therefore, management’s objective is to carry reinsurance segment reserves in the upper quarter of the range of actuarial reserve estimates.
Loss and settlement expense reserves are estimates at a given time of what an insurer expects to pay on incurred losses, based on facts and circumstances then known. During the loss settlement period, which may be many years, additional facts regarding individual claims become known, and accordingly, it often becomes necessary to refine and adjust the estimates of liability. Such changes in reserves for losses and settlement expenses are reflected in operating results in the year such changes are recorded.
Workers’ compensation claim severity increased significantly, with the projected ultimate average claim amount increasing approximately 72 percent over the five year period ending in 2004. An increase of this magnitude made the establishment of adequate case loss reserves challenging. A review of claim data indicated that claims adjusters had underestimated medical costs and the length of time injured workers were away from work. In addition, partial disability benefits had been underestimated or unanticipated. Large increases in drug costs and the availability and utilization of new and costly medical procedures contributed to the rapidly escalating medical costs.
Legal expenses for the other liability line of business increased rapidly over the three years ending in 2004, with defense costs increasing at an average rate of approximately 14 percent per year. This increase in legal expenses occurred despite a reduction in the number of new lawsuits.
In response to an indicated deficiency in case loss reserves at December 31, 2003, the home office claims department in early 2004 instructed each of the 16 branch offices to review and carefully re-evaluate all claim reserves for adequacy. As a result of these reviews, case loss reserves were strengthened in both the second and third quarters of 2004. However, during the required fourth quarter inventory and review process, the branch offices further strengthened their case loss reserves, generating a significant amount of adverse development.
Acquisition costs consisting of commissions, premiums taxes and other underwriting expenses that vary with, and are directly related to, the production of business are deferred and amortized as premium revenue is recognized. This adjustment is necessary because statutory accounting principles require that expenses incurred in the production of insurance business be expensed immediately, while premium revenue is recognized ratably over the terms of the underlying insurance policies.
The pension and postretirement benefit costs, as well as the prepaid assets and liabilities of these plans, are determined by actuarial valuations. Inherent in these valuations are key assumptions regarding the discount rate, the expected long-term rate of return on plan assets, the rate of future compensation increases (pension plans only), and the health care cost trend rate (healthcare postretirement plan only). The assumptions used in the actuarial valuations are updated annually. Material changes in the pension and postretirement benefit costs may occur in the future due to changes in these assumptions or changes in other factors, such as the number of plan participants, the level of benefits provided, asset levels and applicable legislation or regulations.
The discount rate utilized in the valuations is based on an analysis of the total rate of return that could be generated by a hypothetical portfolio of high-quality bonds created to generate cash flows that match the plans’ expected benefit payments. The discount rate produced by this analysis is compared to interest rates of applicable published indices for reasonableness. The discount rates used in the pension and postretirement benefit valuations at December 31, 2006, 2005 and 2004 were 5.75 percent, 5.75 percent and 6.00 percent, respectively. A 0.25 percentage point decrease in the discount rate used in the 2006 valuation would increase the Company’s share of the pension and postretirement benefit net periodic cost for 2007 by approximately $54,000. Conversely, a 0.25 percentage point increase in the 2006 discount rate would decrease the Company’s share of the pension and postretirement benefit net periodic cost for 2007 by approximately $51,000.
The health care cost trend rate assumption represents the anticipated change in the cost of health care benefits due to factors outside of the plan. These factors include health care inflation, changes in health care utilization and delivery patterns, technological advances, and the status of the health of the plan participants. The health care cost trend rate assumption is based on published information and general economic conditions. The health care cost trend rate assumption for 2006 was 11 percent, and is assumed to decrease gradually to 5 percent in 2012 and remain at that level thereafter.
In accordance with GAAP, actuarial gains/losses contained in the valuations that result from (1) actual experience that differs from that assumed, or (2) a change in actuarial assumptions, is accumulated and, if in excess of a specified corridor, amortized to expense over future periods. As of December 31, 2006, both the pension and postretirement benefit plans had accumulated actuarial losses resulting from both experience and assumption changes; however, the accumulated actuarial losses contained in the postretirement benefit plans was not in excess of the corridor and thus will not be amortized to expense in 2007. The Company’s share of the accumulated actuarial losses associated with the pension plans that will be amortized to expense during 2007 amounted to $61,000.
Year ended December 31, 2006 compared to year ended December 31, 2005
The Company reported record net income of $53,547,000 ($3.91 per share) in 2006, an increase of 24.5 percent from the prior record of $43,009,000 ($3.16 per share) reported in 2005. This large increase is attributed to improved underwriting results and, to a lesser extent, an increase in investment income. In 2006, the Company reported an underwriting profit of $27,914,000, compared to $17,698,000 in 2005. This increase in underwriting profit was generated by a significant increase in the amount of favorable development experienced on prior years’ reserves, and a decline in catastrophe and storm losses from hurricane plagued 2005; however, current accident-year underwriting results deteriorated moderately in 2006 as a result of declining premium rates. On a segment basis, underwriting gain increased significantly in the property and casualty insurance segment, but declined in the reinsurance segment. The increase in investment income is primarily attributed to the fact that $107,801,000 in cash received from Employers Mutual in the first quarter of 2005 in connection with the change in pool participation was fully invested throughout 2006.
Premiums earned decreased 5.8 percent to $391,615,000 in 2006 from $415,625,000 in 2005. This decrease is primarily attributed to the reinsurance segment and is associated with, most notably, Employers Mutual’s reduced participation in the MRB pool and the revised terms of the quota share agreement; however, the property and casualty insurance segment also experienced a slight decline in premiums earned. On an overall basis, premium rate competition increased moderately in the property and casualty insurance marketplace during 2006, resulting in an approximate 3.7 percent reduction in premium rate levels. For comparative purposes, premium rate levels declined approximate 0.9 percent in 2005. Market conditions are expected to remain competitive in 2007, which will likely result in further rate reductions.
On March 8, 2007 the management of the MRB pool announced that Auto-Owners Insurance Company will terminate its participation in the MRB pool effective January 1, 2008. The management of the MRB pool anticipates that a new participant will be found to replace Auto-Owners and that the MRB pool will continue operating at the current five participant level in 2008; however, they are prepared to operate the pool with the remaining four participants if necessary. In the event that Employers Mutual becomes a one-fourth participant in the MRB pool in 2008, the premium volume of the Company’s reinsurance subsidiary would be expected to increase by approximately $4.5 million, based on current projections of the MRB pool’s management.
Losses and settlement expenses declined 11.4 percent to $228,453,000 in 2006 from $257,926,000 in 2005. This decline is attributed to a significant increase in the amount of favorable development experienced on prior years’ reserves and a large decrease in catastrophe and storm losses. The loss and settlement expense ratio declined to 58.3 percent in 2006 from 62.1 percent in 2005; however, the current accident-year loss and settlement expense ratio increased moderately in 2006 as a result of declining premium rates. The Company incurred $10,896,000 of catastrophe losses from Hurricanes Katrina, Rita and Wilma in 2005. The December 31, 2005 estimate of direct losses associated with these hurricanes increased only 5.7 percent during 2006, and the vast majority of the claims were adjusted and paid as of December 31, 2006.
The loss and settlement expense ratio for the reinsurance segment increased to 68.5 percent in 2006 from 63.5 percent in 2005. The increase in the 2006 ratio was driven by the revised terms of the quota share agreement with Employers Mutual whereby the full cost of the $2,000,000 cap on losses assumed per event is recorded as a reduction to premiums; however, over half of the increase in the loss and settlement expense ratio is offset by a decline in the acquisition expense ratio due to the elimination of the override commission paid in 2005. Excluding the impact of the revised terms of the quota share agreement, the loss and settlement expense ratio would have declined slightly in 2006. Results for 2006 reflect a significant increase in the amount of favorable development experienced on prior years’ reserves and a substantial decline in catastrophe and storm losses, which is attributed to $4,500,000 of losses recorded in 2005 from Hurricanes Katrina, Rita and Wilma. The favorable development experienced in 2006 is primarily from the 2004 and 2005 accident years in the HORAD book of business.
For the property and casualty insurance segment, the acquisition expense ratio increased to 37.0 percent in 2006 from 35.5 percent in 2005. This increase is attributed to an increase in policyholder dividends, salary and benefit costs and consulting expenses, as well as the decline in premium income. In addition, starting in 2006 the Company began recognizing all share-based payments to employees as expense based upon their fair values. This resulted in the Company recognizing $377,000 of expense through its property and casualty insurance segment. The property and casualty insurance subsidiaries incurred $6,519,000 of commission expense in the first quarter of 2005 in connection with the change in pool participation. This commission expense was used to reimburse Employers Mutual for expenses incurred to generate the additional insurance business that was transferred to the property and casualty insurance subsidiaries on January 1, 2005. However, because acquisition expenses, which include commissions, are deferred and amortized to expense as the related premiums are earned, all of the $6,519,000 of commission expense was capitalized as a deferred policy acquisition cost, and was amortized to expense as the unearned premiums became earned to properly match acquisition expenses and premium income.
Year ended December 31, 2005 compared to year ended December 31, 2004
Premiums earned increased 20.3 percent to $415,625,000 in 2005 from $345,479,000 in 2004. This increase was primarily attributed to the Company’s increased participation in the pooling agreement, but also reflected the impact of rate increases that were implemented in the property and casualty insurance business during 2004. On an overall basis, rate competition increased moderately in the property and casualty insurance marketplace during 2005; however, there were indications of more intense competition in select territories and lines of business. In response to the competitive market conditions, management implemented small premium rate decreases where deemed appropriate. Market conditions remained competitive in 2006, particularly for non-coastal business, as insurance companies sought to reduce their exposures to hurricane losses yet continue to grow their premiums. Management continues to emphasize its goal of achieving profitability over production. Achieving an underwriting profit is always stressed, but is even more critical in a lower interest rate environment.
Premiums earned for the property and casualty insurance segment increased 28.4 percent to $321,165,000 in 2005 from $250,035,000 in 2004. This increase was primarily the result of the change in pool participation. To better understand the results of the property and casualty insurance segment for 2005, it is helpful to look at the net pool numbers, which were not impacted by the change in pool participation. For the pool, net premiums earned increased 0.7 percent in 2005, compared to an increase of 3.6 percent in 2004. The small increase in the pool’s premiums earned for 2005 reflects a transition from the implementation of moderate rate increases in 2004 to steady or declining premium rates in 2005, as well as a continued decline in policy count. Increased rate competition during 2005 resulted in the implementation of some minor premium rate reductions in personal lines business and a slight increase in the use of discretionary credits in commercial lines business. Due to the timing of policy renewals and the earning of premiums ratably over the terms of the underlying policies, a time delay exists for implemented rate changes (both increases and decreases) to have a noticeable impact on premiums earned. The Company was attempting to address the loss of policy count through various measures, including programs geared towards small businesses and enhanced automation to make it easier and more efficient for agents to do business with the Company. During 2005 and 2004, the pool participants ceded additional premiums totaling $1,302,000 and $540,000, respectively, to outside reinsurance companies to reinstate the pool’s catastrophe reinsurance protection after the occurrence of large hurricane losses.
Premiums earned for the reinsurance segment decreased 1.0 percent to $94,460,000 in 2005 from $95,444,000 in 2004. This decline was attributed to the MRB pool, as the HORAD book of business produced a slight increase in premiums earned. The amounts reported for 2005 and 2004 include reinstatement premium income of $2,474,000 and $666,000, respectively, received from ceding companies as a result of increased hurricane activity. The large increase in reinstatement premium income in 2005 helped offset the loss of a significant account during 2005. While no significant new accounts were written during 2005, Employers Mutual did add several new accounts during the January 2006 renewal season. Premium rate increases on excess-of-loss contracts remained relatively flat at both the January and July 2005 renewal periods, but the severe 2005 hurricane season spurred moderate rate increases during the January 2006 renewal period on contracts without significant catastrophe losses in 2005, and large price increases and increased retention levels on contracts with significant catastrophe losses in 2005. Many companies seeking reinsurance protection for 2006 sought higher coverage limits in response to the severe 2005 hurricane season, but the reinsurance subsidiary’s overall exposure remained relatively constant as management continued to limit coastal area aggregate exposures. Premiums earned in 2005 reflect an increase in the estimate of earned but not reported premiums of $165,000, compared to a decrease of $190,000 in 2004.
The loss and settlement expense ratio for the property and casualty insurance segment decreased to 61.6 percent in 2005 from 78.6 percent in 2004. This improvement occurred despite a substantial increase in catastrophe and storm losses that was driven by the severe 2005 hurricane season. Losses from the 2005 hurricane season totaled $6,396,000, which compares to hurricane losses of $2,888,000 in 2004. The improvement in the 2005 loss and settlement expense ratio was primarily the result of $14,808,000 of favorable development experienced on prior years’ reserves, compared to $23,738,000 of adverse development experienced in 2004. The favorable development of 2005 was primarily attributed to downward development of individual case reserves and settlement expense reserves. During the fourth quarter of 2005, the Company eliminated a bulk case reserve carried in the workers’ compensation line of business and reallocated a portion of this reserve to asbestos reserves and settlement expense reserves, resulting in $2,145,000 of favorable development. The adverse development experienced in 2004 reflected a combination of newly reported claims in excess of carried IBNR reserves ($14,758,000), development on case reserves of previously reported claims ($11,037,000), bulk reserve strengthening ($2,350,000) and settlement expense reserve increases resulting from increases in case reserves ($6,209,000). This adverse development was partially offset by $10,437,000 of reinsurance recoveries associated with the case reserve development and IBNR emergence. Substantial case reserve strengthening performed at the branch offices, primarily in the workers’ compensation and other liability lines of business, was the underlying reason for the adverse reserve development that occurred during 2004. As discussed further under the “Critical Accounting Policies” heading of this discussion, the economic factors behind the 2004 case reserve strengthening included, most notably, an increase in workers’ compensation claim severity, increases in construction defect claim activity, the recent occurrence of several large umbrella claims, and increasing legal expenses in the other liability line of business. Claim frequency continued to decline during 2005, but there were signs that it may be leveling out, especially in the workers’ compensation and homeowners lines of business. Claim severity increased in most lines of business with commercial auto liability being an exception.
For the reinsurance segment, the acquisition expense ratio decreased to 27.5 percent in 2005 from 28.1 percent in 2004. The decline in the 2005 ratio was due to a large amount of contingent commission expense reported by MRB in 2004. Commission expense for 2004 also includes $1,033,000 related to the increase in participation in the MRB pool (from 25 percent in 2003 to 33 percent in 2004); however, this expense was partially offset by an increase in the deferred policy acquisition costs asset.
The Company reported net realized investment gains of $3,834,000 in 2005 compared to $4,379,000 in 2004. Included in the realized investment gains of 2004 was $3,826,000 of gains recognized on the Company’s investment in MCI Communications Corporation bonds in conjunction with a payout award received under a bankruptcy court approved “Plan of Reorganization.” This gain was partially offset by $1,323,000 of other-than-temporary impairment losses recognized on the replacement bonds received in this settlement. The Company did not recognize any other-than-temporary impairment losses in 2005.
The Company held $552,000 and $4,270,000 in minority ownership interests in limited partnerships and limited liability companies at December 31, 2006 and 2005, respectively. The Company does not hold any other unregistered securities.
Capital resources consist of stockholders’ equity and debt, representing funds deployed or available to be deployed to support business operations. For the Company’s insurance subsidiaries, capital resources are required to support premium writings. Regulatory guidelines suggest that the ratio of a property and casualty insurer’s annual net premiums written to its statutory surplus should not exceed three to one. All of the Company’s insurance subsidiaries were well under this guideline at December 31, 2006.
The amortized cost and estimated fair value of fixed maturity and equity securities at December 31, 2006 were as follows:
The Company’s insurance and reinsurance subsidiaries have $36 million of surplus notes issued to Employers Mutual. These surplus notes have an annual interest rate of 3.09 percent and do not have a maturity date. Payment of interest and repayment of principal can only be made out of the applicable subsidiary’s statutory surplus and is subject to prior approval by the insurance commissioner of the respective state of domicile. The surplus notes are subordinate and junior in right of payment to all obligations or liabilities of the applicable insurance subsidiaries. The Company’s subsidiaries incurred interest expense of $1,112,000 in 2006, 2005 and 2004 on these surplus notes. At December 31, 2006, the Company’s subsidiaries had received approval for the payment of interest accrued on the surplus notes during 2006.
As of December 31, 2006, the Company had no material commitments for capital expenditures.
The Company held one series of General Motors Acceptance Corporation fixed maturity securities that were considered non-investment grade at December 31, 2006, which were carried at an unrealized loss before tax of $56,000. The Company’s investment in Sears Roebuck Acceptance Corporation fixed maturity securities was also considered non-investment grade at December 31, 2006 and was carried at an unrealized loss before tax of $12,000. All other non-investment grade fixed maturity securities held at December 31, 2006 (Great Lakes Chemical Corporation and US Freightways Corporation) were in an unrealized gain position. The Company does not purchase non-investment grade securities. Any non-investment grade securities held by the Company are the result of rating downgrades that occurred subsequent to their purchase.
Long-term debt reflects the surplus notes issued by the Company’s insurance subsidiaries to Employer Mutual, which have no maturity date. Excluded from long-term debt are pension and other postretirement benefit obligations.
Interest expense on long-term debt reflects the interest expense on the surplus notes issued by the Company’s insurance and reinsurance subsidiaries to Employers Mutual. Interest on the surplus notes is subject to approval by the issuing company’s state of domicile. The balance shown under the heading “More than 5 years” represents interest expense for years six through ten. Since the surplus notes have no maturity date, total interest expense could be greater than the amount shown.
The participants in the pooling agreement have purchased annuities from life insurance companies, under which the claimant is payee, to fund future payments that are fixed pursuant to specific claim settlement provisions. The Company’s share of loss reserves eliminated by the purchase of these annuities was $1,779,000 at December 31, 2006. The Company has a contingent liability of $1,779,000 should the issuers of these annuities fail to perform under the terms of the annuity. All of the issuing companies maintain strong financial ratings, therefore the Company believes the likelihood of failure of any of the issuing companies is remote. The Company’s share of the amount due from any one life insurance company does not equal or exceed one percent of its subsidiaries’ aggregate policyholders’ surplus.
Market risk represents the potential for loss due to adverse changes in the fair value of financial instruments. The market risks of the Company’s financial instruments relate to the investment portfolio, which exposes the Company to interest rate and equity price risk and, to a lesser extent, credit quality and prepayment risk. Monitoring systems and analytical tools are in place to assess each of these elements of market risk.
Interest rate risk includes the price sensitivity of a fixed maturity security to changes in interest rates, and the affect on future earnings from short-term investments and maturing long-term investments given a change in interest rates. The following analysis illustrates the sensitivity of the Company’s financial instruments to selected changes in market rates and prices. A hypothetical one percent increase in interest rates as of December 31, 2006 would result in a corresponding pre-tax decrease in the fair value of the fixed maturity portfolio of approximately $41,873,000, or 4.7 percent. In addition, a hypothetical one percent decrease in interest rates at December 31, 2006 would result in a corresponding decrease in pre-tax income over the next twelve months of approximately $1,165,000, assuming the current maturity and prepayment patterns. The Company monitors interest rate risk through the analysis of interest rate simulations, and adjusts the average duration of its fixed maturity portfolio by investing in either longer or shorter term instruments given the results of interest rate simulations and judgments of cash flow needs. The effective duration of the Company’s fixed maturity portfolio at December 31, 2006 was 3.91 years.
The valuation of the Company’s marketable equity portfolios is subject to equity price risk. In general, equities have more year-to-year price variability than bonds. However, returns from equity securities have been consistently higher over longer time frames. The Company invests in a diversified portfolio of readily marketable equity securities. A hypothetical 10 percent decrease in the S&P 500 index as of December 31, 2006 would result in a corresponding pre-tax decrease in the fair value of the Company’s equity portfolio of approximately $4,803,000.
Fixed maturity securities held by the Company generally have an investment quality rating of “A” or better by independent rating agencies. The following table shows the composition of the Company’s fixed maturity securities, by rating, as of December 31, 2006.
On November 3, 2005 the FASB issued Staff Position No. FAS 115-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” which amended SFAS 115, “Accounting for Certain Investments in Debt and Equity Securities” and nullified certain requirements of EITF Issue 03-1. FAS 115-1 addresses the determination of when an investment is considered impaired, whether that impairment is “other-than-temporary”, and the measurement of an impairment loss. FAS 115-1 also includes accounting considerations subsequent to the recognition of an “other-than-temporary” impairment, requires certain disclosures about unrealized losses that have not been recognized as “other-than-temporary” impairments, and was effective for reporting periods beginning after December 15, 2005, with earlier application permitted. The Company adopted FAS 115-1 in the first quarter of 2006 through the addition of various impairment analysis procedures, including inquiry of the Company’s outside equity manager on their intentions regarding securities that are in an unrealized loss position.
In June 2006, the FASB issued Interpretation No. 48 “Accounting for Uncertainty in Income Taxes.” This interpretation clarifies the accounting for uncertainty in income taxes recognized in an enterprise's financial statements in accordance with SFAS 109 “Accounting for Income Taxes.” This interpretation prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. The interpretation also provides guidance for de-recognition of tax positions, financial statement classification, interest and penalties, accounting in interim periods, disclosure, and transition. This interpretation is effective for fiscal years beginning after December 15, 2006. Adoption of this statement is not expected to have a material effect on the operating results of the Company, as a recently completed assessment of the Company’s current tax positions indicated no uncertainties that would warrant different recognition and valuation from that applied in the Company’s tax returns.
In September 2006, the FASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans.” SFAS 158 requires recognition of the funded status of defined benefit retirement or other postretirement plans as a net asset or liability on the balance sheet, the recognition of future changes in the funded status through other comprehensive income, the measurement of the defined benefit plan assets and obligations as of the end of the employer’s fiscal year and enhanced disclosure. The initial recognition of the funded status is reflected as an adjustment to the ending balance of accumulated other comprehensive income. SFAS 158 does not change the method of calculating the net periodic cost that existed under previous guidance. SFAS 158 is effective for fiscal years ending after December 15, 2006, except for the measurement of assets and obligations as of the end of the employer’s fiscal year, which is effective for fiscal years ending after December 15, 2008. For further discussion of the adoption of this statement see Note 1 of the Consolidated Financial Statements.
The Private Securities Litigation Reform Act of 1995 provides issuers the opportunity to make cautionary statements regarding forward-looking statements. Accordingly, any forward-looking statement contained in this report is based on management’s current beliefs, assumptions and expectations of the Company’s future performance, taking into account all information currently available to management. These beliefs, assumptions and expectations can change as the result of many possible events or factors, not all of which are known to management. If a change occurs, the Company’s business, financial condition, liquidity, results of operations, plans and objectives may vary materially from those expressed in the forward-looking statements. The risks and uncertainties that may affect the actual results of the Company include, but are not limited to, the following: catastrophic events and the occurrence of significant severe weather conditions; the adequacy of loss and settlement expense reserves; state and federal legislation and regulations; changes in our industry, interest rates or the performance of financial markets and the general economy; rating agency actions and other risks and uncertainties inherent to the Company’s business. When the Company uses the words “believe”, “expect”, “anticipate”, “estimate” or similar expressions, the Company intends to identify forward-looking statements. Undue reliance should not be placed on these forward-looking statements.
In our opinion, management’s assessment that EMC Insurance Group Inc. and Subsidiaries maintained effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, EMC Insurance Group Inc. and Subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of EMC Insurance Group Inc. and Subsidiaries as of December 31, 2006 and 2005, and the related consolidated statements of income, comprehensive income, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2006 of EMC Insurance Group Inc. and Subsidiaries and our report dated March 13, 2007, expressed an unqualified opinion thereon.
We have audited the accompanying consolidated balance sheets of EMC Insurance Group Inc. and Subsidiaries as of December 31, 2006 and 2005, and the related consolidated statements of income, comprehensive income, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2006. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of EMC Insurance Group Inc. and Subsidiaries at December 31, 2006 and 2005 and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2006, in conformity with U.S. generally accepted accounting principles.
Property and casualty insurance premiums are recognized as revenue ratably over the terms of the respective policies. Unearned premiums are calculated on the daily pro rata method. Both domestic and foreign assumed reinsurance premiums are recognized as revenues ratably over the terms of the contract period. Amounts paid as ceded reinsurance premiums are reported as prepaid reinsurance premiums and are amortized over the remaining contract period in proportion to the amount of reinsurance protection provided. Reinsurance reinstatement premiums are recognized in the same period as the loss event that gave rise to the reinstatement premiums.
Certain commercial lines of business, primarily workers’ compensation, are eligible for policyholder dividends in accordance with provisions of the underlying insurance policies. Net premiums written subject to policyholder dividends represented approximately 60 percent of the Company’s total net premiums written in 2006. Policyholder dividends are accrued over the terms of the underlying policies.
Ceded reinsurance amounts with nonaffiliated reinsurers relating to reinsurance receivables for paid and unpaid losses and settlement expenses and prepaid reinsurance are reported on the balance sheet on a gross basis. Amounts ceded to Employers Mutual relating to the affiliated reinsurance pooling agreement (see note 2) have not been grossed up because the contracts provide that receivables and payables may be offset upon settlement.
The Company regularly monitors its investments that have a fair value that is less than the carrying value for indications of “other-than-temporary” impairment. Several factors are used to determine whether the carrying value of an individual security has been “other-than-temporarily” impaired. Such factors include, but are not limited to, the security’s value and performance in the context of the overall markets, length of time and extent the security’s fair value has been below carrying value, key corporate events and collateralization of fixed maturity securities. When a security is deemed “other-than-temporarily” impaired, the carrying value is reduced to fair value and a realized loss is recognized and charged to income.
On November 3, 2005 the FASB issued Staff Position No. FAS 115-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments”, which amended SFAS 115, “Accounting for Certain Investments in Debt and Equity Securities” and nullified certain requirements of EITF Issue 03-1. FAS 115-1 addresses the determination of when an investment is considered impaired, whether that impairment is “other-than-temporary”, and the measurement of an impairment loss. FAS 115-1 also includes accounting considerations subsequent to the recognition of an “other-than-temporary” impairment, and requires certain disclosures about unrealized losses that have not been recognized as “other-than-temporary” impairments. FAS 115-1 was effective for reporting periods beginning after December 15, 2005, with earlier application permitted. The Company adopted FAS 115-1 in the first quarter of 2006 through the addition of various impairment analysis procedures, including inquiry of the Company’s outside equity manager on their intentions regarding securities that are in an unrealized loss position.
The Company participates in a securities lending program whereby certain fixed maturity securities from the investment portfolio are loaned to other institutions for a short period of time. The Company requires initial collateral equal to 102 percent of the market value of the loaned securities. The collateral is invested by the lending agent, in accordance with the Company’s guidelines, and generates fee income for the Company that is recognized ratably over the time period the security is on loan. The securities on loan to others are segregated from the other invested assets on the Company’s balance sheet. In accordance with relevant accounting literature, the collateral held by the Company is accounted for as a secured borrowing and is recorded as an asset on the Company’s balance sheet, with a corresponding liability reflecting the Company’s obligation to return this collateral upon the return of the loaned securities.
In December 2004, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 123 (revised 2004) “Share-Based Payment,” which is a revision of SFAS No. 123 (as amended by SFAS 148) “Accounting for Stock-Based Compensation” and supersedes Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees.” SFAS 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements based on their fair values. Effective January 1, 2006, the Company adopted SFAS 123(R) using the modified prospective method, which requires compensation expense to be recorded for all options granted after the date of adoption as well as for existing options for which the requisite service has not been rendered as of the date of adoption. The modified-prospective method does not require restatement of prior periods to reflect the impact of SFAS 123(R). There was no initial change to net income or stockholders’ equity upon the adoption of SFAS 123(R). Under the provisions of SFAS 123(R), the Company recognized compensation expense of $377,294 (gross and net of tax) during 2006 related to incentive stock options and a stock appreciation rights agreement.
The following table provides a detailed breakdown of the initial adjustment to the Company’s consolidated balance sheet at December 31, 2006, as a result of adopting SFAS 158:
The Company’s basic and diluted net income per share is computed by dividing net income by the weighted average number of common shares outstanding during each period. As previously noted, the Company receives the current fair value for all shares issued under Employers Mutual’s stock plans. As a result, the Company had no potential common shares outstanding during 2006, 2005 and 2004 that would have been dilutive to net income per share.
During 2004, the Company’s wholly-owned subsidiary, Farm and City Insurance Company, discontinued writing new nonstandard risk automobile insurance business and began instituting non-renewal procedures on all existing business. The effective dates for these actions were determined by the requirements of the six states in which it conducted business and the terms of the individual policies. Farm and City has completed its non-renewal procedures in all states, with the last policy expiring in January 2006. Farm and City will continue to participate in the pooling agreement even though it no longer writes direct insurance business. Discontinuance of the nonstandard risk automobile insurance business did not have a material impact on the Company’s results of operations.
During 2006, Employers Mutual retained 10.5 percent of the gross assumed premiums written subject to cession to the reinsurance subsidiary ($7,774,480) as compensation for the $2,000,000 cap on losses assumed per event. In 2005 and 2004, the reinsurance subsidiary paid Employers Mutual override commissions of $4,166,464 and $4,393,668 for the $1,500,000 cap per event, and also paid for 100 percent of the outside reinsurance protection Employers Mutual purchased to protect itself from catastrophic losses on the assumed reinsurance business it retained in excess of the cap, excluding reinstatement premiums. This cost was recorded as a reduction to the premiums received by the reinsurance subsidiary and amounted to $3,695,833 and $3,626,833 in 2005 and 2004, respectively. The reinsurance subsidiary’s premiums earned for 2006 reflect a reduction of $508,333 associated with the runoff of the unearned premium from the outside reinsurance protection purchased in 2005, which expired on April 30, 2006. Employers Mutual retained losses and settlement expenses under the quota share agreement totaling $1,029,236 in 2006, $28,682,084 in 2005 and $11,277,246 in 2004.
As of December 31, 2006, reinsurance ceded to two nonaffiliated reinsurers aggregated $21,088,937, which represents a significant portion of the total prepaid reinsurance premiums and reinsurance receivables for losses and settlement expenses. These amounts reflect the property and casualty insurance subsidiaries’ aggregate pool participation percentage of amounts ceded by Employers Mutual to these organizations on a mandatory basis. Credit risk associated with these amounts is minimal, as all companies participating in these organizations are responsible for the liabilities of such organizations on a pro rata basis.
For 2006, premiums written and earned assumed from affiliates, and losses and settlement expenses incurred assumed from affiliates, reflect a reduction in Employers Mutual’s participation in the MRB pool. The board of directors of the MRB pool approved the admission of two new assuming companies to the pool effective January 1, 2006. This reduced Employers Mutual’s participation in the pool from a one-third share to an approximate one-fifth share (one company is only assuming property exposures). The premiums written assumed from affiliates and net premiums written amounts for 2006 also include a negative $3,440,024 portfolio adjustment which serves as an offset to the decrease in unearned premiums recognized in connection with this change in participation.
Underwriting results of the Company are significantly influenced by the estimates of loss and settlement expense reserves. Changes in reserve estimates are reflected in operating results in the year such changes are recorded. The property and casualty insurance segment experienced favorable development on prior years’ reserves in 2006 and 2005, but adverse development in 2004, while the reinsurance segment experienced favorable development in all three years presented.
For the property and casualty insurance segment, the December 31, 2006 estimate of loss and settlement expense reserves for accident years 2005 and prior decreased $32,255,312 from the estimate at December 31, 2005. This decrease represents 7.9 percent of the December 31, 2005 carried reserves and is primarily attributed to the final settlement of closed claims.
For the reinsurance segment, the December 31, 2005 estimate of loss and settlement expense reserves for accident years 2004 and prior decreased $599,528 from the estimate at December 31, 2004. This decrease represents 0.5 percent of the December 31, 2004 carried reserves and is attributed to the HORAD book of business.
For the property and casualty insurance segment, the December 31, 2004 estimate of loss and settlement expense reserves for accident years 2003 and prior increased $23,738,375 from the estimate at December 31, 2003. This increase represents 9.4 percent of the December 31, 2003 carried reserves and is attributed to a combination of newly reported claims in excess of carried IBNR loss reserves ($14,758,000), development on case loss reserves of previously reported claims ($11,037,000), bulk reserve strengthening ($2,350,000), and settlement expense reserve increases resulting from increases in case loss reserves ($6,209,000). This adverse development was partially offset by $10,437,000 of reinsurance recoveries associated with the case loss reserve development and IBNR emergence. Substantial case loss reserve strengthening performed at the Company’s branch offices, primarily in the workers’ compensation and other liability lines of business, is the underlying reason for the adverse reserve development. The economic factors behind this case loss reserve strengthening include, most notably, an increase in workers’ compensation claim severity, increases in construction defect claim activity, the occurrence of several large umbrella claims and increasing legal expenses in the other liability line of business.
The Company’s insurance subsidiaries are required to file financial statements with state regulatory authorities. The accounting principles used to prepare these statutory financial statements follow prescribed or permitted accounting practices that differ from GAAP. Prescribed statutory accounting principles include state laws, regulations and general administrative rules issued by the state of domicile, as well as a variety of publications and manuals of the National Association of Insurance Commissioners (NAIC). Permitted accounting practices encompass all accounting practices not prescribed, but allowed by the state of domicile. The Company’s insurance subsidiaries had no permitted accounting practices during 2006, 2005 and 2004.
Statutory surplus of the Company’s insurance subsidiaries was $310,279,721 and $259,026,263 at December 31, 2006 and 2005, respectively. Statutory net income of the Company’s insurance subsidiaries was $57,701,796, $40,736,759 and $11,878,844 for 2006, 2005 and 2004, respectively.
The NAIC utilizes a risk-based capital model to help state regulators assess the capital adequacy of insurance companies and identify insurers that are in, or are perceived as approaching, financial difficulty. This model establishes minimum capital needs based on the risks applicable to the operations of the individual insurer. The risk-based capital requirements for property and casualty insurance companies measure three major areas of risk: asset risk, credit risk and underwriting risk. Companies having less statutory surplus than required by the risk-based capital requirements are subject to varying degrees of regulatory scrutiny and intervention, depending on the severity of the inadequacy. At December 31, 2006, the Company’s insurance subsidiaries had total adjusted statutory capital of $310,279,721, which is well in excess of the minimum risk-based capital requirement of $52,753,424.
The amount of retained earnings of the Company’s insurance subsidiaries available for distribution as dividends are limited by law to a percentage of the statutory unassigned surplus of each of the subsidiaries as of the previous December 31, as determined in accordance with accounting practices prescribed by insurance regulatory authorities of the state of domicile of each subsidiary. Subject to this limitation, the maximum dividend that may be paid within a 12 month period without prior approval of the insurance regulatory authorities is generally restricted to the greater of 10 percent of statutory surplus as regards policyholders as of the preceding December 31, or net income of the preceding calendar year on a statutory basis, not greater than earned statutory surplus. At December 31, 2006, $57,701,796 was available for distribution to the Company in 2007 without prior approval.
The following table displays the net premiums earned of the property and casualty insurance segment and the reinsurance segment for the three years ended December 31, 2006, by line of insurance.
The amortized cost and estimated fair value of securities held-to-maturity and available-for-sale as of December 31, 2006 and 2005 are as follows. The estimated fair value is based on quoted market prices, where available, or on values obtained from independent pricing services.
The following table sets forth the estimated fair value and gross unrealized losses associated with investment securities that were in an unrealized loss position as of December 31, 2006 and 2005, listed by length of time the securities have been in an unrealized loss position.
Unrealized losses on fixed maturity securities totaled $6,210,463 at December 31, 2006. The unrealized losses on U.S. treasury securities and government obligations, obligations of states and political subdivisions, mortgage-backed securities and debt securities issued by foreign governments were all primarily caused by an increase in interest rates. Because the Company has both the ability and intent to hold these fixed maturity securities until maturity, it was determined that the carrying value of these securities was not “other-than-temporarily” impaired at December 31, 2006.
(2) Investment losses realized on fixed maturity securities available-for-sale for the year ended December 31, 2004 include “other-than-temporary” impairment write-downs totaling $1,323,475 on MCI Communications Corporation bonds.
The actual income tax expense for the years ended December 31, 2006, 2005 and 2004 differed from the “expected” tax expense for those years (computed by applying the United States federal corporate tax rate of 35 percent to income before income tax expense) as follows:
Comprehensive income tax expense included in the consolidated financial statements for the years ended December 31, 2006, 2005 and 2004 is as follows:
On December 28, 2001, three of the Company’s property and casualty insurance subsidiaries issued surplus notes totaling $25,000,000 to Employers Mutual at an annual interest rate of 5.38 percent. On June 27, 2002, the Company’s reinsurance subsidiary issued an $11,000,000 surplus note to Employers Mutual at an annual interest rate of 5.25 percent. These surplus notes do not have a maturity date. Effective April 1, 2003, all of the surplus notes were reissued at an annual interest rate of 3.09 percent. Payment of interest and repayment of principal can only be made out of each subsidiary’s statutory surplus earnings and is subject to approval by the issuing company’s state of domicile. The surplus notes are subordinate and junior in right of payment to all obligations or liabilities of the subsidiaries. Interest expense on surplus notes amounted to $1,112,400 for 2006, 2005 and 2004.
The following table sets forth the funded status of Employers Mutual’s pension and postretirement benefit plans as of December 31, 2006 and 2005, based upon a measurement date of November 1, 2006 and 2005, respectively:
The amounts recognized in the Company’s accumulated other comprehensive income as of December 31, 2006 and 2005 is as follows:
During 2007, the Company will amortize $60,506 of the net actuarial loss and $132,907 of the prior service cost associated with the pension plans into net periodic benefit cost. No portion of the net actuarial loss associated with the postretirement benefit plans will be amortized into net periodic benefit cost during 2007.
Employers Mutual’s Supplemental Retirement Plan had an accumulated benefit obligation in excess of plan assets as of December 31, 2006 and 2005 as follows:
The weighted-average assumptions used to measure the benefit obligations are as follows:
The Company’s financial statements reflect a pension asset of $7,836,958 in 2006 and $5,633,370 in 2005, and a pension liability of $1,913,986 in 2006 and $1,086,438 (including $331,468 of additional minimum liability) in 2005. Pension expense allocated to the Company amounted to $2,641,361, $2,649,234 and $2,122,425 in 2006, 2005 and 2004, respectively.
The weighted-average asset allocation of Employers Mutual’s defined benefit retirement plan as of the measurement dates of November 1, 2006 and 2005 are as follows:
The weighted-average asset allocation of Employers Mutual’s VEBA trusts that are used to fund the postretirement benefit plans as of the measurement dates of November 1, 2006 and 2005 are as follows:
The Company participates in several other retirement plans sponsored by Employers Mutual, including a 401(k) Plan and an Executive Non-Qualified Excess Plan. The Company’s share of expenses for these plans amounted to $1,409,914, $1,064,546 and $1,139,411 in 2006, 2005 and 2004, respectively.
The following benefit payments, which reflect expected future service, as appropriate, are expected to be paid from the plans over the next ten years:
There is a ten year time limit for granting options under the plans. Options can no longer be granted under the 1993 Plan. Options granted under the plans have a vesting period of two, three, four or five years with options becoming exercisable in equal annual cumulative increments. Option prices cannot be less than the fair value of the common stock on the date of grant.
The Senior Executive Compensation and Stock Option Committee (the “Committee”) of Employers Mutual’s Board of Directors (the “Board”) grants the options and is the administrator of the plans. In 2004, the Company’s Board of Directors established its own Compensation Committee (the “Company Compensation Committee”) and, commencing in 2005, the Company Compensation Committee must consider and approve all stock options granted to the Company’s executive officers.
The expected term of the options granted in 2006 was estimated using historical data that was adjusted to remove the effect of option exercises prior to the normal vesting period due to the retirement of the option holder. The expected term of options granted to individuals who are, or will be, eligible to retire prior to the completion of the normal vesting period has been adjusted to reflect the potential accelerated vesting period. This produced a weighted-average expected term of 3.63 years.
The Company’s portion of the total intrinsic value of options exercised under Employers Mutual’s incentive stock option plans was $663,524, $245,441 and $293,583 in 2006, 2005 and 2004, respectively. As stated earlier, under the terms of the pooling and quota share agreements these amounts were paid to Employers Mutual and the Company received the full fair value for all shares issued under these plans. The Company’s portion of the total fair value of options that vested in 2006, 2005, and 2004 was $178,439, $117,710 and $32,373, respectively. Additional Information relating to options outstanding and options vested (exercisable) at December 31, 2006 is as follows:
Employers Mutual’s incentive stock option plans do not generate tax deductions for the Company. Therefore, no cash flow effects have resulted from the application of the provisions of SFAS 123(R) on share-based payment arrangements. The income tax benefit that results from disqualifying dispositions is deemed immaterial.
A total of 500,000 shares of the Company’s common stock have been reserved for issuance under the Employers Mutual Casualty Company 1993 Employee Stock Purchase Plan. Any employee who is employed by Employers Mutual or its subsidiaries on the first day of the month immediately preceding any option period is eligible to participate in the plan. Participants pay 85 percent of the fair market value of the stock on the date of purchase. The plan is administered by the Board of Employers Mutual and the Board has the right to amend or terminate the plan at any time; however, no such amendment or termination shall adversely affect the rights and privileges of participants with unexercised options. Expenses allocated to the Company in connection with this plan totaled $14,724, $14,062 and $9,752 in 2006, 2005 and 2004, respectively.
During 2006, a total of 9,769 options were exercised at prices of $30.47 and $32.69. Activity under the plan was as follows:
The Company maintains a dividend reinvestment and common stock purchase plan which provides stockholders with the option of reinvesting cash dividends in additional shares of the Company’s common stock. Participants may also purchase additional shares of common stock without incurring broker commissions by making optional cash contributions to the plan and may sell shares of common stock through the plan. Employers Mutual participated in the Dividend Reinvestment Plan in the first two quarters of 2004 and reinvested 50 percent of its dividends in additional shares of the Company’s common stock. Due to its participation in the Company’s 2004 stock offering, Employers Mutual discontinued its participation in the plan as of the third quarter of 2004. Activity under the plan was as follows:
During the second quarter of 2005 Employers Mutual initiated a $15 million stock purchase program under which Employers Mutual will purchase shares of the Company’s common stock in the open market. This purchase program does not have an expiration date. The timing and terms of the purchases are determined by management based on market conditions and are conducted in accordance with the applicable rules of the Securities and Exchange Commission. During 2005, Employers Mutual purchased 497,348 shares of the Company’s common stock under this plan at an average cost of $17.97 per share. No purchases were made during 2006.
The fair value of the surplus notes is estimated using discounted cash flow analysis based on the Company’s current incremental borrowing rate for a similar liability.
The estimated fair value of the Company’s financial instruments is summarized below.
The participants in the pooling agreement are subject to guaranty fund assessments by states in which they write business. Guaranty fund assessments are used by states to pay policyholder liabilities of insolvent insurers domiciled in that state. Many states allow assessments to be recovered through premium tax offsets. Estimated guaranty fund assessments of $1,450,944 and $1,493,325 and related premium tax offsets of $928,623 and $729,375 have been accrued as of December 31, 2006 and 2005, respectively. The guaranty fund assessments are expected to be paid over the next two years and the premium tax offsets are expected to be realized within ten years of the payments. The participants in the pooling agreement are also subject to second-injury fund assessments which are designed to encourage employers to employ a worker with a pre-existing disability. Estimated second-injury fund assessments of $1,768,799 and $1,871,969 have been accrued as of December 31, 2006 and 2005, respectively. The second-injury fund assessment accruals are based on projected loss payments. The periods over which the assessments will be paid is not known.