Management intends to identify forward-looking statements when using the words “believe”, “expect”, “anticipate”, “estimate”, “project”, "may", "intend", "likely" or similar expressions. Undue reliance should not be placed on these forward-looking statements. The Company disclaims any obligation to update such statements or to announce publicly the results of any revisions that it may make to any forward-looking statements to reflect the occurrence of anticipated or unanticipated events or circumstances after the date of such statements.
The Company, a majority owned subsidiary of Employers Mutual Casualty Company (Employers Mutual), is an insurance holding company with operations that consist of a property and casualty insurance segment and a reinsurance segment. The operations of the Company are highly integrated with those of Employers Mutual through participation in a property and casualty reinsurance pooling agreement (the "pooling agreement"), a quota share retrocessional reinsurance agreement (the "quota share agreement") and inter-company reinsurance programs with Employers Mutual. All transactions occurring under the pooling agreement, quota share agreement and the inter-company reinsurance programs with Employers Mutual are based on statutory accounting principles. Certain adjustments are made to these amounts to bring them into compliance with U.S. generally accepted accounting principles (GAAP).
Insurance pricing has historically been cyclical in nature. Periods of excess capital and increased competition encourage price reductions 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 rate levels increase and competition subsides as companies strive to strengthen their balance sheets (referred to as a hard market). At the end of 2013, premium rate level increases were beginning to decline, after increasing consistently during the three previous years. This trend of declining premium rate increases has continued since then through 2017, with 2017 premium rates overall being essentially flat. The outlook for 2018 is that the Company's overall premium rate level will continue to remain relatively steady or increase slightly.
On August 30, 2017, an announcement was made that Kevin Hovick, Executive Vice President and Chief Operating Officer, would retire on January 2, 2018. On November 6, 2017, an announcement was made that effective January 2, 2018, Mick Lovell would become Executive Vice President of Operations, and that Scott Jean would become Executive Vice President of Finance and Strategy. The duties and responsibilities of these new positions have been finalized, and the reporting structures of the underlying departments have been established. No new initiatives have resulted from these management changes to date; however, executive management is currently reviewing the operations of the Company, with the intent of identifying changes that could improve the performance of the Company.
Approximately 14.8 percent of the Company’s investment portfolio is invested in equity securities. Net unrealized investment gains on the equity portfolio totaled approximately $66.2 million at December 31, 2017, which is reflected as accumulated other comprehensive income in the Company’s financial statements and represents $3.09 per share of the Company’s December 31, 2017 book value of $28.14 per share. To help protect the Company from a sudden and significant decline in the value of its equity portfolio, management began investing in a limited partnership during the first quarter of 2014 to implement and maintain an equity tail-risk hedging strategy. This hedging strategy is designed to help protect the Company from significant monthly downside price volatility in the equity markets. By maintaining this hedging strategy, management is able to reduce the level of risk contained in the Company’s financial statements without reducing the size of the equity portfolio. While there is a cost associated with this protection, management views this cost similar to the cost of an insurance policy. The cost of the hedging strategy is equal to the decline in the carrying value of the limited partnership that the Company invests in to maintain the strategy, and is reported as a realized investment loss in the Company's financial statements. The decline in the carrying value of the limited partnership primarily reflects the cost of hedging contracts that expired without value during the year, but also includes changes in the value of contracts that were still in effect at year-end.
Premium rate level increases have slowed over the past several years due to increased competition resulting from excess capital in the insurance industry. During this time, management has worked diligently with the sixteen branch offices to stress the importance of achieving modest, but consistent, commercial lines rate level increases whenever possible. These efforts have been successful, as the Company has been able to achieve modest rate level increases during the past four years. Premium rate levels for most commercial lines of business are projected to increase moderately on an industry-wide basis in 2018, and management currently expects the Company's overall rate level to remain steady or increase slightly in 2018. Management will continue to work with the branch offices to ensure that all opportunities for additional rate level increases are pursued.
The Company, like most of the insurance industry, continues to experience high levels of claims frequency and severity in the commercial auto line of business. The commercial auto line of business represents approximately 25 percent of the property and casualty insurance segment's commercial business; therefore, improving the profitability is a top priority for management. Management continues to devote a significant amount of resources to the intensive, multi-year Accelerate Commercial Auto Profitability project that was implemented in 2016, which has a goal of returning this line of business to profitability by mid-2019. There are indications that the action plans developed by each of the eight teams charged with returning this line of business to profitability are beginning to take effect; however, the actuarially determined ultimate loss and settlement expense ratio projections have not, and will not, be adjusted until there is clear evidence that adequate premium is being charged for the exposures being assumed.
During the third quarter of 2016, management implemented a new reserving methodology for the determination of bulk reserves in the property and casualty insurance segment. The new methodology, which is referred to as the accident year ultimate estimate approach, utilizes explicit claim frequency and severity assumptions to establish ultimate loss and settlement expense ratio projections for each line of business and each accident year. This methodology better conforms to industry practices, and provides improved transparency of the drivers of the property and casualty insurance segment's performance.
Over the past eighteen months, management has gained additional insight using this new methodology. As a result, ultimate loss and settlement expense ratio selections have been refined to produce what are believed to be better estimates of expected ultimates than when the methodology change was first implemented. For several lines of business this resulted in a decrease of previously selected ultimate ratios. Accordingly, some portion of the reductions implemented in the ultimate loss and settlement expense ratio selections during 2017 may not represent actual improvement in the performance of the underlying lines of business.
Underlying Loss and Settlement Expense Ratio. The underlying loss and settlement expense ratio is a non-GAAP financial measure that represents the loss and settlement expense ratio, excluding the impact of catastrophe and storm losses and development on prior years' reserves. Management uses this ratio as an indicator of the property and casualty insurance segment's underwriting discipline and performance for the current accident year. Management believes this ratio is useful for investors to understand the property and casualty insurance segment's periodic earnings and variability of earnings caused by the unpredictable nature (i.e., the timing and amount) of catastrophe and storm losses and development on prior years' reserves. While this measure is consistent with measures utilized by investors and analysts to evaluate performance, it is not intended as a substitute for the GAAP financial measure of loss and settlement expense ratio. The loss and settlement expense ratio is reconciled to this non-GAAP financial measure under "Results of Operations" below.
Acquisition Expense Ratio. The acquisition expense ratio is the ratio (expressed as a percentage) of net acquisition and other expenses incurred 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.
As previously noted, a new reserving methodology was implemented in 2016. Under this new methodology, ultimate loss and allocated settlement expense amounts expected to be incurred are established by accident year and line of business. The amount of IBNR loss and allocated settlement expense reserves carried at each reporting date is determined by subtracting the amounts incurred to date from the ultimate estimated incurred amounts.
As previously noted, one assumption underlying the reserve estimation process is that the inflation trends implicitly built into the historical loss and allocated settlement expense development patterns will continue into the future. To estimate the sensitivity of the estimated ultimate loss and allocated settlement expense payments to an unexpected change in inflationary trends, the actuarial department derived expected payment patterns separately for each major line of business. These patterns were applied to the December 31, 2017 loss and allocated settlement expense reserves to generate estimated annual incremental loss and allocated settlement expense payments for each subsequent calendar year. Then, for the purpose of sensitivity testing, an explicit annual inflationary variance of one percent was added to the inflationary trend that is implicitly embedded in the estimated payment patterns, and revised incremental loss and settlement expense payments were calculated. This unexpected inflation trend could arise from a variety of sources including a change in economic inflation, social inflation and, especially for the workers’ compensation line of business, the introduction of new medical technologies and procedures, changes in the utilization of procedures and changes in life expectancy. The estimated cumulative impact that this unexpected one percent variance in the inflationary trend would have on the Company’s results of operations over the lifetime of the underlying claims is shown below. A variance in the inflationary trend would also affect the Company’s financial position in that the Company’s equity would be impacted by an amount equivalent to the change in net income. A variance of this type would typically be recognized in loss and settlement expense reserves and, accordingly, would not have a material effect on liquidity because the claims have not been paid. A one percent variance in the projected inflationary trend is considered reasonably likely based on the range of actuarial indications developed during the analysis of the property and casualty insurance segment’s carried reserves. The after tax impact on earnings is calculated using the federal corporate tax rate of 35 percent.
The Company uses standard actuarial methods to produce estimates of ultimate loss ratios by accident year and line of business. Underlying each selection are explicit assumptions regarding the ultimate claim frequency and severity associated with the selected ultimate ratio. As the assumptions are based on estimates made at a specific point in time, it is likely that the ultimate claim frequency and severity experience, and, therefore, the ultimate loss ratio, will vary upwards or downwards from prior estimates. The expected variation will be greater for less mature accident years, and decreases as each accident year ages. This uncertainty is reflected in the unpaid loss estimates underlying the selected estimated ultimate loss ratios, which produce the carried loss reserves. Assuming the unpaid loss estimates are unbiased, the cumulative impact on the Company's results of operations of a one percent variance in the associated carried loss reserves over the lifetime of the underlying claims is shown below. A variance in carried loss reserves would also affect the Company’s financial position in that the Company’s equity would be impacted by an amount equivalent to the change in net income. A one percent variance in the unpaid loss estimates underlying the selected ultimate loss ratio estimates is considered reasonably likely based on the range of actuarial indications developed during the analysis of the property and casualty insurance segment’s carried loss reserves. The after tax impact on earnings is calculated using the federal corporate tax rate of 35 percent.
Assumed reinsurance losses tend to be reported later than direct losses. This lag is reflected in loss projection factors for assumed reinsurance that tend to be higher than for direct business. The result is that assumed reinsurance IBNR loss reserves as a percentage of total reserves tend to be higher than for direct loss reserves. IBNR loss reserves totaled $103.1 million and $98.4 million at December 31, 2017 and 2016, respectively, and accounted for approximately 45 percent and 48 percent, respectively, of the reinsurance segment’s total loss and settlement expense reserves. IBNR loss reserves are, by nature, less precise than case loss reserves. A five percent change in IBNR loss reserves at December 31, 2017 would equate to $3.3 million, net of tax, which represents 8.3 percent of the net income reported for 2017 and 0.5 percent of stockholders’ equity.
Employers Mutual’s actuarial department annually reviews the MRB reserves for reasonableness. These analyses use a variety of actuarial techniques, which are applied at a line-of-business level. MRB staff supplies the reserve analysis data, which is verified for accuracy by Employers Mutual’s actuaries. This review process is replicated by certain other MRB member companies, using actuarial techniques they deem appropriate. Based on these reviews, Employers Mutual and the other MRB member companies have consistently found the MRB reserves to be adequate.
The Company’s exposure to asbestos and environmental claims through assumed reinsurance is 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.
At December 31, 2017, the Company carried asbestos and environmental reserves for direct insurance and assumed reinsurance business totaling $11.7 million, which represents 1.6 percent of total loss and settlement expense reserves. The asbestos and environmental reserves include $4.5 million of case loss reserves, $4.3 million of IBNR loss reserves and $2.9 million of bulk settlement expense reserves. Ceded reinsurance on these reserves totaled $290,000. Loss and settlement expense reserves were strengthened approximately $900,000 in 2017 because of deterioration in the implied survival ratio.
Following is a summary of loss and settlement expense reserves and payments associated with asbestos, environmental, products liability and casualty excess reinsurance exposures for 2017, 2016 and 2015:
Following is a summary of the claim activity associated with asbestos, environmental and products liability exposures for 2017, 2016 and 2015:
During each quarter an actuarially determined range of estimates is developed for the major components of the loss and settlement expense reserves as of the preceding quarter-end. All reserves are reviewed with the exception of reserves for involuntary workers’ compensation pools, which are set by the National Council on Compensation Insurance (NCCI) and are assumed to be adequate (the impact of potential variability of this segment on overall reserve adequacy is considered immaterial). Shown below are the actuarially determined ranges of reserve estimates as of December 31, 2017 along with the statutory-basis carried reserves, which are displayed net of ceded reinsurance. The GAAP-basis loss and settlement expense reserves contained in the Company’s financial statements are reported gross of ceded reinsurance, and contain a small number of adjustments from the statutory-basis amounts presented here. The last two columns display the estimated after-tax impact on earnings, calculated using the federal corporate tax rate of 35 percent, if the reserves were moved to the high end-point or low end-point of the ranges.
On a quarterly basis, the Company receives from its independent pricing service a list of fixed maturity securities, if any, that were priced solely from broker quotes. For these securities, fair value may be determined using the broker quotes, or by the Company using similar pricing techniques as the Company’s independent pricing service. Depending on the level of observable inputs, these securities would be classified as Level 2 or Level 3 fair value measurements. At December 31, 2017 and 2016, the Company had no securities priced solely from broker quotes.
Essentially all securities in the Company’s investment portfolios have transparent pricing. All equity securities (with two exceptions) are traded on national exchanges with observable prices. Fixed maturity securities are typically high quality, liquid issues with daily pricing from the Company’s independent pricing source. Prices are validated through a variety of techniques. When performing these validations, the Company uses graduated tolerance levels for determining exceptions. Equity securities and U.S. treasury and government-sponsored agency fixed maturity securities have the highest transparency in pricing, and therefore have the smallest tolerance levels for variance. These are followed by (in order of decreasing transparency/increasing tolerance levels) municipal, corporate, high-yield and finally mortgage-backed fixed maturity securities. The validations performed include:
Comparisons of the prices reported by the independent pricing source to daily runs of offerings and bids from several brokers for a sample of securities.
Comparison of the prices reported by the independent pricing source to prices realized from the Company’s own purchase and sale transactions.
When an equity security is deemed to be “other-than-temporarily” impaired, the amortized cost is reduced to fair value and a realized loss is recognized through earnings.
Acquisition costs, consisting of commissions, premium taxes, and salary and benefit expenses of employees directly involved in the underwriting of insurance policies that are successfully issued, are deferred and amortized to expense as premium revenue is recognized. Deferred policy acquisition costs and related amortization are calculated separately for the property and casualty insurance segment and the reinsurance segment. The methodology followed in computing deferred policy acquisition costs limits the amount of such deferred costs to the estimated realizable value. In determining estimated realizable value, the computation gives effect to the premium to be earned, related investment income, anticipated losses and settlement expenses, anticipated policyholder dividends, and certain other costs expected to be incurred to administer the insurance policies as the premium is earned. The anticipated losses and settlement expenses are based on the segment’s projected loss and settlement expense ratios for the next twelve months, which include provisions for anticipated catastrophe and storm losses based on historical results adjusted for recent trends. Utilizing these projections, deferred policy acquisition costs for the property and casualty insurance segment and the reinsurance segment were not subject to limitation at December 31, 2017. Based on an analysis performed by management, the actuarial projections of the expected loss and settlement expense ratios for the next twelve months would have needed to increase 19.9 percentage points in the property and casualty insurance segment and 6.3 percentage points in the reinsurance segment before deferred policy acquisition costs would have been subject to limitation. Such increases in the expected loss and settlement expense ratios would likely be driven by many factors, including higher provisions for anticipated catastrophe and storm losses.
The expected long-term rate of return on plan assets is developed considering actual historical results, current and expected market conditions, the mix of plan assets and investment strategy. The expected long-term rate of return on plan assets produced by this analysis and used in the calculation of the net periodic pension benefit costs for the years ended December 31, 2017 and 2016 was 7.00 percent and 7.00 percent, respectively. The expected long-term rate of return on plan assets used in the calculation of the net periodic postretirement benefit costs for the years ended December 31, 2017 and 2016 was 6.50 percent and 6.50 percent, respectively. The expected rate of return on plan assets to be used in the calculation of the 2018 net periodic benefit costs for the pension and postretirement benefit plans will be 7.00 percent and 6.50 percent, respectively. The actual rate of return earned on plan assets during 2017 was approximately 18 percent for the pension plan and 15 percent for the postretirement benefit plans. The expected long-term rate of return assumption is subject to the general movement of the economy, but is generally less volatile than the discount rate assumption. A decrease in the expected long-term rate of return assumption increases future expenses, whereas an increase in the assumption reduces future expenses. A 0.25 percentage point change in the expected long-term rate of return assumption for 2018 would change the Company’s net periodic pension and postretirement benefit costs by approximately $312,000. For detailed information regarding the current allocation of assets within the pension and postretirement benefit plans, see note 12 of Notes to Consolidated Financial Statements under Part II, Item 8 of this Form 10-K.
2 During the third quarter of 2016, management implemented a new reserving methodology for the determination of direct bulk reserves in the property and casualty insurance segment. The new methodology, which is referred to as the accident year ultimate estimate approach, better conforms to industry practices and provides increased transparency of the drivers of the property and casualty insurance segment's performance. In connection with this change in reserving methodology, there was a reallocation of IBNR loss reserves and allocated settlement expense reserves from prior accident years to the current accident year in multiple lines of business. This resulted in the movement of approximately $5.6 million of reserves from prior accident years to the current accident year that is technically reportable as favorable development; however, this development is "mechanical in nature" and did not have an impact on earnings because the total amount of carried reserves did not change. During 2015, revisions to the accident year allocation factors used in the prior reserving methodology produced $423,000 of favorable development that was also "mechanical in nature". These "mechanical" development amounts have been excluded from the favorable development amounts presented for 2016 and 2015 to improve comparability.
2 See notes above regarding adjustments made to the development amounts presented for the property and casualty insurance segment and the reinsurance segment in 2016 and 2015.
Premiums earned, losses and settlement expenses incurred, and the corresponding loss and settlement expense ratios, by line of business for each segment and on a consolidated basis, for the two years ended December 31, 2017 are as follows:
Losses and settlement expenses increased 9.1 percent to $422.0 million in 2017 from $386.9 million in 2016, and the loss and settlement expense ratio increased to 69.5 percent in 2017 from 65.3 percent in 2016. Higher catastrophe and storm losses in the reinsurance segment (including a record amount during the third quarter of 2017), along with a decline in favorable development on prior years' reserves, were the primary drivers of the increase in the ratio. These increases were partially offset by an improvement in the property and casualty insurance segment's underlying loss and settlement expense ratio. Fourth quarter catastrophe and storm losses in the reinsurance segment, which primarily resulted from the California wildfires, were mitigated by the inter-company reinsurance program with Employers Mutual. Since the retention amount under the annual aggregate treaty was filled during the third quarter, the reinsurance segment only retained 20 percent of the fourth quarter wildfire losses. The inter-company reinsurance programs implemented in 2016 have performed as expected, and have reduced the volatility of the Company's quarterly earnings. The actuarial analysis of the Company’s carried reserves at December 31, 2017 indicates that they are in the upper third of the range of reasonable reserves.
The loss and settlement expense ratio for the reinsurance segment increased to 88.3 percent in 2017 from 68.1 percent in 2016. The large increase is primarily due to a significant increase in catastrophe and storm losses, which accounted for 22.4 percentage points of the loss and settlement expense ratio in 2017 compared to just 9.3 percentage points in 2016. Gross losses from Hurricanes Harvey, Irma and Maria are currently estimated to be approximately $9.0 million, $7.0 million and $3.5 million, respectively, and the aggregate losses from the California wildfires are estimated at approximately $9.5 million. The reinsurance subsidiary ceded $16.8 million and ($467,000) of catastrophe and storm losses to Employers Mutual under the inter-company reinsurance program in 2017 and 2016, respectively. Taking the loss recoveries and the premiums paid to Employers Mutual into consideration, the inter-company reinsurance program reduced the reinsurance segment's loss and settlement expense ratio by 9.0 percentage points for the year ended December 31, 2017, but increased it by 2.8 percentage points in 2016. The inter-company reinsurance program has been renewed for 2018. The only change is a $400,000 increase in the cost of the program.
Acquisition and other expenses increased 0.8 percent to $193.3 million in 2017 from $191.8 million in 2016. The acquisition expense ratio decreased to 31.8 percent in 2017 from 32.4 percent in 2016. Both segments contributed to the decrease in this ratio. Acquisition and other expenses reported for both years include net periodic postretirement benefit income resulting from the amortization of a large prior service credit that resulted from an amendment of Employers Mutual's postretirement medical plan in the fourth quarter of 2013. This prior service credit was recognized in accumulated other comprehensive income in the fourth quarter of 2013, and is being amortized out of accumulated other comprehensive income and into net income over a period of 10 years. To remain competitive in the quickly changing insurance market and achieve management's goal of being a leader in innovation, upgrades are being made to the Company's systems and additional team members with the skills necessary to meet these objectives are being hired. As a result, the Company's acquisition expense ratio is projected to increase in 2018.
The acquisition expense ratio for the reinsurance segment decreased to 23.6 percent in 2017 from 24.3 percent in 2016. This decrease reflects a shift in the mix of business towards excess of loss contracts from pro rata contracts, as pro rata contracts typically have higher commission rates. The decrease also reflects declines in salary and benefit expenses (inclusive of bonuses) and contingent commissions.
The Company reported net realized investment gains of $6.6 million in 2017, compared to $4.1 million in 2016. Included in these amounts are losses of $6.3 million in both 2017 and 2016 from declines in the carrying value of a limited partnership that the Company invests in to help protect the equity portfolio from a sudden and significant decline in value (an equity tail-risk hedging strategy). The Company recognized "other-than-temporary" impairment losses of $1.1 million and $1.3 million during 2017 and 2016, respectively. With the exception of a $209,000 impairment loss recorded in 2016 on a new investment that conveys investment tax credits (included in other long-term investments), these impairment losses were recognized on securities held in the Company's equity portfolio.
The Company reported net income of $46.2 million ($2.20 per share) in 2016 compared to $50.2 million ($2.43 per share) in 2015. The decrease in net income was primarily due to declines in underwriting profitability and realized investment gains.
Losses and settlement expenses increased 4.4 percent to $386.9 million in 2016 from $370.7 million in 2015, and the loss and settlement expense ratio increased slightly to 65.3 percent in 2016 from 65.0 percent in 2015. An increase in the reinsurance segment's loss and settlement expense ratio was largely offset by a decline in the property and casualty insurance segment's ratio. During the third quarter of 2016, management implemented a new reserving methodology for the determination of direct bulk reserves in the property and casualty insurance segment, which impacted the process for determining how reserve adequacy was measured, and how reserves were allocated by accident year. Due to the expansion of the number of historical accident years included in the review process, the size of the range of reasonable reserves increased. The actuarial analysis of the Company’s carried reserves at December 31, 2016 indicated that they were in the upper half of the range of reasonable reserves. This placement in the range was lower than in previous years due to the range expansion associated with the process change; however, exclusive of the process change, the adequacy of the carried reserves appeared to be consistent with prior evaluations.
The loss and settlement expense ratio for the property and casualty insurance segment decreased to 64.5 percent in 2016 from 65.3 percent in 2015. This decrease was primarily attributed to a significant amount of favorable reserve development experienced on loss reserves and allocated settlement expense reserves in the workers' compensation and other liability lines of business. The favorable development in the workers' compensation line of business was generated by decreases in the claim frequency assumption for accident year 2015 and decreases in the claim severity assumptions for the five most recent accident years. The favorable development in the other liability line of business was generated by decreases in the claim severity assumptions for the last ten accident years. As previously noted, approximately $5.6 million of "mechanical" favorable development was generated during the implementation of the new reserving methodology in 2016. This development did not have any impact on earnings because it resulted from the movement of direct bulk reserves from prior accident years into the current accident year, with no change in total reserves.
Acquisition and other expenses increased 7.6 percent to $191.8 million in 2016 from $178.3 million in 2015. The acquisition expense ratio increased to 32.4 percent in 2016 from 31.3 percent in 2015. Acquisition and other expenses reported for both years included net periodic postretirement benefit income resulting from the amortization of a large prior service credit that resulted from an amendment of Employers Mutual's postretirement medical plan in the fourth quarter of 2013. This prior service credit was recognized in accumulated other comprehensive income in the fourth quarter of 2013, and is being amortized out of accumulated other comprehensive income and into net income over a period of 10 years. The increase in the 2016 ratio was primarily attributed to higher policyholder dividend expense in the property and casualty insurance segment.
The acquisition expense ratio for the reinsurance segment decreased to 24.3 percent in 2016 from 25.1 percent in 2015. The 2015 ratio reflected a $1.1 million commission adjustment for prior periods reported by a ceding company. A decrease in contingent commission expense on the offshore energy and liability proportional account contributed to the decline in the acquisition expense ratio in 2016. The 2016 ratio also reflected the reduction in the total cost of the revised inter-company reinsurance program with Employers Mutual, which reduced the acquisition expense ratio by 0.2 percentage points.
Included in other income were foreign currency exchange gains and losses recognized on the reinsurance segment’s foreign currency denominated reinsurance business. The reinsurance segment had foreign currency exchange gains of $356,000 and $898,000 in 2016 and 2015, respectively.
Income tax expense decreased 20.9 percent to $17.0 million in 2016 from $21.5 million in 2015. The effective tax rate for 2016 was 26.9 percent, compared to 30.0 percent in 2015. The primary contributors to the differences between these effective tax rates and the United States federal corporate tax rate of 35 percent were tax-exempt interest income earned, the dividends received deduction, and, in 2016, $1.5 million of investment tax credits recognized from a renewable energy tax credit investment.
Liquidity is a measure of a company’s ability to generate sufficient cash flows to meet cash obligations. The Company had positive cash flows from operations of $58.9 million in 2017, $83.4 million in 2016 and $85.6 million in 2015. The Company typically generates substantial positive cash flows from operations because cash from premium payments is generally received in advance of cash payments made to settle claims. These positive cash flows provide the foundation of the Company’s asset/liability management program and are the primary driver of the Company’s liquidity. The Company invests in high quality, liquid securities to match the anticipated payments of losses and settlement expenses of the underlying insurance policies. Because the timing of the losses is uncertain, the majority of the portfolio is maintained in short to intermediate maturity securities that can be easily liquidated or that generate adequate cash flow to meet liabilities.
At the insurance subsidiary level, the primary sources of cash are premium income, investment income and proceeds from called or matured investments. The principal outflows of cash are payments of claims, commissions, premium taxes, operating expenses, income taxes, dividends, interest and principal payments on debt, and investment purchases. Cash outflows vary because of uncertainties regarding settlement dates for unpaid losses and the potential for large losses, either individually or in the aggregate. Accordingly, the insurance subsidiaries maintain investment and reinsurance programs intended to provide adequate funds to pay claims without forced sales of investments. The insurance subsidiaries also have the ability to borrow funds on a short-term basis (180 days) from Employers Mutual under an Inter-Company Loan Agreement. In addition, Employers Mutual maintains access to a line of credit with the Federal Home Loan Bank that could be used to provide the insurance subsidiaries additional liquidity if needed.
The Company participates in reverse repurchase arrangements, involving the purchase of investment securities from third-party sellers with the agreement that the purchased securities be sold back to the third-party sellers for agreed-upon prices at specified future dates. The third-party sellers are required to pledge collateral with a value greater than the amount of cash received in the transactions. In accordance with GAAP, the investment securities purchased under the reverse repurchase agreements are not reflected in the Company's consolidated balance sheets, but instead a receivable is recorded for the principal amount lent. The Company's receivable under reverse repurchase agreements was $16.5 million and $20.0 million at December 31, 2017 and 2016, respectively.
Employers Mutual contributed $7.0 million, $9.0 million and $4.0 million to its qualified pension plan in 2017, 2016 and 2015, respectively, and plans to contribute approximately $8.0 million to the qualified pension plan in 2018. The Company reimbursed Employers Mutual $2.1 million, $2.7 million and $1.2 million for its share of the pension contributions in 2017, 2016 and 2015, respectively. Employers Mutual did not make any contributions to its postretirement benefit plans during 2017, 2016, or 2015, and does not expect to make any contributions in 2018 due to the plan amendment that was announced during 2013.
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 property and casualty insurance subsidiaries were well under this guideline at December 31, 2017.
The Company’s insurance subsidiaries are required to maintain a certain minimum level of surplus on a statutory basis, and are subject to regulations under which the payment of dividends from statutory surplus is restricted and may require prior approval of their domiciliary insurance regulatory authorities. The Company’s insurance subsidiaries are also subject to annual Risk Based Capital (RBC) requirements that may further impact their ability to pay dividends. RBC requirements attempt to measure minimum statutory capital needs based upon the risks in a company’s mix of products and investment portfolio. At December 31, 2017, the Company’s insurance subsidiaries had total adjusted statutory capital of $560.1 million, which is well in excess of the minimum risk-based capital requirement of $94.4 million.
The Company’s property and casualty insurance subsidiaries have $25.0 million of surplus notes issued to Employers Mutual. The interest rate on the surplus notes is 1.35 percent. Reviews of the interest rate are conducted by the Inter-Company Committees of the boards of directors of the Company and Employers Mutual every five years, and was recently increased to 2.73 percent effective February 1, 2018, subject to regulatory approval. Payments of interest and repayments of principal can only be made out of the applicable subsidiary’s statutory surplus and are subject to prior approval by the insurance commissioner of the respective states of domicile. The surplus notes are subordinate and junior in right of payment to all obligations or liabilities of the applicable insurance subsidiaries. Total interest expense incurred on these surplus notes was $337,000 in 2017, 2016 and 2015. At December 31, 2017, the Company’s property and casualty insurance subsidiaries had received approval for the payment of interest accrued on the surplus notes during 2017.
Employers Mutual collects from agents, policyholders and ceding companies all written premiums associated with the insurance business produced by the pool participants and the assumed reinsurance business ceded to the reinsurance subsidiary. Employers Mutual also collects from its reinsurers all losses and settlement expenses recoverable under the reinsurance contracts protecting the pool participants and, starting in 2016, the reinsurance subsidiary, as well as the fronting business ceded to the reinsurance subsidiary. Employers Mutual settles with the pool participants (monthly) and the reinsurance subsidiary (quarterly) the premiums written from these insurance policies and the paid losses and settlement expenses recoverable under the external reinsurance contracts, providing full credit for the premiums written and the paid losses and settlement expenses recoverable under the external reinsurance contracts generated during the period (not just the collected portion). Due to this arrangement, and since a significant portion of the premium balances are collected over the course of the underlying coverage periods, Employers Mutual carries a substantial receivable balance for insurance and reinsurance premiums in process of collection and, to a lesser extent, paid losses and settlement expenses recoverable from the external reinsurance companies. Any of these receivable amounts that are ultimately deemed to be uncollectible are charged-off by Employers Mutual and the expense is charged to the reinsurance subsidiary or allocated to the pool members on the basis of pool participation. As a result, the Company has off-balance sheet arrangements with an unconsolidated entity that results in credit-risk exposures (Employers Mutual’s insurance and reinsurance premium receivable balances, and paid loss and settlement expense recoverable amounts) that are not reflected in the Company’s financial statements. The average annual expense for such charge-offs allocated to the Company over the past ten years is $380,000. Based on this historical data, this credit-risk exposure is not considered to be material to the Company’s results of operations or financial position and, accordingly, no loss contingency liability has been recorded.
The Company recorded $1.1 million of “other-than-temporary” investment impairment losses during 2017, compared to $1.3 million during 2016. With the exception of a $209,000 impairment loss recorded in 2016 on a new investment that conveys renewable energy tax credits (included in other long-term investments), these impairment losses were recognized on securities held in the Company's equity portfolio.
At December 31, 2017, the Company had unrealized losses on available-for-sale securities as presented in the following table. The estimated fair value is based on quoted market prices, where available. In cases where quoted market prices are not available, fair values are based on a variety of valuation techniques depending on the type of security. None of these securities are considered to be in concentrations by either security type or industry. The Company uses several factors 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, for fixed maturity securities, the amount of collateral available. Based on these factors, the absence of management’s intent to sell these securities prior to recovery or maturity, and the fact that management does not anticipate that it will be forced to sell these securities prior to recovery or maturity, it was determined that the carrying value of these securities were not “other-than-temporarily” impaired at December 31, 2017. Risks and uncertainties inherent in the methodology utilized in this evaluation process include interest rate risk, equity price risk, and the overall performance of the economy, all of which have the potential to adversely affect the value of the Company’s investments. Should a determination be made at some point in the future that these unrealized losses are “other-than-temporary”, the Company’s earnings would be reduced by approximately $9.9 million, net of tax; however, the Company’s financial position would not be affected because unrealized losses on available-for-sale securities are reflected in the Company’s financial statements as a component of stockholders’ equity, net of deferred taxes.
Following is a schedule of the length of time securities have continuously been in an unrealized loss position as of December 31, 2017.
3 Interest expense on long-term debt reflects the interest expense on the surplus notes issued by the Company’s property and casualty insurance subsidiaries to Employers Mutual. The interest rate on the surplus notes is subject to change every five years (rate was increased to 2.73 percent effective February 1, 2018, with the next review scheduled for 2023). Interest payments on the surplus notes are subject to prior approval of the regulatory authorities of the issuing company’s state of domicile. The balance shown under the heading “More than 5 years” represents estimated interest expense for years six through ten. Since the surplus notes have no maturity date and the interest rate is subject to change every five years, interest expense could be greater than the amounts shown.
Prepayment risk refers to changes in prepayment patterns that can shorten or lengthen the expected timing of principal repayments and thus the average life and the effective yield of a security. Such risk exists within the portfolio of mortgage-backed securities. Prepayment risk is monitored regularly through the analysis of interest rate simulations. At December 31, 2017, the effective duration of the mortgage-backed securities, excluding interest-only securities, is 6.9 with an average life of 8.6 years and a yield to worst of 3.1 percent. At December 31, 2016, the effective duration of the mortgage-backed securities, excluding interest-only securities, was 4.9, with an average life of 5.9 years and a yield to worst of 2.8 percent.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the 2017 consolidated financial statements of the Company and our report dated March 5, 2018 expressed an unqualified opinion thereon.
To the Stockholders and the Board of Directors of EMC Insurance Group Inc.
We have audited the accompanying consolidated balance sheets of EMC Insurance Group Inc. and Subsidiaries (the Company) as of December 31, 2017 and 2016, 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, 2017, and the related notes and financial statement schedules listed in the Index at Item 15(a) (collectively referred to as the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company at December 31, 2017 and 2016, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2017, in conformity with U.S. generally accepted accounting principles.
The method followed in computing deferred policy acquisition costs limits the amount of such deferred costs to the estimated realizable value. In determining estimated realizable value, the computation gives effect to the premium to be earned, related investment income, anticipated losses and settlement expenses, anticipated policyholder dividends, and certain other costs expected to be incurred to administer the insurance policies as the premium is earned. The anticipated losses and settlement expenses are not discounted and are based on the Company’s projected loss and settlement expense ratios for the next twelve months, which include catastrophe loads based on historical results adjusted for recent trends. The occurrence of a significant catastrophic event, and/or the accumulation of catastrophe losses would not have a direct impact on the determination of premium deficiencies; however, such occurrences would be included in the historical results that are used to establish the catastrophe loads. A premium deficiency is first recognized by expensing the amount of unamortized deferred policy acquisition costs necessary to eliminate the deficiency. If the premium deficiency is greater than the unamortized deferred policy acquisition costs, a liability is accrued for the excess deficiency. The Company did not record a premium deficiency for the years ended December 31, 2017, 2016 or 2015.
Currently, all securities are classified as available-for-sale and are carried at fair value, with unrealized holding gains and losses reported as a component of accumulated other comprehensive income in stockholders’ equity, net of deferred income taxes. Other long-term investments consist of holdings in limited partnerships that are carried under the equity method of accounting, and holdings in limited partnerships and limited liability companies that are carried at amortized cost. The Company has an investment in a limited partnership that is designed to help protect the Company from a sudden and significant decline in the value of its equity portfolio. This limited partnership is carried under the equity method of accounting. Because of the nature of this investment, which is used solely to support the equity tail-risk hedging strategy, changes in the carrying value of the limited partnership are recorded as realized investment gains (losses), rather than as a component of investment income. Short-term investments generally include money market funds, U.S. Treasury bills and commercial paper that are carried at fair value, which approximates cost.
Premiums and discounts on fixed maturity securities are amortized over the expected life of the security as an adjustment to yield using the effective interest method. Amortization of premiums and discounts on mortgage-backed securities incorporates prepayment assumptions to estimate expected lives. Prepayment assumptions are reviewed quarterly and adjusted as necessary. Gains and losses realized on the disposition of investments are included in net income. The cost of investments sold is determined on the specific identification method using the highest cost basis first. Included in investments at December 31, 2017 and 2016 are securities on deposit with various regulatory authorities as required by law amounting to $11.3 million and $11.0 million, respectively.
The Company has a stock-based compensation plan for non-employee directors. Compensation expense under this plan is based upon grant date fair value, which is recognized as the requisite service period is rendered. The Company has no other stock-based compensation plans of its own; however, Employers Mutual has several stock plans that utilize the common stock of the Company. The Company receives the current fair value for all shares issued under Employers Mutual's plans, and a portion of the compensation expense recognized by Employers Mutual is allocated to the Company’s property and casualty insurance subsidiaries though their participation in the pooling agreement (see note 2). For granted options and restricted stock awards, the expense is based upon the grant date fair value, which is recognized as the requisite service periods are rendered. For granted restricted stock units, the expense is determined in accordance with the liability-based model, whereby Employers Mutual records a liability representing the current value of the Company's stock granted for the portion of the service period that has been rendered (both the liability and the resulting expense are allocated to the Company's property and casualty insurance subsidiaries through the pooling agreement). Excess tax benefits (deficiencies) related to non-qualified stock option activities allocated to the Company's property and casualty insurance subsidiaries through the pooling agreement are recognized through the consolidated statements of income as components of current and deferred income taxes, with the associated cash flows reflected as cash flows from operating activities. Because a portion of Employers Mutual’s stock compensation expense is reflected in the Company’s financial statements and issuances of the Company’s stock under Employers Mutual’s stock plans have an impact on the Company’s capital accounts, the disclosures required by the Compensation - Stock Compensation Topic 718 of the FASB ASC are included in the Company’s consolidated financial statements (see note 13).
Employers Mutual collects from agents, policyholders and ceding companies all written premiums associated with the insurance business produced by the pool participants and the assumed reinsurance business ceded to the reinsurance subsidiary. Employers Mutual also collects from its reinsurers all losses and settlement expenses recoverable under the reinsurance contracts protecting the pool participants and, starting in 2016, the reinsurance subsidiary (see note 2), as well as the fronting business ceded to the reinsurance subsidiary. Employers Mutual settles with the pool participants (monthly) and the reinsurance subsidiary (quarterly) the premiums written from these insurance policies and the paid losses and settlement expenses recoverable under the external reinsurance contracts, providing full credit for the premiums written and the paid losses and settlement expenses recoverable under the external reinsurance contracts generated during the period (not just the collected portion). Due to this arrangement, and since a significant portion of the premium balances are collected over the course of the underlying coverage periods, Employers Mutual carries a substantial receivable balance for insurance and reinsurance premiums in process of collection and, to a lesser extent, paid losses and settlement expenses recoverable from the external reinsurance companies. Any of these receivable amounts that are ultimately deemed to be uncollectible are charged-off by Employers Mutual and the expense is charged to the reinsurance subsidiary or allocated to the pool members on the basis of pool participation. As a result, the Company has off-balance sheet arrangements with an unconsolidated entity that results in credit-risk exposures (Employers Mutual’s insurance and reinsurance premium receivable balances, and paid loss and settlement expense recoverable amounts) that are not reflected in the Company’s financial statements. The average annual expense for such charge-offs allocated to the Company over the past ten years is $380,000. Based on this historical data, this credit-risk exposure is not considered to be material to the Company’s results of operations or financial position and, accordingly, no loss contingency liability has been recorded.
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, with the exception of the immaterial number of shares of outstanding non-vested restricted stock issued to the Company's non-employee directors, the Company had no potential common shares outstanding during 2017, 2016 or 2015 that would have been dilutive to the calculation of net income per share. The outstanding non-vested restricted stock issued to the Company's non-employee directors is not material enough to produce a diluted net income per share different from the basic net income per share; therefore, the Company does not disclose an amount for the diluted weighted average number of common shares outstanding.
In May 2014, the FASB updated its guidance related to the Revenue from Contracts with Customers Topic 606 of the ASC. The objective of this update (and other related following updates) is to improve the reporting of revenue by providing a more robust framework for addressing revenue issues, and improved disclosure requirements. Current revenue recognition guidance in U.S. GAAP is comprised of broad revenue recognition concepts together with numerous revenue requirements for particular industries or transactions, which sometimes result in different accounting for economically similar transactions. This guidance is to be applied retrospectively to annual and interim reporting periods beginning after December 15, 2017, with early adoption permitted as of the original effective date (annual and interim reporting periods beginning after December 15, 2016). The Company has adopted this guidance as of January 1, 2018. Since premium revenue from insurance contracts is excluded, the Company has only minimal revenue items that are covered by this guidance. The largest revenue item, outside of premium income, is commission income on excess and surplus lines business marketed by EMC Underwriters, LLC, which is included in "Other income" in the consolidated statements of income. Applying this new revenue recognition guidance to commission income produces no material difference compared to that recognized under current practices, as the commission income is typically recognized in full at the time the policy is issued, which is when substantially all of the performance obligation is performed. Adoption of this guidance will have no impact on the consolidated financial condition or operating results of the Company.
In January 2016, the FASB updated its guidance related to the Financial Instruments-Overall Subtopic 825-10 of the ASC. The objective of this update is to enhance the reporting model for financial instruments to provide financial statement users with more decision-useful information. The major change in reporting from this update that will impact the Company is a requirement that equity investments (excluding those accounted for under the equity method of accounting or those that are consolidated) be measured at fair value, with changes in fair value recognized in net income. While all of the Company's equity investments are already measured at fair value (with the exception of those that are consolidated and those that are accounted for under the equity method of accounting), the Company currently classifies all of its investments in equity securities as available-for-sale, and as such, the changes in fair value are currently recognized in other comprehensive income rather than net income. This guidance is to be applied to annual and interim reporting periods beginning after December 15, 2017, with recognition of a cumulative-effect adjustment to the balance sheet as of the beginning of the fiscal year of adoption. Early adoption is not permitted. The Company adopted this guidance on January 1, 2018, and reclassified $66.2 million from accumulated other comprehensive income to retained earnings which is equal to the amount of net unrealized gains on available-for-sale equity securities as of December 31, 2017, net of deferred income tax. Adoption of this guidance is expected to introduce volatility to the Company's consolidated net income.
Since 2016, the Company's property and casualty insurance subsidiaries and Employers Mutual have been parties to an inter-company reinsurance program. This reinsurance program is intended to reduce the volatility of the Company's quarterly results caused by excessive catastrophe and storm losses, and provide protection from both the frequency and severity of such losses. The reinsurance program consists of two semi-annual aggregate catastrophe excess of loss treaties. The first treaty is effective each year from January 1 through June 30, and has a retention of $20.0 million and a limit of $24.0 million. The total cost of this treaty was approximately $6.0 million in 2017. The second treaty is effective each year from July 1 through December 31, and has a retention of $15.0 million and a limit of $12.0 million. The total cost of this treaty was approximately $1.4 million in 2017. The terms of these treaties were the same in 2016 with the exception of the costs, which were $6.3 million during the first half of 2016 and $1.5 million during the second half of 2016. Losses and settlement expenses ceded to Employers Mutual under the inter-company reinsurance program totaled $19.2 million, compared to $7.5 million during 2016. All catastrophe and storm losses assumed by the property and casualty insurance subsidiaries (net of applicable reinsurance recoveries from external reinsurance protections purchased by the pool participants) are subject to the terms of these treaties, and there is no co-participation provision. In accordance with the terms of the treaties, all outstanding balances associated with the 2016 treaties were commuted at the end of 2017. In connection with that commutation, Employers Mutual paid the property and casualty insurance subsidiaries $2.8 million to settle the outstanding loss and settlement expense reserves, with no gain or loss recognized on the commutation.
In connection with the change in the inter-company reinsurance program in 2016, the reinsurance subsidiary began purchasing additional reinsurance protection in peak exposure territories from external parties in which coverage is triggered when losses experienced by the insurance industry from a catastrophic event exceed a specified threshold. Any reinsurance recoveries received from external parties reduces the amount of losses ceded to Employers Mutual under the inter-company reinsurance program. No recoveries have been made from external parties in 2017 or 2016.
Premiums earned assumed by the reinsurance subsidiary from Employers Mutual amounted to $135.7 million, $135.2 million and $129.6 million in 2017, 2016 and 2015, respectively. Losses and settlement expenses assumed by the reinsurance subsidiary from Employers Mutual amounted to $131.1 million, $90.9 million and $77.5 million in 2017, 2016 and 2015, respectively. It is customary in the reinsurance business for the assuming company to compensate the ceding company for the acquisition expenses incurred in the generation of the business. Commissions incurred by the reinsurance subsidiary under the quota share agreement with Employers Mutual amounted to $27.5 million, $27.4 million and $27.3 million in 2017, 2016 and 2015, respectively.
As of December 31, 2017 and 2016, amounts recoverable from nonaffiliated reinsurers (three in 2017 and two in 2016) totaled $22.7 million and $10.4 million respectively, which represents a significant portion of the total prepaid reinsurance premiums and reinsurance receivables for losses and settlement expenses. Included in the 2017 balance is the property and casualty insurance subsidiaries’ aggregate pool participation percentage of amounts ceded by Employers Mutual to an organization on a mandatory basis. Credit risk associated with these amounts are minimal, as all companies participating in the organization are responsible for the liabilities of the organization on a pro rata basis.
The effect of reinsurance on premiums written and earned, and losses and settlement expenses incurred, for the three years ended December 31, 2017 is presented below. The classification of the assumed and ceded reinsurance amounts between affiliates and nonaffiliates is based on the participants in the underlying reinsurance agreements, and is intended to provide an understanding of the actual source of the reinsurance activities. This presentation differs from the classifications used in the consolidated financial statements, where all amounts flowing through the pooling and quota share agreements and inter-company reinsurance programs with Employers Mutual are reported as “affiliated” balances.
“Ceded to nonaffiliates” for the property and casualty insurance subsidiaries represents their aggregate 30 percent pool participation percentage of 1) the amounts ceded to nonaffiliated reinsurance companies in accordance with the terms of the reinsurance agreements providing protection to the pool and each of its participants, and 2) the amounts ceded on a mandatory basis to state organizations in connection with various programs. For the reinsurance subsidiary, this line includes 1) reinsurance business that is ceded to other insurance companies in connection with “fronting” activities initiated by Employers Mutual, and 2) starting in 2016, amounts ceded to purchase additional reinsurance protection in peak exposure territories from external parties.
“Ceded to affiliates” for the property and casualty insurance subsidiaries represents the cession of their direct business to Employers Mutual under the terms of the pooling agreement and, beginning in 2016, amounts ceded to Employers Mutual under the terms of the inter-company reinsurance program. For the reinsurance subsidiary this line represents amounts ceded to Employers Mutual under the terms of the inter-company reinsurance program.
For the reinsurance segment, the December 31, 2017 estimate of loss and settlement expense reserves for accident years 2016 and prior decreased $3.9 million from the estimate at December 31, 2016. This decrease represents 1.9 percent of the December 31, 2016 gross carried reserves and primarily reflects favorable development in the property/casualty global pro rata and excess contracts, and the per risk excess contracts. For the property/casualty global pro rata contracts, the favorable development was related to a change in ultimate loss assumptions for several prior years due to the use of company experience in place of Reinsurance Association of America data for calculating development factors to ultimate.
During the third quarter of 2016, management implemented a new reserving methodology for the determination of direct bulk reserves in the property and casualty insurance segment. The new methodology, which is referred to as the accident year ultimate estimate approach, better conforms to industry practices and provides increased transparency of the drivers of the property and casualty insurance segment's performance. In connection with this change in reserving methodology, there was a reallocation of IBNR loss reserves and allocated settlement expense reserves from prior accident years to the current accident year in multiple lines of business. This change resulted in the movement of approximately $5.6 million of reserves from prior accident years to the current accident year that was reported as favorable development; however, this development is "mechanical in nature", and did not have an impact on earnings because the total amount of carried reserves did not change.
For the property and casualty insurance segment, the December 31, 2016 estimate of loss and settlement expense reserves for accident years 2015 and prior decreased $30.0 million from the estimate at December 31, 2015. Excluding the $5.6 million of "mechanical" favorable development that resulted from the change in reserving methodology noted above, the implied amount of favorable development that had an impact on earnings was approximately $24.4 million. This decrease represented 5.1 percent of the December 31, 2015 gross carried reserves and was primarily attributed to a significant amount of favorable reserve development experienced in the workers' compensation and other liability lines of business. The favorable development in the workers' compensation line of business was generated from a change in assumptions due to better than expected loss frequency for accident year 2015 and loss severity for the most recent accident years. The favorable development in the other liability line of business was generated from a change in assumptions due to better than expected loss severity.
For the property and casualty insurance segment, the December 31, 2015 estimate of loss and settlement expense reserves for accident years 2014 and prior decreased $13.8 million from the estimate at December 31, 2014. No changes were made in the key actuarial assumptions utilized to estimate loss and settlement expense reserves during 2015; however, the accident year allocation factors applied to IBNR loss reserves, bulk case loss reserves and the defense and cost containment portion of settlement expense reserves were revised at December 31, 2015 as part of the annual review. This change resulted in the movement of $423,000 of reserves from prior accident years to the current accident year, and hence, was reported as favorable development on prior years' reserves. Development on prior years’ reserves resulting solely from changes in the allocation of bulk reserves between the current and prior accident years is also "mechanical in nature", and does not have an impact on earnings. Excluding this $423,000 of "mechanical" favorable development, the implied amount of favorable development that had an impact on earnings was approximately $13.4 million. This decrease represented 2.9 percent of the December 31, 2014 gross carried reserves and was primarily attributed to better than expected outcomes on claims reported in prior years and favorable development on prior years' settlement expenses.
For the reinsurance segment, the December 31, 2015 estimate of loss and settlement expense reserves for accident years 2014 and prior decreased $21.3 million from the estimate at December 31, 2014. No changes were made in the key actuarial assumptions utilized to estimate loss and settlement expense reserves during 2015; however, the accident year allocation factors applied to IBNR loss reserves were revised during 2015, resulting in $1.0 million of "mechanical" adverse development. Excluding this $1.0 million of adverse development, the implied amount of favorable development that had an impact on earnings was approximately $22.3 million. This decrease represented 11.3 percent of the December 31, 2014 gross carried reserves and was attributed to several factors, including adjustments made in the offshore energy and liability proportional account, a reduction in carried IBNR loss reserves that was no longer necessary and a negative bulk IBNR loss reserve established for the MRB book of business.
At present, the pool participants are defending approximately 1,872 asbestos bodily injury lawsuits, some of which involve multiple plaintiffs. Most of the lawsuits are subject to express reservation of rights based upon the lack of an injury within the applicable policy periods, because many asbestos lawsuits do not specifically allege dates of asbestos exposure or dates of injury. The pool participants’ policyholders named as defendants in these asbestos lawsuits are typically peripheral defendants who have little or no exposure and are often dismissed from asbestos litigation with nominal or no payment (i.e., small contractors, supply companies, and a furnace manufacturer).
While the Company does not have a significant amount of exposure to asbestos claims, management has been strengthening the reserves carried for these exposures each year to the amount believed to be management's best estimate. In 2017, the settlement expense reserves for asbestos claims were strengthened by $900,000.
Statutory surplus of the Company’s insurance subsidiaries was $560.1 million and $526.8 million at December 31, 2017 and 2016, respectively. Statutory net income of the Company’s insurance subsidiaries was $30.1 million, $48.3 million and $48.8 million for 2017, 2016 and 2015, respectively.
The following table displays the premiums earned for the property and casualty insurance segment and the reinsurance segment for the three years ended December 31, 2017, by line of insurance.
The estimated fair value of the surplus notes is derived by discounting future expected cash flows at a rate deemed appropriate. The discount rate was set at the average of current yields-to-maturity on several insurance company surplus notes that are traded in observable markets, adjusted upward by 50 basis points to reflect illiquidity and perceived risk premium differences. Other assumptions include a 25-year term (the surplus notes have no stated maturity date) and an interest rate that continues at the current 1.35 percent interest rate. The rate is typically adjusted every five years (next review due in 2018) and is based upon the then-current Federal Home Loan Bank borrowing rate for 5-year funds available to Employers Mutual.
The amortized cost and estimated fair value of securities available-for-sale as of December 31, 2017 and 2016 are as follows. All securities are classified as available-for-sale and are carried at fair value.
The following tables set forth the estimated fair values and gross unrealized losses associated with investment securities that were in an unrealized loss position as of December 31, 2017 and 2016, listed by length of time the securities were consistently in an unrealized loss position.
All of the fixed maturity securities that are in an unrealized loss position are considered investment grade by credit rating agencies. Because management does not intend to sell these securities, does not believe it will be required to sell these securities before recovery, and believes it will collect the amounts due on these securities, it was determined that these securities were not “other-than-temporarily” impaired at December 31, 2017.
No individual equity security accounted for a material amount of unrealized losses. Because the Company has the ability and intent to hold these securities for a reasonable amount of time to allow for recovery, it was determined that these securities were not “other-than-temporarily” impaired at December 31, 2017.
All of the Company’s preferred stock holdings that are in an unrealized loss position are perpetual preferred stocks. The Company evaluates these perpetual preferred stocks with unrealized losses for “other-than-temporary” impairment similar to fixed maturity securities since they have debt-like characteristics such as periodic cash flows in the form of dividends and call features, are rated by rating agencies and are priced like other long-term callable fixed maturity securities. There was no evidence of any credit deterioration in the issuers of the preferred stocks and the Company does not intend to sell these securities before recovery, nor does it believe it will be required to sell these securities before recovery; therefore, it was determined that these securities were not “other-than-temporarily” impaired at December 31, 2017.
The amortized cost and estimated fair values of fixed maturity securities at December 31, 2017, by contractual maturity, are shown below. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations, with or without call or prepayment penalties.
Gains and losses realized on the disposition of investments are included in net income. The cost of investments sold is determined on the specific identification method using the highest cost basis first. The Company did not have any outstanding cumulative credit losses on fixed maturity securities that have been recognized in earnings from “other-than-temporary” impairments during any of the reported periods. The amounts reported as “other-than-temporary” impairments on equity securities do not include any individually significant items. The net realized investment losses recognized on other long-term investments primarily represent changes in the carrying value of a limited partnership that is used solely to support an equity tail-risk hedging strategy, but for 2016 also included an "other-than-temporary" impairment loss of $209,000 on an investment that conveys investment tax credits.
On December 22, 2017, the Securities Exchange Commission issued Staff Accounting Bulletin No. 118 (SAB 118), which allows a company to record a provisional amount for certain income tax effects of the TCJA that are based on reasonable estimates in circumstances in which the accounting is incomplete. Pursuant to SAB 118, the Company made reasonable estimates of the effects the TCJA had on the deferred income tax assets and liabilities. For other items where the Company could not make a reasonable estimate, primarily loss reserve discounting, the Company is using existing accounting guidance and the provisions of the tax laws that were in place prior to the enactment until further guidance is released by the Internal Revenue Service (IRS) with updated discount factors. The Company will continue to gather information to provide a more precise re-measurement of deferred income tax assets and liabilities, and expects to complete its analysis of the effects of the TCJA within a year of the enactment date.
The Company files a U.S. federal income tax return, along with various state income tax returns. The Company is no longer subject to U.S. federal and state income tax examinations by tax authorities for years before 2014.
The Company’s property and casualty insurance subsidiaries have $25.0 million of surplus notes issued to Employers Mutual at an interest rate of 1.35 percent. The Inter-Company Committees of the boards of directors of the Company and Employers Mutual approved a change in the interest rate on the surplus notes to 2.73 percent effective February 1, 2018, subject to regulatory approval. Reviews of the interest rate are conducted every five years, with the next review due in 2023. Payments of interest and repayments of principal can only be made out of the applicable subsidiary’s statutory surplus and are subject to prior approval by the insurance commissioner of the respective states of domicile. The surplus notes are subordinate and junior in right of payment to all obligations or liabilities of the applicable insurance subsidiaries. Total interest expense on these surplus notes was $337,000 in 2017, 2016 and 2015. At December 31, 2017, the Company’s property and casualty insurance subsidiaries had received approval for the payment of the 2017 interest expense on the surplus notes.
The qualified defined benefit plan covers substantially all of its employees. This plan is funded by employer contributions and provides a benefit under a cash balance formula for most employees; however, benefits are provided to a few long-term employees based on a traditional benefit formula. On December 18, 2017, Employers Mutual notified its employees that effective January 1, 2019, the benefits provided under the cash balance formula will be based on a combination of age and years of service, rather than just age. This change did not have a material impact on the pension benefit obligation. Benefits generally vest after three years of service or the attainment of 55 years of age. It is Employers Mutual’s funding policy to make contributions sufficient to be in compliance with minimum regulatory funding requirements, plus additional amounts as determined by management.
During 2018, the Company will amortize $150,000 of net actuarial loss and no prior service cost associated with the pension plans into net periodic benefit cost. In addition, the Company will amortize $260,000 of net actuarial loss and $3.2 million of prior service credit associated with the postretirement benefit plans into net periodic postretirement benefit income in 2018.
Amounts recognized in the Company’s consolidated statements of comprehensive income, before deferred income taxes:
Net periodic pension benefit cost allocated to the Company amounted to $2.8 million, $2.9 million and $1.8 million for the years ended December 31, 2017, 2016 and 2015, respectively. Net periodic postretirement benefit income allocated to the Company for the years ended December 31, 2017, 2016 and 2015 amounted to $2.9 million, $3.0 million, and $3.0 million, respectively.
See note 8 for a discussion on fair value measurement. Following is a description of the valuation techniques and inputs used for each major class of assets measured at fair value in Employers Mutual’s VEBA trust.
Life Insurance Contract: Valued at the cash surrender value, which approximates fair value.
During 2017, Employers Mutual began issuing restricted stock unit awards rather than restricted stock awards. In connection with this change, Employers Mutual will now acquire stock to fulfill its obligations to the recipients of the restricted stock unit awards on the date they vest, rather than on the grant date of the awards. Because of this change, an account Employers Mutual established to hold previously granted restricted stock awards until they vest will contain excess shares of the Company's stock stemming from forfeitures and surrenders. During 2017, the Company repurchased 67,974 shares of stock from this unvested restricted stock account at an average cost of $27.34. Like restricted stock awards, restricted stock unit awards generally have a vesting period of four years, with shares vesting in equal annual cumulative increments commencing on the first anniversary of the grant. Upon death, disability or change in control, any granted but unvested restricted stock units become fully vested and settled. Upon qualifying for "Approved Retirement" [attaining 70 points (combined age plus whole years of continuous service) with a minimum age of 55 years, or reaching age 65], restricted stock units will generally become non-forfeitable on a pro-rated basis over the 12 months following the grant date. Settlement of non-forfeitable restricted stock units is deferred until the date on which the restricted stock units otherwise vest and settle pursuant to the normal four-year vesting schedule. Holders of unvested restricted stock units do not receive compensation income equal to the amount of dividends declared on the common stock.
For restricted stock awards, the average of the high and low trading prices of the Company's common stock on the dates of grant were used to determine their fair values. The Company received in 2016 and 2015 the full fair value, as of the grant date, for all shares issued in connection with Employers Mutual's grant of restricted stock awards. At December 31, 2017, the Company’s portion of the unrecognized compensation cost associated with restricted stock awards that are not currently vested was $640,000 with a 1.56 year weighted-average period over which the compensation expense is expected to be recognized. The Company's portion of the total fair value of restricted stock awards that vested was $545,000, $414,000 and $233,000 in 2017, 2016 and 2015, respectively. A summary of restricted stock awards activity for 2017, 2016 and 2015 is as follows:
On March 14, 2013, the Company registered 300,000 shares of its common stock for issuance under the 2013 Employers Mutual Casualty Company Non-Employee Director Stock Purchase Plan. All non-employee directors of Employers Mutual and its subsidiaries and affiliates, as well as non-employee directors of the Company, are eligible to participate in the plan. Each eligible director can purchase shares of common stock at 75 percent of the fair value of the stock on the exercise date in an amount equal to a minimum of 25 percent and a maximum of 100 percent of their annual cash retainer. The plan will continue through the period of the 2023 annual meetings. The plan is administered by the Corporate Governance and Nominating Committee of the Board of Directors of Employers Mutual. The Board may amend or terminate the plan at any time; however, no such amendment or termination shall adversely affect the rights and privileges of the participants. Expenses allocated to the Company in connection with this plan totaled $65,000, $84,000 and $62,000 in 2017, 2016 and 2015, respectively.
Employers Mutual did not participate in this plan in 2017, 2016 or 2015. Activity under the plan was as follows:
The following tables display amounts reclassified out of accumulated other comprehensive income and into net income during the three years ended December 31, 2017.
During the second quarter of 2005, Employers Mutual initiated a $15.0 million stock purchase program under which Employers Mutual may purchase shares of the Company’s common stock in the open market. This purchase program does not have an expiration date; however, this program is currently dormant and will remain so while the Company’s repurchase program is in effect. 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. No purchases were made during 2017, 2016 and 2015. As of December 31, 2017, $4.5 million remained available under this plan for additional purchases.