The Inter-Company Committees of the boards of directors of the Company and Employers Mutual approved a new inter-company reinsurance program between the Company's insurance subsidiaries in the property and casualty insurance segment and Employers Mutual for calendar year 2016. This reinsurance program is intended to reduce the volatility of the Company's quarterly results caused by excessive catastrophe and storm losses, and will provide protection from both the frequency and severity of such losses. The reinsurance program for 2016 will consist of two semi-annual aggregate catastrophe excess of loss treaties. The first treaty will be effective from January 1, 2016 through June 30, 2016, and will have a retention of $20.0 million and a limit of $24.0 million. The cost of this treaty will be approximately $6.3 million. The second treaty will be effective from July 1, 2016 through December 31, 2016, and will have a retention of $15.0 million and a limit of $12.0 million. The cost of this treaty will be approximately $1.5 million. 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) will be subject to the terms of these treaties, and there is no co-participation provision.
Under the terms of the quota share agreement, the reinsurance subsidiary receives reinstatement premium income that is collected by Employers Mutual from the ceding companies when reinsurance coverage is reinstated after a loss event; however, the cap on losses assumed per event contained in the excess of loss agreement is automatically reinstated without cost.
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 continued through 2015, with premium rate increases currently in the low single digits. It is important to note that the hardening of the market that occurred during 2011, 2012 and 2013 was somewhat unusual in that it was not driven by a reduction in capital adequacy, but rather by a persistent decline in investment income and an increase in severe weather events. The outlook for 2016 is that the Company's overall premium rate level will continue to increase, but only by a few percentage points.
The majority of the Company’s investment portfolio is invested in fixed maturity securities. The prolonged low interest rate environment has had a positive impact on the Company’s financial condition because the portfolio of fixed maturity securities available-for-sale had net unrealized holding gains of $20.0 million at December 31, 2015, reflecting the fact that the average yield on the Company’s portfolio is higher than the yields currently available in the fixed maturity marketplace. However, proceeds from maturing securities and cash from operating activities are being invested at the current low yields, which has had a negative impact on investment income over the past several years. Interest rates increased approximately 10 basis points during 2015, which reduced the amount of unrealized gains on the Company's fixed maturity portfolio. If the current low interest rate environment continues, future growth in investment income will be negatively impacted.
Approximately 14.6 percent of the Company’s investment portfolio is invested in equity securities. Net unrealized investment gains on the equity portfolio totaled approximately $40.3 million at December 31, 2015, which is reflected as accumulated other comprehensive income in the Company’s financial statements and represents $1.94 per share of the Company’s December 31, 2015 book value of $25.26 per share. To help protect the Company from a sudden and significant decline in the value of its equity portfolio, management invested in a limited partnership during the first quarters of 2014 and 2015 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 implementing this hedging strategy, management was 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 invested in to implement 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 levels have improved steadily during the past four years, and 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 was able to implement high-single-digit rate level increases during 2012 and 2013, and more modest increases during 2014 and 2015. Rate levels for commercial lines of business are projected to decline on an industry-wide basis in 2016, but management currently expects the Company's overall rate level to increase in the low-single-digit range in 2016. 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, has experienced a significant increase in both claims frequency and severity in the commercial auto line of business in recent years. To address this issue, management has created a commercial auto task force charged with identifying the causes of the increase in claims, and developing solutions to improve profitability. Areas that the task force has identified for improvement include more aggressive underwriting and pricing, proper classification of risks, and a more thorough review of driver qualifications and class of business restrictions. Management will continue to monitor and scrutinize the profitability of this line of business, as the success of this initiative is of utmost importance in the increasingly competitive marketplace.
During 2015, management created a new senior level position to oversee strategic analytics. One of the key priorities for this position is to partner with the Company's 16 local branch offices to provide differentiated value to our agency partners and policyholders. This will be accomplished by the development of innovative products and services, improved claims fraud detection capabilities, prioritized claims resources, and the integration of decision science discipline into the decision making process. This increased focus on strategic analytics is expected to enhance agency relationships, provide value to the Company's policyholders by identifying cost savings opportunities, and improve overall profitability.
The property and casualty insurance segment's bulk reserves (formula IBNR loss reserve, bulk case loss reserve and settlement expense reserve) are initially established for all accident years combined, and the total is then allocated to the various accident years. During this allocation process, a portion of the total bulk reserves may be reallocated from the current accident year to prior accident years, or from prior accident years to the current accident year, to achieve the actuarial department's desired reserve level by accident year. When reserves are moved to, or from, prior accident years, the change is reported as development on prior years' reserves. However, this type of development is "mechanical" in nature, and does not have an impact on earnings because the total amount of carried reserves did not change. Management identifies, quantifies and discloses this "mechanical" development so that users of the Company's financial statements can better understand how development on prior years' reserves impacts the Company's results of operations.
In the property and casualty insurance segment, liabilities for losses are based upon case-basis estimates of reported losses supplemented with bulk case loss reserves, and estimates of IBNR losses. Case loss reserves are established independently of the IBNR loss reserves and the two amounts are added together to determine the total liability for losses. Under this methodology, adjustments to the individual case loss reserve estimates do not result in corresponding adjustments to IBNR loss reserves. An estimate of the expected expenses to be incurred in the settlement of the claims provided for in the loss reserves is established as the liability for settlement expenses.
In the reinsurance segment, Employers Mutual records the case and IBNR loss reserves reported by the ceding companies for the Home Office Reinsurance Assumed Department (“HORAD”) book of business. Since many ceding companies in the HORAD book of business do not report IBNR loss reserves, Employers Mutual establishes a bulk IBNR loss reserve, which is based on an actuarial reserve analysis, to cover a lag in reporting. For MRB, Employers Mutual records the case and IBNR loss reserves reported to it by the management of the association, along with a relatively small IBNR loss reserve to cover a one-month reporting lag. The booking of the lag IBNR loss reserve may be suspended during periods when actuarial reviews indicate MRB's carried reserves are more than adequate to cover its liabilities. To verify the adequacy of the reported reserves, an actuarial evaluation of MRB’s reserves is performed at each year-end.
Following is a summary of the carried loss and settlement expense reserves for the property and casualty insurance segment at December 31, 2015 and 2014.
The goal of the claims department is to establish and maintain case loss reserves that are sufficient, but not excessive. Since specific guidelines are utilized for establishing case loss reserves, the claims department does not incorporate a provision for uncertainty (either implicitly or explicitly) when setting individual case loss reserve estimates. Employers Mutual’s actuaries do, however, review the adequacy of the aggregate case loss reserves on a quarterly basis and, if deemed appropriate, make recommendations for adjustments to management. Management reviews all recommendations submitted by the actuaries and considers such recommendations in the determination of its best estimate of overall liability. Adjustments to the aggregate case loss reserves, when approved by management, are accomplished through the establishment of bulk case loss reserves in the applicable line(s) of business, which supplement the aggregate case loss reserves. For financial reporting purposes, bulk case loss reserves are included in case loss reserves.
At December 31, 2015, IBNR loss reserves accounted for $72.5 million, or 15.1 percent, of the property and casualty insurance segment’s total loss and settlement expense reserves, compared to $71.4 million, or 15.4 percent, at December 31, 2014. IBNR loss reserves are, by nature, less precise than case loss reserves. A five percent change in IBNR loss reserves at December 31, 2015 would equate to $2.4 million, net of tax, which represents 4.7 percent of the net income reported for 2015 and 0.4 percent of stockholders’ equity.
One assumption underlying aggregate reserve estimation methods is that the claims inflation trends implicitly built into the historical loss and settlement expense development patterns will continue into the future. To estimate the sensitivity of the estimated ultimate loss and 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, 2015 loss and settlement expense reserves to generate estimated annual incremental loss and 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 pattern, and revised incremental loss and settlement expense payments were calculated. This unexpected claims 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.
At December 31, 2015, the carried reserves for HORAD and MRB combined were in the upper quartile of the range of actuarial reserve indications. This selection reflects the fact that there are inherent uncertainties involved in establishing reserves for assumed reinsurance business. Such uncertainties include the fact that a reinsurance company generally has less knowledge than the ceding company about the underlying book of business and the ceding company’s reserving practices. Because of these uncertainties, there is a risk that the reinsurance segment’s reserves for losses and settlement expenses could prove to be inadequate, with a consequential adverse impact on the Company’s future earnings and stockholders’ equity.
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 $101.8 million and $101.8 million at December 31, 2015 and 2014, respectively, and accounted for approximately 51 percent and 51 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, 2015 would equate to $3.3 million, net of tax, which represents 6.6 percent of the net income reported for 2015 and 0.6 percent of stockholders’ equity.
Toxic tort (primarily asbestos), environmental and other uncertain exposures (property and casualty insurance segment and reinsurance segment)
Prior to 2008, actual losses paid for asbestos-related claims had been minimal due to the plaintiffs’ failure to identify an exposure to any asbestos-containing products associated with the pool participants’ current and former policyholders. However, paid losses and settlement expenses have increased significantly since 2008 as a result of claims attributed to one former policyholder. During the period 2009 through 2015, the Company's share of paid losses and settlement expenses attributed to this former policyholder, a furnace manufacturer, was $9.4 million (primarily settlement expenses). The asbestos exposure associated with this former policyholder has increased in recent years, and this trend may possibly continue into the future with increased per plaintiff settlements. Settlement expense payments associated with this former policyholder have increased significantly since 2008 and have been a driver behind recently implemented reserve increases. The primary cause of this increase in paid settlement expenses is the retention of a national coordinating counsel in 2008 due to this former policyholder’s exposure in numerous jurisdictions. The national coordinating counsel has provided, and continues to provide, significant services in the areas of document review, discovery, deposition and trial preparation. Approximately 655 asbestos exposure claims associated with this former policyholder remain open. Whenever possible, the pool participants have participated in cost sharing agreements with other insurance companies to reduce overall expenses.
During 2009, the Company completed a comprehensive policy search and coverage review, and began defending (pursuant to policies issued 1969-1975) a lawsuit filed against a municipalities’ sewerage commission in United States District Court in Wisconsin in 2008. The Company has a joint defense agreement with two other companies, but currently retains the majority share. The lawsuit is potentially one of the largest CERCLA actions pending against numerous parties in the United States and seeks in excess of $1.5 billion from the defendants. The pool participants reached a settlement with the insured and issued payment for $625,000 (the Company’s share) during 2015. The settlement has been approved by the Court. The case remains open while a final agreement is reached to conclude the pending legal expenses.
Following is a summary of loss and settlement expense reserves and payments associated with asbestos, environmental, products liability and casualty excess reinsurance exposures for 2015, 2014 and 2013:
Following is a summary of the claim activity associated with asbestos, environmental and products liability exposures for 2015, 2014 and 2013:
The Company does not determine a range of estimates for all components of the loss and settlement expense reserve at the time the reserves are established. During each quarter, however, 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, 2015 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 if the reserves were moved to the high end-point or low end-point of the ranges.
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 the reserves for losses and settlement expenses are reflected in net income in the year such changes are recorded.
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, 2015 and 2014, the Company had no securities priced solely from broker quotes.
The net periodic 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, and the rate of future compensation increases (pension plans only). Due to the conversion of the postretirement health care plan to an Employers Mutual-funded Health Reimbursement Arrangement (HRA) effective January 1, 2015, an assumption for the health care cost trend rate is no longer necessary. The assumptions used in the actuarial valuations are updated annually. Material changes in the net periodic 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 values and applicable legislation or regulations.
In accordance with GAAP, the funded status of defined benefit pension and other postretirement plans is recognized as an asset or liability on the balance sheet. Changes in the funded status of the plans are recognized through other comprehensive income.
Results of operations by segment and on a consolidated basis for the three years ended December 31, 2015 are as follows:
The following table presents the reported amounts of favorable development experienced on prior years’ reserves and the portion of the reported development amounts that resulted solely from changes in the allocation of bulk reserves between the current and prior accident years in the reinsurance segment (no impact on earnings). The result is an approximation of the implied amount of favorable development that had an impact on earnings.
The following table presents the reported amounts of favorable development experienced on prior years’ reserves and the portion of the reported development amounts that resulted solely from changes in the allocation of bulk reserves between the current and prior accident years (no impact on earnings). The result is an approximation of the implied amount of favorable development that had an impact on earnings.
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, 2015 are as follows:
Premiums earned for the property and casualty insurance segment increased 5.9 percent to $447.2 million in 2015 from $422.4 million in 2014. The increase is primarily associated with renewal business, which increased four percent during 2015 due to a combination of rate level increases and growth in insured exposures. Renewal rates across both commercial and personal lines of business increased approximately two percent during 2015, and are expected to continue to increase at low single-digit levels throughout 2016 due to competition restraints. New business premium (representing 13 percent of the pool participants’ direct written premiums) is approximately three percent higher than 2014, with an increase in commercial lines new business premium being partially offset by a decline in personal lines new business premium. Commercial lines new business continues to be in the desired range of growth, and was strongest outside of the core Midwest market. This growth helps diversify the pool participants' book of business geographically, while staying consistent with the industry and line of business mix of the existing book of business. While retention levels for personal lines of business remained stable, new business written premiums were down as management continued to focus on the development and implementation of its new personal lines strategy. During 2015, the overall policy retention rate remained strong at 86.5 percent (commercial lines at 86.7 percent and personal lines at 84.8 percent). These retention rates approximate those experienced in 2014.
Premiums earned for the reinsurance segment increased 4.0 percent to $123.1 million in 2015 from $118.3 million in 2014; however, premium adjustments made in 2015 and 2014 are impacting this percentage increase. In 2015, a negative premium adjustment of $7.2 million reported by the ceding company for the offshore energy and liability proportional account was recorded to reduce the ultimate amount of premiums expected to be earned for underwriting years 2012 through 2014. In 2014, a $7.7 million reduction in earned but not reported premiums was recognized on pro rata accounts. Without these adjustments, premiums earned would have increased approximately 3.3 percent. This growth was driven by new accounts, changes in current contract structures, a decline in terminated accounts in the HORAD book of business, and an increase in pro rata business in the MRB book of business. The premium adjustments made in 2015 and 2014 did not have a material impact on net income because corresponding adjustments were made to IBNR loss reserves, commission expense reserves and the cost of the excess of loss reinsurance protection. The negative premium adjustment recorded for the offshore energy and liability proportional account, coupled with reduced participation in this account for the 2015 contract year, resulted in a $10.3 million decline in premiums earned from this program in 2015. Competition in the reinsurance market began to increase during 2014 due to the entrance of non-traditional capital into the marketplace. This trend continued into 2015, but at a more moderate level. As a result, total premiums earned for excess of loss business was down slightly in 2015 compared to 2014. The January 1, 2016 renewal season, when approximately 70 percent of the reinsurance segment's business renews, saw continued pricing pressure similar to that experienced in 2015.
Losses and settlement expenses decreased 3.8 percent to $370.7 million in 2015 from $385.5 million in 2014, and the loss and settlement expense ratio decreased to 65.0 percent in 2015 from 71.3 percent in 2014. Both segments experienced significant improvements in their loss and settlement expense ratios during 2015, due in large part to below normal catastrophe and storm losses and an increase in favorable reserve development. The actuarial analysis of the Company’s carried reserves at December 31, 2015 indicates that the level of reserve adequacy is consistent with other recent evaluations. From management’s perspective, this measure is more relevant to an understanding of the Company’s results of operations than the composition of the underwriting results between the current and prior accident years.
The property and casualty insurance segment's loss and settlement expense ratios for 2015 and 2014 reflect $13.8 million (3.1 percent of earned premiums) and $8.1 million (1.9 percent of earned premiums), respectively, of reported favorable development on prior years' reserves; however, these amounts include $423,000 and $2.2 million, respectively, of favorable development that resulted solely from changes in the allocation of bulk reserves between the current and prior accident years, and therefore had no impact on net income. Net income is only impacted by changes in the total amount of carried reserves.
Acquisition and other expenses increased 7.8 percent to $178.3 million in 2015 from $165.4 million in 2014. The acquisition expense ratio increased to 31.3 percent in 2015 from 30.6 percent in 2014. 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. The increase in the 2015 ratio is attributed to a combination of higher technology costs, increased pension expense, and an increase in variable expenses such as contingent commissions and bonus accruals that are based on the improved underwriting results reported in 2015.
For the property and casualty insurance segment, the acquisition expense ratio increased to 32.9 percent in 2015 from 32.3 percent in 2014. The higher acquisition expense ratio in 2015 is primarily attributed to higher technology costs, increased pension expense, and an increase in the variable expense categories of contingent commissions and bonus accruals. Policyholders' dividend expense, another variable expense based on the underwriting results of some individual policies and the safety dividend groups, declined significantly and thus limited the increase in the acquisition expense ratio.
For the reinsurance segment, the acquisition expense ratio increased to 25.1 percent in 2015 from 24.3 percent in 2014. This increase is primarily attributed to higher contingent commission expense on the offshore energy and liability proportional account. Growth in pro rata business, which carries higher commission rates than excess of loss business, also contributed to the increase in the ratio.
Net investment income decreased 1.9 percent to $45.6 million in 2015 from $46.5 million in 2014. Net investment income for 2014 included approximately $442,000 that resulted from the early payoff of a commercial mortgage-backed security that was purchased at a significant discount to par value, which accelerated the accretion of the discount to par value and therefore increased investment income. Excluding this amount, net investment income declined approximately 1.0 percent. Current interest rate levels remain below the average book yield of the fixed maturity portfolio, and will therefore likely continue to limit future growth in net investment income. The average coupon rate on the fixed maturity portfolio, excluding interest-only securities, has remained relatively steady at 3.9 percent since December 31, 2014, but is down slightly from 4.0 percent at December 31, 2013. The effective duration of the fixed maturity portfolio, excluding interest-only securities, also remained steady at 4.6 at December 31, 2015 and 2014. The Company’s equity portfolio produced dividend income of $5.6 million and $6.0 million in 2015 and 2014, respectively.
Included in other income is 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 $898,000 and $2.2 million in 2015 and 2014, respectively.
Premiums earned for the property and casualty insurance segment increased 7.6 percent to $422.4 million in 2014 from $392.7 million in 2013. The increase was primarily associated with renewal business, which increased seven percent during 2014 due to a combination of rate level increases, and to a lesser extent, growth in insured exposures. Renewal rates increased approximately 4.5 percent in commercial lines of business and 3.5 percent in personal lines during 2014, though it should be noted that the level of rate increases slowed as the year progressed, and this trend was expected to continue through 2015. The pool participants did not implement broad-based rate level increases across the entire book of business, but instead implemented rate level increases based on the loss history and risk exposures associated with each renewing policy, in order to achieve a more adequate overall rate level. This approach allowed the property and casualty insurance segment to retain its core book of business, while working to improve underwriting margins. While renewal rates for personal lines of business increased, written premiums were down due to an intentional reduction in policy count to lessen exposure concentrations. During 2014, the overall policy retention rate continued to be strong at 85.9 percent (commercial lines at 86.7 percent and personal lines at 84.8 percent), which was slightly higher than the retention rate at the end of 2013. Although new business continued to account for a relatively small portion (just 14 percent) of the pool participants’ direct written premiums, the pool participants were able to capitalize on some new business opportunities outside of the core Midwest market to further diversify into areas less prone to weather-related events, while at the same time staying consistent with the industry and line of business mix of the existing book of business. New business in the Northwest, Southwest and Southeast parts of the United States grew, and was generally expected to continue to grow, at a slightly faster pace than other regions. New business premium increased six percent in the commercial lines of business (corresponding policy count was down), while personal lines new business premium was down six percent.
Effective January 1, 2013, Church Mutual became a member of the MRB underwriting association. As a result, Employers Mutual became a one-fifth participant in MRB, down from its previous one-fourth participation. In connection with Employers Mutual’s decreased participation in MRB, the reinsurance segment recorded a $585,000 portfolio adjustment decrease in premiums written in the first quarter of 2013. This portfolio adjustment did not affect earned premium since there was a corresponding decrease in unearned premiums. Nine percent of this amount ($53,000) was recorded as a reduction in the cost of the excess of loss coverage provided by Employers Mutual, and the reinsurance segment recognized $223,000 of negative commission allowance (commission income) to compensate for the acquisition costs incurred to generate the business ceded to Church Mutual.
Losses and settlement expenses increased 15.7 percent to $385.5 million in 2014 from $333.3 million in 2013, and the loss and settlement expense ratio increased to 71.3 percent in 2014 from 64.7 percent in 2013. Both segments experienced increases in their loss and settlement expense ratios during 2014, but the increase was especially large in the reinsurance segment due to increases in both loss severity and catastrophe and storm losses, and the unusually low loss and settlement expense ratio reported for 2013. The improved premium rate adequacy achieved over the past several years helped reduce the impact that the elevated level of losses would have otherwise had on the loss and settlement expense ratios. The actuarial analysis of the Company’s carried reserves at December 31, 2014 indicated that the level of reserve adequacy was consistent with other recent evaluations. From management’s perspective, this measure was more relevant to an understanding of the Company’s results of operations than the composition of underwriting results between the current and prior accident years.
The property and casualty insurance segment's loss and settlement expense ratios for 2014 and 2013 reflected $6.0 million (1.4 percent of earned premiums) and $755,000 (0.2 percent of earned premiums), respectively, of implied favorable development on prior years' reserves that had an impact on earnings (implied favorable development). The implied favorable development amounts excluded $2.2 million and $6.5 million, respectively, of favorable development included in the reported amounts of favorable development for 2014 and 2013 that resulted solely from changes in the allocation of bulk reserves between the current and prior accident years, and therefore had no impact on net income. Net income is only impacted by changes in the total amount of carried reserves.
Acquisition and other expenses decreased 3.5 percent to $165.4 million in 2014 from $171.3 million in 2013. The acquisition expense ratio decreased to 30.6 percent in 2014 from 33.2 percent in 2013. The decrease in the acquisition expense ratio was primarily attributed to large declines in the amount of net periodic pension and postretirement benefit costs allocated to the Company, as well as declines in contingent commission and policyholder dividend expenses, and an overall improvement in premium rate adequacy. Net periodic pension benefit cost declined to $680,000 in 2014, from $3.0 million in 2013. This decrease reflected an increase in the expected return on plan assets, due to an increase in plan assets, and a decline in the amount of net actuarial loss amortized into expense. Net periodic postretirement benefit cost changed significantly as a result of the plan amendment that was announced in the fourth quarter of 2013. The Company recognized net periodic postretirement benefit income of $3.1 million in 2014, compared to net periodic postretirement benefit expense of $2.9 million in 2013. The Company would be allocated approximately $1.7 million of net periodic pension benefit cost and $3.0 million of net periodic postretirement benefit income in 2015. The plan amendment created a large prior service credit that was being amortized into benefit expense over a period of 10 years. In addition, the service cost and interest cost components of the revised plan's net periodic benefit cost were significantly lower than those of the prior plan.
For the reinsurance segment, the acquisition expense ratio increased to 24.3 percent in 2014 from 23.7 percent in 2013. During the first quarter of 2013, the reinsurance segment recognized a $223,000 negative commission allowance in conjunction with the addition of Church Mutual to the MRB underwriting association. A portion of this negative commission allowance was offset by the amortization of the related deferred policy acquisition cost asset, resulting in an immediate expense reduction of approximately $105,000 during the first quarter of 2013. The total amount of commission expense reserves carried at December 31, 2014 declined in conjunction with the decline in EBNR premiums noted above, however, this did not produce any meaningful impact on the acquisition expense ratio.
The Company reported net realized investment gains of $4.3 million in 2014 compared to $9.0 million in 2013. Included in the 2014 amount was $2.8 million of realized losses attributed to the decline in the carrying value of a limited partnership that the Company invested in during the first quarter of 2014 to help protect it from a sudden and significant decline in the value of its equity portfolio (an equity tail-risk hedging strategy). Also contributing to the decline in net realized investment gains was the fact that during the fourth quarter of 2013 the Company took advantage of the outsized equity returns that occurred during the year by selling some stocks. The Company recognized "other-than-temporary" impairment losses of $878,000 and $63,000 during 2014 and 2013, respectively.
Included in other income was foreign currency exchange gains and losses recognized on the reinsurance segment’s foreign currency denominated reinsurance business. The reinsurance segment had a foreign currency exchange gain of $2.2 million in 2014 compared to a foreign currency exchange loss of $366,000 in 2013. The decline in interest expense during 2014 was due to a reduction in the interest rate on the property and casualty insurance segment's outstanding surplus notes from 3.60 percent to 1.35 percent that became effective February 1, 2013.
Income tax expense decreased 37.0 percent to $10.9 million in 2014 from $17.3 million in 2013. The effective tax rate for 2014 was 26.7 percent, compared to 28.5 percent in 2013. The primary contributor to the differences between these effective tax rates and the United States federal corporate tax rate of 35 percent was tax-exempt interest income earned.
The Company is a holding company whose principal asset is its investment in its property and casualty insurance subsidiaries and its reinsurance subsidiary (“insurance subsidiaries”). As a holding company, the Company is dependent upon cash dividends from its insurance subsidiaries to meet all its obligations, including cash dividends to stockholders and the funding of the Company’s stock repurchase programs. State insurance regulations restrict the maximum amount of dividends insurance companies can pay without prior regulatory approval. The maximum amount of dividends that the insurance subsidiaries can pay to the Company in 2016 without prior regulatory approval is approximately $49.8 million. The Company received $9.2 million, $378,000 and $10.0 million of dividends from its insurance subsidiaries and paid cash dividends to its stockholders totaling $14.2 million, $12.6 million and $11.3 million in 2015, 2014 and 2013, respectively.
The Company maintains a portion of its investment portfolio in relatively short-term and highly liquid investments to ensure the availability of funds to pay claims and expenses. A variety of maturities are maintained in the Company’s investment portfolio to assure adequate liquidity. The maturity structure of the fixed maturity portfolio is also established by the relative attractiveness of yields on short, intermediate and long-term securities. The Company does not invest in non-investment grade debt securities. Any non-investment grade securities held by the Company are the result of rating downgrades subsequent to their purchase.
The Company invests for the long term and generally purchases fixed maturity securities with the intent to hold them to maturity. Despite this intent, the Company currently classifies fixed maturity securities as available-for-sale to provide flexibility in the management of its investment portfolio. At December 31, 2015 and 2014, the Company had net unrealized holding gains, net of deferred taxes, on its fixed maturity securities available-for-sale of $20.0 million and $30.9 million, respectively. The fluctuation in the fair value of these investments is primarily due to changes in the interest rate environment during this time period, but also reflects fluctuations in risk premium spreads over U.S. Treasuries. Since the Company intends to hold fixed maturity securities to maturity, such fluctuations in the fair value of these investments are not expected to have a material impact on the operations of the Company, as forced liquidations of investments are not anticipated. The Company closely monitors the bond market and makes appropriate adjustments in its portfolio as conditions warrant.
During 2015, the Company began participating in a reverse repurchase arrangement, 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 $16.9 million at December 31, 2015.
The Company’s cash balance was $224,000 and $383,000 at December 31, 2015 and 2014, respectively.
Employers Mutual contributed $4.0 million, $7.0 million and $14.0 million to its qualified pension plan in 2015, 2014 and 2013, respectively, and plans to contribute approximately $8.2 million to the qualified pension plan in 2016. The Company reimbursed Employers Mutual $1.2 million, $2.2 million and $4.3 million for its share of the pension contributions in 2015, 2014 and 2013, respectively. Employers Mutual contributed $500,000 to its postretirement benefit plans in 2013, but did not make any contributions during 2015 or 2014, and does not expect to make any contributions in 2016 due to the plan amendment that was announced during 2013. The Company reimbursed Employers Mutual $144,000 for its share of the postretirement benefit plan contribution in 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, 2015.
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, 2015, the Company’s insurance subsidiaries had total adjusted statutory capital of $485.2 million, which is well in excess of the minimum risk-based capital requirement of $77.4 million.
The amortized cost and estimated fair value of fixed maturity and equity securities at December 31, 2015 were as follows:
As of December 31, 2015, the Company had no material commitments for capital expenditures.
At December 31, 2015, 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, 2015. 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 $9.3 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.
The Company does not purchase non-investment grade fixed maturity securities. Any non-investment grade fixed maturity securities held are the result of rating downgrades that occurred subsequent to their purchase. At December 31, 2015, the Company held $3.2 million of non-investment grade fixed maturity securities in a net unrealized gain position of $72,000.
The following table reflects the Company's contractual obligations as of December 31, 2015. Included in the table are the estimated payments that the Company expects to make in the settlement of its loss and settlement expense reserves and with respect to its long-term debt. One of the Company’s property and casualty insurance subsidiaries leases office facilities in Bismarck, North Dakota with lease terms expiring in 2024. Employers Mutual has entered into various leases for branch and service office facilities with lease terms expiring through 2025. All of these lease costs are included as expenses under the pooling agreement. Included in the following table is the Company's current 30.0 percent aggregate participation percentage of all operating lease obligations of the parties to the pooling agreement.
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 those states. Many states allow assessments to be recovered through premium tax offsets. The Company has accrued estimated guaranty fund assessments of $912,000 and $931,000 as of December 31, 2015 and 2014, respectively. Premium tax offsets of $1.1 million and $969,000, which are related to prior guarantee fund payments and current assessments, have been accrued as of December 31, 2015 and 2014, 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 workers with pre-existing disabilities. The Company had accrued estimated second-injury fund assessments of $1.9 million and $1.7 million as of December 31, 2015 and 2014, 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.
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, 2015.
We have audited the accompanying consolidated balance sheets of EMC Insurance Group Inc. and Subsidiaries (the Company) as of December 31, 2015 and 2014, 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, 2015. 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.
We also have audited, in accordance with standards of the Public Company Accounting Oversight Board (United States), EMC Insurance Group Inc. and Subsidiaries’ internal control over financial reporting as of December 31, 2015, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) and our report dated March 8, 2016 expressed an unqualified opinion thereon.
Costs related to the acquisition of insurance contracts are deferred and amortized to expense as the associated premium revenue is recognized. Only incremental costs or costs directly related to the successful acquisition of new or renewal insurance contracts are to be capitalized. Accordingly, acquisition costs consist of commissions, premium taxes, and salary and benefit expenses of employees directly involved in the underwriting of insurance policies that are successfully issued.
Liabilities for losses reflect losses incurred through the balance sheet date and are based upon case-basis estimates of reported losses supplemented with bulk case loss reserves, estimates of unreported losses based upon prior experience adjusted for current trends, and estimates of losses expected to be paid under assumed reinsurance contracts. Liabilities for settlement expenses are provided by estimating expenses expected to be incurred in settling the claims provided for in the loss reserves. Changes in reserves estimates are reflected in net income in the year such changes are recorded (see note 4).
During 2015, the Company began participating in a reverse repurchase arrangement, 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. Net proceeds/disbursements related to the reverse repurchase transactions are reported as a component of investing activities in the consolidated statements of cash flows, and the income as a component of operating activities.
Premiums and discounts on fixed maturity securities are amortized over the 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. 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, 2015 and 2014 are securities on deposit with various regulatory authorities as required by law amounting to $11.2 million and $11.7 million, respectively.
During 2015, the Company early adopted the updated accounting guidance issued by the Financial Accounting Standards Board (FASB) in Accounting Standards Update (ASU) 2015-07 related to the Fair Value Measurement Topic 820 of the Accounting Standards Codification™ (Codification or ASC). This new accounting guidance allowed the Company to continue to avail itself of a practical expedient to measure the pooled separate account investments in Employers Mutual's qualified pension plan at the net asset value per share, but removed the requirement to categorize these investments within the fair value hierarchy.
Goodwill represents the excess of cost over the fair value of net assets of acquired subsidiaries. Goodwill is not amortized, but is subject to impairment if the carrying value of the goodwill exceeds the estimated fair value of net assets. If the carrying amount of the subsidiary (including goodwill) exceeds the computed fair value, an impairment loss is recognized through the income statement equal to the excess amount, but not greater than the balance of the goodwill. Goodwill was not deemed to be impaired in 2015, 2014 or 2013.
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 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 will adopt this guidance during the first quarter of 2018. Since premium revenue from insurance contracts is excluded from the scope of this updated guidance, adoption is expected to have little or no impact on the consolidated financial condition or operating results of the Company. The Company's largest non-premium revenue items are service charges related to the billing of the pool participants' direct written premiums to policyholders, and commission income on excess and surplus lines business marketed by EMC Underwriters, LLC, both of which are included in "Other income" in the consolidated statements of income.
In February 2016, the FASB issued updated guidance in Leases Topic 842 of the ASC, which supersedes the guidance in Leases Topic 840 of the ASC. The objective of this update is to increase transparency and comparability among organizations by requiring recognition of lease assets and lease liabilities on the balance sheet, and disclosure of key information about leasing arrangements. This guidance is effective for interim and annual periods beginning after December 15, 2018, and is to be applied using a modified retrospective approach. Early adoption is permitted. The Company will adopt this guidance during the first quarter of 2019. The Company is currently evaluating the impact this guidance will have on the Company's consolidated financial condition and operating results.
The purpose of the pooling agreement is to spread the risk of an exposure insured by any of the pool participants among all the companies. The pooling agreement produces a more uniform and stable underwriting result from year to year for all companies in the pool than might be experienced individually. In addition, each company benefits from the capacity of the entire pool, rather than being limited to policy exposures of a size commensurate with its own surplus, and from the wide range of policy forms, lines of insurance written, rate filings and commission plans offered by each of the companies.
The Company’s reinsurance subsidiary is party to a quota share agreement and an excess of loss agreement with Employers Mutual. Under the terms of the quota share agreement, the reinsurance subsidiary assumes 100 percent of Employers Mutual’s assumed reinsurance business, subject to certain exceptions. Under the terms of the excess of loss agreement (covering both business assumed from Employers Mutual through the quota share agreement, as well as business obtained outside the quota share agreement), the reinsurance subsidiary retains the first $4.0 million of losses per event, and also retains 20.0 percent of any losses between $4.0 million and $10.0 million and 10.0 percent of any losses between $10.0 million and $50.0 million. The cost of the excess of loss reinsurance protection, which includes reimbursement for the cost of reinsurance protection purchased by Employers Mutual to protect itself from the assumption of excessive losses in the event of a major catastrophe, is 8.0 percent (9.0 percent in 2013) of the reinsurance subsidiary’s total assumed reinsurance premiums written.
The reinsurance subsidiary does not directly reinsure any of the insurance business written by Employers Mutual or the other pool participants; however, Employers Mutual assumes reinsurance business from the Mutual Reinsurance Bureau underwriting association (MRB), which provides a small amount of reinsurance protection to the members of the EMC Insurance Companies pooling agreement. 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 MRB are applied. In addition, the reinsurance subsidiary does not reinsure any “involuntary” facility or pool business that Employers Mutual assumes pursuant to state law. The reinsurance subsidiary assumes all foreign currency exchange gain/loss associated with contracts incepting on January 1, 2006 and thereafter that are subject to the quota share agreement. Operations of the quota share and excess of loss agreements give rise to inter-company balances with Employers Mutual, which are generally settled during the month following the end of each quarter. The investment and income tax activities of the reinsurance subsidiary are not subject to the quota share agreement.
Under the terms of the quota share agreement, the reinsurance subsidiary receives reinstatement premium income that is collected by Employers Mutual from the ceding companies when reinsurance coverage is reinstated after a loss event; however, the cap on losses assumed per event contained in the excess of loss agreement is automatically reinstated without cost. The reinsurance subsidiary recognized $1.8 million, $2.3 million and $2.5 million of reinstatement premium in 2015, 2014 and 2013, respectively.
Investment expenses are based on actual expenses incurred by the Company plus an allocation of other investment expenses incurred by Employers Mutual, which is based on a weighted-average of total invested assets and number of investment transactions. Investment expenses allocated to the Company by Employers Mutual amounted to $1.4 million, $1.3 million and $1.6 million in 2015, 2014 and 2013, respectively.
As of December 31, 2015 and 2014, amounts recoverable from nonaffiliated reinsurers (three each in 2015 and 2014) totaled $12.7 million and $16.3 million respectively, which represents a significant portion of the total prepaid reinsurance premiums and reinsurance receivables for losses and settlement expenses. Included in these balances are amounts due from the MRB underwriting association, of which the Company (through Employers Mutual) is a member with other unaffiliated reinsurers. All members of MRB have joint and several liability for MRB's obligations. Also included in these balances is the property and casualty insurance subsidiaries’ aggregate pool participation percentage of amounts ceded by Employers Mutual to organizations on a mandatory basis. Credit risk associated with these amounts are minimal, as all companies participating in the organizations are responsible for the liabilities of the organizations on a pro rata basis.
“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 reinsurance business that is ceded to other insurance companies in connection with “fronting” activities initiated by Employers Mutual.
Development on prior years’ reserves resulting solely from changes in the allocation of bulk reserves between the current and prior accident years does not have an impact on earnings. This is due to the fact that such development is simply a mathematical by-product of the mechanical process used to reallocate bulk reserves to the various accident years. Earnings are only impacted by changes in the total amount of carried reserves.
The following table presents the reported amounts of favorable development experienced on prior years’ reserves and the portion of the reported development amounts that resulted solely from changes in the allocation of bulk reserves between the current and prior accident years (no impact on earnings). The result is an approximation of the implied amounts of favorable development that had an impact on earnings.
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. This decrease represents 3.0 percent of the December 31, 2014 gross carried reserves and is primarily attributed to better than expected outcomes on claims reported in prior years and favorable development on prior years' settlement expenses. 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 does not have an impact on earnings.
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. This decrease represents 10.8 percent of the December 31, 2014 gross carried reserves and is attributable to several factors, including adjustments made in the offshore energy and liability proportional account, a reduction in carried IBNR loss reserves that could no longer be justified and a negative bulk IBNR loss reserve established for the MRB book of business. 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. This change resulted in the movement of $1.0 million of reserves from the current accident year to prior accident years, and hence, was reported as adverse 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 does not have an impact on earnings.
For the property and casualty insurance segment, the December 31, 2014 estimate of loss and settlement expense reserves for accident years 2013 and prior decreased $8.1 million from the estimate at December 31, 2013. This decrease represented 1.9 percent of the December 31, 2013 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 expense reserves. No changes were made in the key actuarial assumptions utilized to estimate loss and settlement expense reserves during 2014; 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, 2014 as part of the annual review. This change resulted in the movement of $2.2 million 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 does not have an impact on earnings.
For the property and casualty insurance segment, the December 31, 2013 estimate of loss and settlement expense reserves for accident years 2012 and prior decreased $7.3 million from the estimate at December 31, 2012. This decrease represented 1.8 percent of the December 31, 2012 gross carried reserves and was primarily attributed to favorable development on settlement expense reserves and ceded reinsurance reserves. No changes were made in the key actuarial assumptions utilized to estimate loss and settlement expense reserves during 2013; 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, 2013 as part of the annual review. This change resulted in the movement of $6.5 million of reserves from the 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 does not have an impact on earnings.
For the reinsurance segment, the December 31, 2013 estimate of loss and settlement expense reserves for accident years 2012 and prior decreased $5.5 million from the estimate at December 31, 2012. This decrease represented 3.2 percent of the December 31, 2012 gross carried reserves and was largely attributed to reported losses that were below the December 2012 implicit projections for policy year 2012 in the Home Office Reinsurance Assumed Department ("HORAD") book of business.
The Company has exposure to asbestos and environmental related claims associated with the insurance business written by the parties to the pooling agreement and the reinsurance business assumed from Employers Mutual by the reinsurance subsidiary. These exposures are not considered to be significant. Asbestos and environmental losses paid by the Company have averaged $1.8 million per year over the past five years. Reserves for asbestos and environmental related claims for direct insurance and assumed reinsurance business totaled $11.5 million and $9.4 million ($11.2 million and $9.3 million net of reinsurance) at December 31, 2015 and 2014, respectively.
While the Company does not have a significant amount of exposure to asbestos claims, management has been proactive in strengthening the reserves carried for these exposures when deemed necessary. In 2015, the loss and settlement expense reserves for asbestos claims were strengthened approximately $4.1 million.
The Company’s operations consist of a property and casualty insurance segment and a reinsurance segment. The property and casualty insurance segment writes both commercial and personal lines of insurance, with a focus on medium-sized commercial accounts. The reinsurance segment provides reinsurance for other insurers and reinsurers. The segments are managed separately due to differences in the insurance products sold and the business environments in which they operate. The accounting policies of the segments are described in note 1, Summary of Significant Accounting Policies.
The carrying amount and the estimated fair value of the Company’s financial instruments is summarized below.
Presented in the tables below are the estimated fair values of the Company’s financial instruments as of December 31, 2015 and 2014.
There were no transfers into or out of Levels 1 or 2 during 2015 or 2014. It is the Company’s policy to recognize transfers between levels at the beginning of the reporting period.
The amortized cost and estimated fair value of securities available-for-sale as of December 31, 2015 and 2014 are as follows. All securities are classified as available-for-sale and are carried at fair value.
Unrealized losses on fixed maturity securities increased during 2015 due to an increase in interest rates. Most of these securities 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, 2015.
The Company had no provision for uncertain income tax positions at December 31, 2015 or 2014. The Company recognized $1,000 of interest income related to U.S. federal income taxes during 2014. The Company did not recognize any interest expense or other penalties related to U.S. federal or state income taxes during 2015, 2014 or 2013. It is the Company’s accounting policy to reflect income tax penalties as other expense, and interest as interest expense.
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 2012.
The Company’s property and casualty insurance subsidiaries have $25.0 million of surplus notes issued to Employers Mutual. Effective February 1, 2013, the interest rate on the surplus notes was reduced to 1.35 percent from the previous rate of 3.60 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, with the next review due in 2018. 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 2015, $337,000 in 2014 and $384,000 in 2013. At December 31, 2015, the Company’s property and casualty insurance subsidiaries had received approval for the payment of the 2015 interest expense on the surplus notes.
Employers Mutual also offers postretirement benefit plans which provide certain health care and life insurance benefits for retired employees. Substantially all of its employees may become eligible for those benefits if they reach normal retirement age and have attained the required length of service while working for Employers Mutual. Through 2014, the health care postretirement plan required contributions from participants and contained certain cost sharing provisions such as coinsurance and deductibles. Effective January 1, 2015, the health care plan was replaced with a new Employers Mutual - funded Health Reimbursement Arrangement (HRA). Under the HRA, Employers Mutual reimburses participants, up to a pre-determined maximum, for amounts expended to enroll in publicly available health care plans and/or pay for qualifying out-of-pocket health care costs. The obligations of the HRA are based on the total amount of reimbursements expected to be made by Employers Mutual over the lives of the participants, rather than the total amount of medical benefits expected to be paid over the participants’ lives. Therefore, the obligations of the HRA are not impacted by changes in the cost of health care. The life insurance plan is noncontributory. The benefits provided under both plans are subject to change.
Employers Mutual maintains a Voluntary Employee Beneficiary Association (VEBA) trust that has historically been used to accumulate funds for the payment of postretirement health care and life insurance benefits. Contributions to the VEBA trust have been used to fund the projected postretirement benefit obligation, as well as pay benefits. Given the overfunded position of the postretirement benefit plans, contributions to the VEBA trust are not anticipated for the foreseeable future.
The following tables set forth the amounts recognized in the Company’s financial statements as a result of the property and casualty insurance subsidiaries’ aggregate 30 percent participation in the pooling agreement and amounts allocated to the reinsurance subsidiary as of December 31, 2015 and 2014:
During 2016, the Company will amortize $1.3 million of net actuarial loss and $10,000 of prior service cost associated with the pension plans into net periodic benefit cost. In addition, the Company will amortize $422,000 of net actuarial loss and $3.3 million of prior service credit associated with the postretirement benefit plans into net periodic postretirement benefit income in 2016.
Net periodic pension benefit cost allocated to the Company amounted to $1.8 million, $680,000 and $3.0 million in 2015, 2014 and 2013, respectively. Net periodic postretirement benefit cost (income) allocated to the Company for the years ended December 31, 2015, 2014 and 2013 amounted to $(3.0) million, $(3.1) million, and $2.9 million, respectively.
The Company manages its VEBA trust assets internally. Assets contained in the VEBA trust to fund Employers Mutual’s postretirement benefit obligations are currently invested in universal life insurance policies (issued by EMC National Life Company, an affiliate of Employers Mutual), mutual funds and an exchange-traded fund (ETF). The mutual funds are fixed income, international equity and domestic equity funds. The ETF is an emerging markets fund.
Pooled Separate Accounts: Each of the funds held by the Plan is in a pooled or commingled investment vehicle that is maintained by the fund sponsor, each with many investors. The Plan asset is represented by a “unit of account” and a per unit value, whose value is the accumulated value of the underlying investments less liabilities. The sponsor of the fund specifies the source(s) used for the underlying investment asset prices and the protocol used to value each fund. There are no redemption restrictions on these investments. The investments selected for the Plan represent a well diversified portfolio of assets, including fixed income securities, equity investments, and real estate investment trusts. The portfolio seeks to maximize investment returns while maintaining an appropriate level of risk. These underlying investments are valued in the following ways.
The Company has no stock-based compensation plans of its own; however, Employers Mutual has several stock plans which utilize the common stock of the Company. Employers Mutual can provide the common stock required under its plans by: 1) using shares of common stock that it currently owns; 2) purchasing common stock in the open market; or 3) directly purchasing common stock from the Company at the current fair value. Employers Mutual has historically purchased common stock from the Company for use in its stock plans and its non-employee director stock plans. During 2014, Employers Mutual also began purchasing common stock from the Company to fulfill its obligations under its employee stock purchase plan (previously the shares needed for this were purchased in the open market).
Employers Mutual currently maintains two separate stock plans for the benefit of officers and key employees of Employers Mutual and its subsidiaries. A total of 2,250,000 shares of the Company’s common stock have been reserved for issuance under the 2003 Employers Mutual Casualty Company Incentive Stock Option Plan (2003 Plan) and a total of 3,000,000 shares have been reserved for issuance under the 2007 Employers Mutual Casualty Company Stock Incentive Plan (2007 Plan).
At December 31, 2015, the Company’s portion of the unrecognized compensation cost associated with option awards issued under Employers Mutual’s stock plans that are not currently vested was $71,000, with a 0.82 year weighted-average period over which the compensation expense is expected to be recognized.
Employers Mutual uses the average of the high and low trading prices of the Company's stock on the date of grant to determine the fair value of its restricted stock awards. At December 31, 2015, the Company’s portion of the unrecognized compensation cost associated with restricted stock awards issued under Employers Mutual’s stock plans that are not currently vested was $983,000, with a 2.52 year weighted-average period over which the compensation expense is expected to be recognized. A summary of non-vested restricted stock activity under Employers Mutual’s stock plans for 2015, 2014 and 2013 is as follows:
During 2015, shares were purchased under the plan at prices ranging from $18.75 to $21.40. Activity under the plan was as follows:
On March 14, 2013, the Company registered 300,000 shares of the Company’s 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 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. The 2003 Employers Mutual Casualty Company Non-Employee Director Stock Option Plan is no longer active. All outstanding options granted under this plan expired in May, 2013, and no further options can be granted due to the expiration of the term of the plan. On April 26, 2013, a total of 222,306 shares reserved for issuance under the 2003 Employers Mutual Casualty Company Non-Employee Director Stock Option Plan were deregistered. Expenses allocated to the Company in connection with this plan totaled $62,000, $49,000 and $36,000 in 2015, 2014 and 2013, respectively.
During 2015, shares were purchased under the plan at prices ranging from $15.51 to $18.26. Activity under the plan was as follows:
Effective March 14, 2012, the Company’s Board of Directors temporarily suspended the issuance of shares of common stock under the Plan. The temporary suspension of the issuance of shares of common stock under the Plan was due to a late filing of an amendment to a Current Report on Form 8-K. On March 29, 2013, the Company filed a Form S-3 Registration Statement with the Securities and Exchange Commission registering 991,778 shares of common stock for use in the Plan, which was reinstated for the third quarter dividend payment.
Employers Mutual did not participate in this plan in 2015, 2014 or 2013. Activity under the plan was as follows:
On October 19, 2006, Employers Mutual entered into a stock appreciation rights (SAR) agreement with the Company’s Executive Vice President and Chief Operating Officer (Mr. Murray) at that time. Because the SAR agreement will be settled in cash, it is considered to be a liability-classified award under ASC Topic 718. As a result, the value of this agreement must be re-measured at fair value at each financial statement reporting date, subject to a minimum fair value stipulated in the SAR agreement. The full value of this agreement was expensed in 2006 because Mr. Murray was eligible for retirement and was entitled to keep the award at retirement, and as a result, the award did not have any subsequent service requirements. Subsequent changes in the fair value of this agreement are reflected as compensation expense, until the agreement is ultimately settled in 2016. Expenses allocated to the Company during 2015 and 2014 associated with this award totaled $(7,000) and $15,000, respectively. The Company recognized no compensation expense related to this award during 2013 because the fair value of the award did not exceed the floor amount in the agreement.
The Company has available-for-sale securities and receives an allocation of the actuarial losses and net prior service credits associated with Employers Mutual’s pension and postretirement benefit plans, both of which generate accumulated other comprehensive income (loss) amounts. The following table reconciles, by component, the beginning and ending balances of accumulated other comprehensive income, net of tax.
The following tables display amounts reclassified out of accumulated other comprehensive income and into net income during the three years ended December 31, 2015.
These reclassified components of accumulated other comprehensive income are included in the computation of net periodic pension and postretirement benefit cost (income) (see Note 12, Employee Retirement Plans, for additional details).
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 those states. Many states allow assessments to be recovered through premium tax offsets. The Company has accrued estimated guaranty fund assessments of $912,000 and $931,000 as of December 31, 2015 and 2014, respectively. Premium tax offsets of $1.1 million and $969,000, which are related to prior guarantee fund payments and current assessments, have been accrued as of December 31, 2015 and 2014, 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 workers with pre-existing disabilities. The Company has accrued estimated second-injury fund assessments of $1.9 million and $1.7 million as of December 31, 2015 and 2014, 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.